TECHNICAL ANALYSIS

in Analysis
TECHNICAL ANALYSIS

Mrs. P. Pirakatheeswari, Lecturer in Commerce,   Sri Sarada College for Women (Autonomous), Salem -16.

INTRODUCTION

 Technical Analysis as a study of the stock market considering factors related to the supply and demand of stocks. Technical Analysis doesn't look at underlying earnings potential of a company while evaluating stocks (unlike fundamental Analysis).  It uses charts and computer programs to study the stock's trading volume and price movements in the hope of identifying a trend. In fact the decision made on the basis of technical analysis is done only after inferring a trend and judging the future movement of the stock on the basis of the trend.

 In finance, technical analysis is a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume.

 Assumptions

Technical Analysis assumes that the market is efficient and the price has already taken into consideration the other factors related to the company and the industry. It is because of this assumption that many think technical analysis is a tool, which is effective for short-term investing.

History

The principles of technical analysis derive from the observation of financial markets over hundreds of years. The oldest known hints of technical analysis appear in Dutch markets in the 17th century. In Asia, the oldest example of technical analysis is thought to be a method developed during early 18th century which evolved into the use, and is today a main charting tool.

Dow theory is based on the collected writings of modern technical analysis from the end of the 19th century.  Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.  Technical Analysis as a tool of investment for the average investor thrived in the late nineteenth century.

General description

Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns. While technicians use various methods and tools, the study of price charts is primary.  Technicians especially search for archetypal patterns, such as the well-known head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and cup and handle patterns.  Technical analysts also extensively use indicators, which are typically mathematical transformations of price or volume. These indicators are used to help determine whether an asset is trending, and if it is, its price direction. Technicians also look for relationships between price, volume and, in the case of futures, open interest.

Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in options (implied volatility) and put/call ratios with price. Other technicians include sentiment indicators, such as Put/Call ratios and Implied Volatility in their analysis.

Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper risk control and money management.  There are several schools of technical analysis. Adherents of different schools (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one school. Some technical analysts use subjective judgment to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be. Some technical analysts also employ a strictly mechanical or systematic approach to pattern identification and interpretation.

Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that influence prices in financial markets. Technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.  Users of technical analysis are most often called technicians or market technicians. Some prefer the term technical market analyst or simply market analyst. An older term, chartist, is sometimes used, but as the discipline has expanded and modernized the use of the term chartist has become less popular.

Characteristics

Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.  Technical analysis stands in contrast to the fundamental analysis approach to security and stock analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. For example, any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team.  Technical analysis is widely used among traders and financial professionals, and is very often used by active day traders, market makers, and pit traders.

 In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park reported that 56 of 95 modern studies found it produces positive results, but noted that many of the positive results were rendered dubious by issues such as data snooping so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be pseudoscience. Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis. Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.

In the foreign exchange markets, its use may be more widespread than fundamental analysis. Recent research suggests that combining various trading signals into a Combined Signal Approach may be able to increase profitability and reduce dependence on any single rule.

Principles

Technicians say that a market's price reflects all relevant information, so their analysis looks at the history of a security's trading pattern rather than external drivers such as economic, fundamental and news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior – hence technicians' focus on identifiable trends and conditions.

How is Technical Analysis done?

Technical Analysis is done by identifying the trend from past movements and then using it as a tool to predict future price movements of the stock. It can be done by using any of the following methods:

a) Moving Averages—This method is used to predict the trend and specify various support and resistance levels in the short and long term period. Most commonly used moving averages are 30 DMAs and 200 DMAs. Where DMA means Days Moving Average.

b) Charts & Patterns—Some analysts' uses charts and patterns to decide on the trend and then judge the future movement. The tool used by such analyst is converting the chart in one of the many form of many shapes commonly formed by stocks.

 Role of Volume: Volume plays a key role in deciding about the kind of future movement in stock. Whenever there is a sudden rise in the volume of the stock and if it is not followed by a price fall, it is a sign of consolidation and that the price may rise in near future. Generally if any stock breaks any trend it is accompanied by huge rise in volume.

In case of range bound trend the volume tends to die down to a great extent. Smart investors uses technical analysis to judge the rise in volume and take early positions in the stock during breakthroughs

 Volume-based indicators

  • Accumulation/distribution index — based on the close within the day's range
  • Money Flow — the amount of stock traded on days the price went up
  • On-balance volume — the momentum of buying and selling stocks
  • PAC charts — two-dimensional method for charting volume by price level

Prices move in trends

Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. The basic definition of a price trend was originally put forward by Dow Theory.

Types of trends: Trends can be classified broadly in 3 types. They are:

a) Uptrend: - Generally a stock moves in any direction with phases of consolidation or moving against the trend for a short period. But still it creates a higher Highs and Lows in case of an uptrend. In short each short rally will create new High for the stock.

b) Downward: - In this case as against Uptrend the stock creates lower Highs and Lows. Furthermore in case of Downtrend the fall is much more steeper than the rise in case of Uptrend.

c) Range-bound: - In case of such a trend the price moves in a small range for the long period. There is no apparent direction as far as trend is concerned in this case.

Charting terms and indicators

Types of charts

  • OHLC "Bar Charts" — Open-High-Low-Close charts, also known as bar charts, plot the span between the high and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually a tick to the left for the open price and a tick to the right for the closing price.
  • Candlestick chart — Of Japanese origin and similar to OHLC, candlesticks widen and fill the interval between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.
  • Line chart — Connects the closing price values with line segments.
  • Point and figure chart — a chart type employing numerical filters with only passing references to time, and which ignores time entirely in its construction.

Concepts

  • Resistance — a price level which acts as a ceiling above prices
  • Support — a price level which acts as a floor below prices
  • Breakout — the concept whereby prices forcefully penetrate an area of prior support or resistance, usually, but not always, accompanied by an increase in volume.
  • Trending — the phenomenon by which price movement tends to persist in one direction for an extended period of time
  • Average true range — averaged daily trading range, adjusted for price gaps
  • Chart pattern — distinctive pattern created by the movement of security prices on a chart
  • Dead cat bounce — the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
  • Elliott wave principle and the golden ratio to calculate successive price movements and retracements
  • Fibonacci ratios — used as a guide to determine support and resistance
  • Momentum — the rate of price change
  • Point and figure analysis — A priced-based analytical approach employing numerical filters which may incorporate time references, though ignores time entirely in its construction.

Who uses Technical Analysis?

Investors for their short-term trading decisions use Technical Analysis. This short-term may be further divided in day trading, short-term investment and for hedging purposes.  The role played by Technical Analysis in each case is as follows:

1) Day Traders: A day trader is one who takes and squares off his position both on the same day. Mostly a day trader counts on turnover rather than margin. A day trader will interpret the market movement.

2) Short term investors: These people form the biggest clientele base of both the brokers and the Technical Analyst.

3) Hedgers: These are generally big investors, who have lot of money at stake and hence they look to have some hedging of their risk. The strategy followed by this section of investors is that they compare the stock in consideration with the index and on the basis of the result of this comparison they take their position in the stock.

Conclusion

If we use only technical analysis in itself and do not consider other aspects it is very unlikely that we will have much success in the long run, particularly in case of short-term investments. But if we use Technical analysis along with fundamental analysis or discount the industry and company related news while considering the valuation, our chances of minimizing the risk brightens.

One thing that we must realize is that technical analysis provides us only with the trend and judge future on that basis, it can be far from actual in few cases. By no imagination and no analysis one could have guessed the same or rather have come closed to it. Therefore the best use of technical analysis is to realize the trend and levels at which it will break the trend so that one is prepared to take positions when such trend breaks. It is because of this disadvantage that Technical analysis more useful only for short-term investing…

 References:

1.Security Analysis and Portfolio management: D.E.Fisher & R.J.Jordon

2.http://www.datek.smartmoney.com

3.http://www.tradersedgeindia.com

4. http://www.deanlebaron.com

5. http://www.stockcharts.com

6.http://www.nseindia.com

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This article was published on 2010/10/28