TECHNICAL ANALYSIS

1. TECHNICAL ANALYSIS

2. PRICE PATTERNS

3. A typical price cycle has three trends: up, sideways, and down. • The sideways trend is essentially a horizontal or transitional one which separates the two major market movements. • Sometimes a highly emotional market can change without warning but this rarely happens.

4. The Rectangle • The transitional or horizontal phase separating rising and falling price trends is a pattern known as a rectangle. • The rectangle marking the turning point between the bull and bear phases is termed as a reversal pattern. • Reversal patterns at market tops are known as distribution patterns and those at market bottoms are called accumulation patterns.

6. Resistance and Support levels • Line AA is technically termed as a resistance area because at this point the index shows opposition to a further price rise. • When the demand/supply relationship comes into balance at AA, the market quickly turns in favour of the sellers because prices react. • This temporary reversal may occur because buyers refuse to pay more for a security or because the higher price attracts more sellers or for both these reasons.

7. Resistance and Support levels • Following the unsuccessful assault on AA, the prices turn down until line BB, known as support level. • At line BB, prices become attractive for buyers who missed the boat on the way up, while sellers who feel that the price will again reach AA hold off.

8. WHIPSAWS • So far, it has been assumed that any move, however small, out of a rectangle constitutes a valid signal of a trend reversal or resumption. • Sometimes, the moves out of rectangle may be misleading. These misleading moves are known as whipsaws. • It is helpful to establish certain criteria to minimise the possibility of misinterpretation. • Conventional wisdom holds that you should wait for a 3 percent penetration of the boundaries before concluding that the breakout is valid.

9. VOLUME • During bull markets, volume increases with price rise and declines with price declines and vice-versa in bear markets. • Also, volume generally falls in advance of major declines in the market index and rises sharply during market bottoms.

11. HEAD & SHOULDERS PATTERNS • H&S is probably the most reliable of all chart patterns. • It occurs at both market tops and market bottoms. • It consists of two shoulders, a head and a neckline. • Volume characteristics are of critical importance in assessing the validity of these patterns. • Activity is normally heaviest during the formation of left shoulder and also tends to be quite heavy as prices approach the peak. • The formation of right shoulder is accompanied by lower volume.

14. Inverse H&S • H&S pattern at the market bottom is known as inverse H&S or reverse H&S or H&S bottom. • Normally, volume is high at the bottom of left shoulder and during the formation of the head. • The activity contracts substantially on the right shoulder and expands substantially on the breakout. • Like the H&S patterns, inverse H&S pattern can have a number of variations in trend line slope and no. of shoulders.

16. Double tops and bottoms • A double top consists of two peaks separated by a reaction or valley in prices. • Its main characteristic is that the second top is formed with distinctly less volume than the first. • A double bottom is accompanied by high volume on the first bottom, very light volume on the second and very heavy volume on the breakout.

18. MOVING AVERAGE (MA) • MA is constructed by totaling a set of data and dividing the sum by the number of observations. • In order to get the average to move, a new item of data is added and the first item on the list subtracted. The new total is then divided by the number of observations and the process is repeated. • Generally speaking, a rising MA indicates market strength and a declining one denotes weakness.

19. A change from a rising to a declining market is signaled when the price moves below its MA. • A bullish signal is triggered when the price rallies above the average. • Changes in price trend are identified by the price crossing its MA, not by a reversal in direction of the MA. • The more times a MA is touched i.e. it acts as a support or resistance area, the greater the significance when it is violated.

20. What constitutes a valid crossover in MA? • A crossover is any penetration of a MA. • However, there may be a number of whipsaws or false signals in a MA chart. • It is possible to avoid some whipsaws by using filtering techniques. • The type of filter to be used depends on the time span in question and is very much a matter of individual experimentation. • For example, an analyst may decide to take action on MA crossovers for which a 3 percent penetration takes place and to ignore all others.

21. The 3 percent penetration filter might be fine with a 9 month moving average where average price movement is of 15 to 20 percent. • However, a 3 percent filter would probably encompass the whole move of a 2 week moving average and this kind of filter would be of no use in that case.

22. Choice of time span for MA • The time span for MA depends on the type of market trend that is to be identified: short, intermediate or primary. • If it is assumed that a bull and bear cycle lasts for 4 years, a 24 month average would give very slow confirmation of a change in trend. On the other hand, a 4 week average would be so sensitive that it would continually give misleading or whipsaw signals.

23. RELATIVE STRENGTH • RS is a technical concept that measures the relationship between two assets. • A RS line is obtained by dividing the price of one item by another. • The most common and important use of RS is to compare a stock to a market average like sensex. • When RS line is rising, it means that the stock is outperforming the market.

24. A RS indicator is just what its name implies – relative. • A rising line does not mean that a stock is advancing in price, but merely that it is outperforming the market. • For example, the market as measured by sensex may have fallen by 20%, and a stock may have fallen by 10%. Both have lost value but the RS line would be rising because the stock retreated less than the market.

25. When the stock-bond approach is used, the analyst opts for a higher proportion of stocks in the portfolio in a bull market and a higher proportion of bonds in the portfolio in a bear market. • In other words, he selects the security type with the most relative strength in the prevailing market. • According to Robert Levy, this switching between bonds and stocks could give higher returns as compared to a “buy and hold strategy”.