SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

Author : Dr. Dhanesh Khatri

Copyright Macmillan Publishers India Ltd.

CHAPTER 13

TECHNICAL ANALYSIS

Copyright Macmillan Publishers India Ltd.

Technical Analysis
Technical analysis means analysis of share prices and traded volume to predict the near future price movement. It is 90 per cent psychological and 10 per cent logical. Market is driven by the psychology of investors in 90 per cent of the times and for 10 per cent of the times logical factors affect the market.

Technical Analysis (Cont.)

Premises of technical analysis Every kind of price-sensitive information is discounted into prices. Prices follow a particular path continuously.
Type of charts Line Chart Bar Chart Point & Figure Chart Candle Chart

Use of Technical Analysis

To Predict Overall Market Trends To Predict for Individual Shares Trends To predict overall market trends Prediction about the overall market is based on the movement of an index representing the trend of market.

Features of Index Constituents

Minimum impact cost
High value representation in market capitalization Large number of trades per day Large traded volume per day

Tools for analysis of overall market trends

Dow Jones Theory Advance Decline Index Client Account Position

DOW JONES THEORY

Developed by Charles Dow Jones He was of the opinion that movement in share prices is always supported by a definite activity business trends, overall business transaction, fundamental factors affecting the shares, etc. He created two averages (indices):
Dow Jones Industrial Average (DJIA) Dow Jones Transport Average (DJTA)

DOW JONES THEORY

With the help of movement of both of these averages following signals can be generated: Buying signal Selling signal Signal of indifference
Trends According to Dow Jones Theory

Uptrend Downtrend Horizontal Trend

UPTREND
Uptrend is formed when the subsequent peak and subsequent trough get formed at a higher price level, as compared to price level of previous peak and trough.
Peaks Peaks PRICE Peaks Trough Trough Peaks Trough

Trough

DATE

DOWNTREND
Downtrend is formed when both subsequent peak and subsequent trough get formed at a lower price level as compared to the price level of previous peak and trough respectively.
Peaks Trough

PRICE

Peaks Peaks Trough

Trough

DATE

Horizontal Trend
Identified when every peak is almost at the same level as the previous level of peak, and troughs are formed in a similar pattern.
Peaks Peaks Peaks Peaks

PRICE

Trough

Trough

Trough

Trough

DATE

Advance Decline Index

Advance decline index is the difference between the number of shares showing an advance and the number of shares showing a decline on a particular trading day. Signals about the market
If price index and advance decline index are rising, it indicates continuation of upward trend in the market If price index and advance decline index are falling, it indicates continuation of down trend in the market If price index is rising but advance decline index is falling, or vice-versa, it indicates divergence in the price trend in the near future

Client Account Position

As per the requirements of market regulator, every broker is required to maintain a separate bank account for keeping client money The balance position of this account can be used to indicate expected market movement.

Tools to Predict for Individual Shares Trends

Moving Average Analysis

Oscillators

Chart Patterns

MACD

ROS

RSI

Moving Average Analysis

Moving average is simply the rolling average of past prices.
Following signals can be generated:
Buying Signals Selling Signals

Oscillators
Oscillators are fine tools to predict future movements much before such movement takes place; these leave a sufficient time gap to take decisions. Prominent oscillators are as follows: MACD (Moving Average Convergence & Divergence) ROC (Rate of Change) RSI (Relative Strength Index)

MACD
MACD is the difference between short-term moving average and long-term moving average. MACD = Short Period Moving Average Long Period Moving Average Buying signals: Whenever, MACD line is above the moving average line of MACD; MACD line moves towards the average line and thereafter moves towards upside. It is a buying signal. Selling signals: Whenever MACD line is below the line of moving average. At this point MACD moves towards average line but fails to break through it, instead starts moving towards downside; it is a sell signal.

ROC
In calculating ROC, the current days market price is divided by the price that had prevailed few days ago for the share. ROC is an indicator, which helps in identifying over brought and over sold market. Buying signals: When ROC is more than one (ROC >1) and moving upward continuously, it indicates that market is likely to move upward. Selling signals: When ROC line is increasing but the pace has declined, it indicates that market is about to reach the over-bought zone, after which it is likely to decline.

ROC Continued
Selling Signal : When ROC line is declining towards 1 or below 1 it is sell signal.
Buying Signal : When ROC is below 1 and declining but the pace of decline has slowed sown then it indicates that the market for the share is about to reach oversold zone there after prices are likely to rise very soon.

RSI
Under RSI, gains and losses of the prices over the immediate previous days price for a certain period is calculated.

RSI
Buying signals: When RSI is more than 50 and moving upward continuously, it indicates that the market is likely to move upward.
Selling signals: When RSI line is increasing above the 50 mark but the pace of increase has declined, it indicates that market is about to reach the over bought zone, after which, it is likely to decline. One should take precaution at this level; or a risk averse investor should wait for more clear signals.

RSI Continued
Over Bought Zone : When RSI is at 70 or above level it indicates over bought market which is likely to take a downward turn. Over Sold zone : When RSI is at 30 or below level it indicates over sold market which is likely to take a upward turn.

Chart Patterns
These patterns are used to generate signals about the expected movement of the market These chart patterns can be generated for the index value as well for the prices of individual shares These help in identifying the following:
Support Level is the lower price level at which demand for the shares gains momentum. Resistance Level is the upper price level at which supply for the shares gains momentum.

Support & Resistance in Upward Moving Market

Support & Resistance in Downward Moving Market

Support & Resistance in Horizontal Trend

Type of Chart Patterns

Head and Shoulders
Inverse Head and Shoulders Triangle

Flag

Head & shoulders

Head & Shoulders reflects resistance and support level in an upward-moving market.

Inverse Head & Shoulders

Inverse Head & Shoulders reflects resistance and support level in downward-moving market.

Triangles
Triangles are the price patterns, which show the movement of shifting resistance and support level.

Upward Moving Triangle

Download Moving Triangle

Horizontal Moving Triangle

Flag
A flag is identified as a narrow movement of the market either after an up trend or a down trend.

Flag

Inverted Flag

Confirmation through Traded Volume

Buying and selling signals generated with the help of different tools like Dow Jones Theory, Moving Average, Oscillators MACD, ROC, RSI, and Chart Patterns need to be confirmed with the help of traded volumes. A thin traded volume simply indicates lack of support in the indicated trend by majority of the investors A heavy traded volume, indicates about association of more and more investors for the indicated trend