Introduction to Technical Analysis

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Technical Analysis

Technical analysis is the study of price using charts in order to "anticipate" their future performance.

I have deliberately used the word "anticipate" rather than "forecast" or "predict". The market can go up or down at any time; it is only the probability (of each move) that varies.

Technical analysis isn't a crystal ball that predicts the future, but it is an investing strategy that helps you spot stock patterns that have the potential to make huge moves.

Sentiment drives the market
The price at which an investor is willing to buy or sell depends primarily on his expectations. If he expects the security's price to rise, he will buy it; if the investor expects the price to fall, he will sell it.

As any trade requires a buyer and seller, it automatically means they have entirely opposite views on the stock.

The collective majority of market participants ultimately decides the direction of the stock price and the market. Finally, whichever you look at it, price is matter of demand and supply and nothing else.

Fundamentals don't matter
Greed and fear is what moves the market up or down. If the markets are bullish, even a stock with no fundamentals (penny stocks) will rise and give good returns. But if markets turn bearish, then even stock with good fundamentals will crash.

Price reflects everything
Price is a function of demand and supply and nothing else.

The price of a stock reflects everything about the stock. This includes FII inflows, analyst reports, balance sheets, impact of crude and interest rates, govt policies, politicians and their antics and whatever you may care to add.

Different people have varying degrees of access to this information and form their own perception (rightly or wrongly) - this ultimately decides the current price of the stock.

Since everything about a stock is reflected in the price, it makes sense to study price movements. In other words, "what is happening" is more important than "why it is happening".

Trying to identify the "why" is an exercise in futility. One can arrive at any number of reasons depending on how many "experts" you choose to listen to.

The beauty of technical analysis is that it applies to all time frames (intraday, daily, weekly, monthly charts) and across equities, commodities (rice, gold, crude oil, aluminium etc).

Technical Analysis is not 100% accurate
Technical Analysis should not be used to make predictions because we never know the outcome of a particular pattern or series of events with 100 per cent certainty. The best that we can hope to achieve is a probability of around 80 per cent for any particular outcome; which means that something unexpected will occur at least one in five times.

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Follow the Trend

The easiest and safest way to earn excellent profits consistently is to simply follow the trend and trade.
By following the trend, you will always be on the "right" side of the market.

Trend analysis helps distinguish emotional decisions ("I think it's time to sell...") from analytical decisions ("I will hold until the current rising trend is broken"). Trend analysis will also discourage you from going short in a bullish market or going long in a bearish market.

What is a trend?
A trend is simply, the persistence of a security's price to move in a particular direction. A trend can be bullish, bearish or flat. Also, a trend is in effect till it is reversed.

Markets are either bullish, bearish or flat. However markets never go up or down in a straight line. There are always corrections (in bullish markets) and pullbacks or relief rallies (in bearish markets). By identifying trends and reversals, you can enter and exit trends at the correct time and earn excellent profits with minimum risks.

Advantages:
By following the trend, you will not be affected by:

- Performance of companies
- EPS, PE, RONW and other ratios
- Elections, budgets, GDP
- FII inflows, crude oil prices
- Interest rates and inflation
- Newspaper reports and analyst talks
- Intra-day fluctuations and volatility

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The Dow Theory

The Dow theory has been around for almost 100 years, yet even in today's volatile and technology-driven markets, the basic components of Dow theory still remain valid. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did almost 100 years ago.

Background
Charles Dow developed the Dow theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street Journal. Although he never wrote a book on the subject, he did write some editorials that reflected his views on speculation and the role of the rail and industrial averages.

Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term "Dow theory." Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.

Market Movements
There are 3 types of movements: primary movements, secondary movements and daily fluctuations. Primary moves last from a few months to many years and represent the broad underlying trend of the market. Secondary (or reaction) movements last from a few weeks to a few months and move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.

Stages of Bull and Bear markets
Stages relate as much to the psychological state of the market as to the movement of prices. A primary bull market is defined as a long sustained advance marked by improving business conditions that elicit increased speculation and demand for stocks. A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and subsequent decrease in demand for stocks. In both primary bull markets and primary bear markets, there will be secondary movements that run counter to the major trend.

Bull Market
Stage 1 - Accumulation: The first stage of a bull market is largely indistinguishable from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is out of stocks, the news from corporates and valuations are usually at historical lows. However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is the stage of the market when those with patience see value in owning stocks for the long haul. Stocks are cheap, but nobody seems to want them.

In the first stage of a bull market, stocks begin to find a bottom and quietly firm up. When the market starts to rise, there is widespread disbelief that a bull market has begun. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that careful analysis is warranted to determine if the decline is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed.

Stage 2 - Big Move: The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is considered the easiest stage to make money as participation is broad and the trend followers begin to participate.

Stage 3 - Excess: The third stage of a primary bull market is marked by excessive speculation and the appearance of inflationary pressures. Dow formed these theorems about 100 years ago, but this scenario is certainly familiar. During the third and final stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image to the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to offer tips, the top cannot be far off.

Bear Market
Stage 1 - Distribution: Just as accumulation is the hallmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the "smart money" begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is still involved in the market at this stage and become willing buyers. There is little in the headlines to indicate a bear market is at hand and general business conditions remain good. However, stocks begin to lose a bit of their luster and the decline begins to take hold.

While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move) that retraces a portion of the decline. Reaction rallies during bear markets were quite swift and sharp and a large percentage of the losses would be recouped in a matter of days or perhaps weeks. This quick and sudden movement would invigorate the bulls to proclaim the bull market alive and well. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market.

Stage 2 - Big Move: As with the primary bull market, stage two of a primary bear market provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues.

Stage 3 - Despair: At the top of a primary bull market, hope springs eternal and excess is the order of the day. By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. Corporate news is bad, the economic outlook bleak and not a buyer is to be found. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.

Conclusions
The goal of Dow and Hamilton was to identify the primary trend and catch the big moves. They understood that the market was influenced by emotion and prone to over-reaction both up and down. With this in mind, they concentrated on identification and following: identify the trend and then follow the trend. The trend is in place until proved otherwise. That is when the trend will end, when it is proved otherwise.

Dow theory helps investors identify facts, not make assumptions or forecast. It can be dangerous when investors and traders begin to assume. Predicting the market is a difficult, if not impossible, game. Hamilton readily admitted that the Dow theory was not infallible. While Dow theory may be able to form the foundation for analysis, it is meant as a starting point for investors and traders to develop analysis guidelines that they are comfortable with and understand.

Reading the markets is an empirical science. As such there will be exceptions to the theorems put forth by Hamilton and Dow. They believed that success in the markets required serious study and analysis that would be fraught with successes and failures. Success is a great thing, but don't get too smug about it. Failures, while painful, should be looked upon as learning experiences. Technical analysis is an art form and the eye grows keener with practice. Study both successes and failures with an eye to the future.

[vjondalalstreet]

The Elliot Wave Theory

Elliot discovered that the ever-changing path of stock market prices reveals a structural design that in turn reflects a basic harmony found in nature. From this discovery, he developed a rational system of market analysis.

Under the Wave Principle, every market decision is both produced by meaningful information and produces meaningful information. Each transaction, while at once an effect, enters the fabric of the market and, by communicating transactional data to investors, joins the chain of causes of others� behavior. This feedback loop is governed by man�s social nature, and since he has such a nature, the process generates forms. As the forms are repetitive, they have predictive value.

Wave Patterns
In markets, progress ultimately takes the form of five waves of a specific structure. Three of these waves, which are labeled 1, 3 and 5, actually effect the directional movement. They are separated by two countertrend interruptions, which are labeled 2 and 4. The two interruptions are apparently a requisite for overall directional movement to occur.

At any time, the market may be identified as being somewhere in the basic five wave pattern at the largest degree of trend. Because the five wave pattern is the overriding form of market progress, all other patterns are subsumed by it.

The 5 wave pattern is often followed by 3 corrective waves labelled as A-B-C.




Wave Mode
There are two modes of wave development: impulsive and corrective. Impulsive waves have a five wave structure, while corrective waves have a three wave structure or a variation thereof. Impulsive mode is employed by both the five wave pattern and its same-directional components, i.e., waves 1, 3 and 5. Their structures are called �impulsive� because they powerfully impel the market. Corrective mode is employed by all countertrend interruptions, which include waves 2 and 4. Their structures are called �corrective� because they can accomplish only a partial retracement, or �correction,� of the progress achieved by any preceding impulsive wave. Thus, the two modes are fundamentally different, both in their roles and in their construction, as will be detailed in an upcoming section.

Wave subdivision
Waves can be repeatedly subdivided into lower degrees as follows:





Some observations

-Wave 4 never overlaps or enters the area of wave 1. An overlap means one shd consider the possibility of A-B-C corrective
-An exception to the above is a 5th wave ending diagonal
-Wave 3 is never the shortest.
-Wave 3 & 5 are related to wave 1 by a Fibonacci ratio (equality or 1.618 or 2.618)
-In any corrective, wave C is related to wave A by a Fibonacci ratio (equality or 1.618 or 2.618)
-In any corrective, wave B is related to wave A by a Fibonacci ratio (0.618 or equality)
-Compared to impulses, correctives are difficult to trade. There are more than 23 types of patterns. Sometimes the best thing to do is let the market make up its mind and then decide what to do.
-In an impulse, it is common for a wave 3 or wave 5 to extend.
-Any correction following a 5th wave extension will typically end at wave 2 of the extension
-Alternation: if wave 2 is a sideways correction, wave 4 will be fast/ straight/ swift (and vice versa).
-Waves are fractal and principles apply across all time frames. A 1-2-3-4-5 impulse could be a part of larger A which in turn can be a part of a larger 1

[vjondalalstreet]

Charts

A picture is worth a thousand words...and this is true of any chart.

Line chart
This is the most basic chart. Take the following chart of SESAGOA. A simple look reveals that the stock has been in an uptrend and has minor corrections from time to time.

Line charts are plotted using the "closing" price of the stock.

The red line represents the 50 day moving average (DMA). More on this later.



Bar chart
Bar charts provide more information than line charts as one can see the open, high and low for the day (apart from the close).

The red bar means stock closed lower relative to the previous close. The blue bar means stock closed higher relative to the previous close. The "tick" on the left side is the open and the tick on the right side is the close.



Candle sticks
Candle sticks (a 300 year old Japanese technique) give the same information as a bar but are visually more easy to read.

Red candles means stock closed lower relative to the previous close. Blue candles means stock closed higher relative to the previous close.

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Moving Averages

Moving averages provide an excellent way to identify trends or confirm reversals.
Moving averages are not "predictive" but are "lagging" indicators as a time delay is always present.

Moving averages are an extremely simple and convenient way to trade. They are excellent in strongly trending markets but are practically useless in sideways markets as they tend to generate too many whipsaws.

The moving average removes emotions from the stock. One should remain long as long as the stock remains above the MA. When the stock cuts the MA from above, exit position.

The chart below has 20 DMA (grey), 50 DMA (red) and 200 DMA (blue).

Sometimes, the moving average will give a "whipsaw" or false buy / sell signals. This means the stock is rangebound and the direction wil be clear only a break out of the trading range.

As one can see from the chart, the 20 DMA has generated the highest whipsaws while the 200 DMA has only given a hold (in relation the timeframe).

[vjondalalstreet]

Time Frames

Principles of technical analysis remain same irrespective of time frames.

This means that the all indicators can be applied uniformly across all time frames - intraday, daily, weekly, monthly, quarterly etc.

Having said this, a word of caution is in order. One should always identify the broader trend (pricewise/ timewise) and use that to decide action for the shorter trend.

For eg., if the daily or weekly trend is bullish, one should lean more towards long positions in daytrading than towards the short side.

Similarly if the broader trend is down, one should look to build short positions on any significant rise.

A word of advice: A smaller time frame is more prone to manipulation as compared to a broader time frame. For eg., daily/ intraday trends can be misleading but it is almost impossible to manipulate the broader trend (say a 6 month bull run).

Lastly, shorter time frames (eg. intraday, daily) tend to be extremely volatile and choppy. Most technical indicators, with the exception of support / resistance levels and trend lines, will give confusing results.

[vjondalalstreet]

Support and Resistance

What is support?
Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.

What is resistance?
Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.

Support becomes resistance (and vice versa)
Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.

The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.



Conclusion
Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a security is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.

[vjondalalstreet]

Trading Rectangles

Sometimes a stock does nothing except trade in a range defined by support and resistance lines. This activity can go on for months before a breakout happens.

The breakout when it happens, is invariably strong as all selling is over and there are only buyers in the stock.

For swing traders, rectangles offer a safe way to earn money. Buy at lower end, sell at upper end.

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Using Trendlines

Trendlines offer a great way to draw lines of support or resistance.



The red (falling) trendline shows resistance and a break out of this is a good reason to buy.

Similarly, the blue (rising) trendline offers support and a break of this is an indication to book some profits.

Incidentally, some stocks tend to have very clear trendlines while some, either because of volatility (or poor liquidity) have extreme spikes which complicates task of drawing trendlines.

[vjondalalstreet]

Trailing Stop Losses

Trading in the markets is more about managing risks than running after profits. Once the risk is contained, profits accrue automatically.

When you decide to invest in a stock, it is based on certain fundamental or technical reasons. Many times, this justification itself can be flawed and the market can go against your action. Protective stops force an exit and thus help protect capital.

Stoplosses vary depending on your timeframe. The same stock will have vastly different stoploss levels for a day trader, futures trader, swing trader, short term or long term investor.

Incidentally, the word "long term" means different things to different people. For some people, it could be 6 months whereas for someone else it could be 5 years. On the other hand, many investors become long term investors out of choice!

Defining stoplosses is not easy as many people have seen a stoploss gets triggered and the stock subsequently rallies. There is no quick fix solution for this but a thorough knowledge of charts and daily study does help substantially.

Trailing stoplosses: this is nothing but the stoploss level you change everyday in direction of the trend.

Trailing stoplosses help you capture the real gains. Since one does not know with certainity how much stock can rally, it makes sense to simply increase the stoploss everyday till it gets trigerred.

Setting stoplosses: Short term investors can use the 10 day or 20 day lowest close as the trailing stoploss. Where a stock rallies extremely fast, one can even use a 5 day lowest close as the stoploss.

Long term investors can use the 50 day lowest close as the trailing stoploss. This will get triggered once or twice a year.

I use the most recent "significant" support or resistance as the stoploss. The keyword here is the word "significant". For example, for short term trades I use a 5% change for determining peaks and troughs (you need sophisticated charting software for this). This is highly accurate and extremely reliable.

NOTE as long as the trend is up, you will always make money. Sometime or the other, the broader trend must and will reverse. No one knows when the trend will reverse and hence the stoploss is important.

Never make the mistake of dreaming that sometime or the other, the stock will rally and you will recover your investment. This may take years or a lifetime. Just to remind, there are people who have bought ACC at Rs.8000/- or HIMACHALFUT at Rs.2000/-...they are still holding this in the fond hope that they will recoup their losses!

[vjondalalstreet]

Fibonacci Numbers

Perhaps one of the finest and most beautiful series ever discovered and why there is order in apparently chaotic events.

Fibonacci numbers are a series of numbers discovered by Leonardo Fibonacci, an Italian mathematician somewhere in the 10th century.

Very simply, it is a series of numbers where each number is the sum of the prior two numbers. For eg., 1,1,2,3,5,8,13,21,34,55,89.....

These numbers have some very interesting properties and are ALL inter-related to each other in ratios.

Take any two consecutive numbers. Depending on the order, all numbers are related to the next or previous number by 1.618 or 0.618.

Further, the inverse of 0.618 is 1.618.

Instead of taking 2 consecutive numbers, one can consider alternate numbers. You will always get 0.328 or 2.618.

These numbers occur in nature in several different ways and demonstrates how efficiently nature keeps some control in apparently chaotic situations.

Incidentally, the most visually attractive rectangle is the one where the length is 1.618 the width!

So you have these numbers appearing in the pyramids of Egypt, DNA helix, length of parts of the human body, orbitals of planets or electrons, nuclear physics and now the stock markets.

Stock markets are the best example of mass psychology or collective human behaviour and it is no wonder that stocks when they move or correct tend to stop exactly at certain levels.

The numbers 0.618 or 1.618 are called the "golden mean" or the "golden number".



Application in stock markets
Take the most recent top and bottom of a trend (up or down). Fibonacci retracements will generate targets for rallies and corrections.

UP targets = Support + X *(Resistance-Support)

DOWN targets = Resistance - X *(Resistance-Support)

Where X equals 0.382 or 0.5 or 0.618 or 1.618 or 2.618

In Elliot waves also, all waves (impulse or corrective) are related to each other Fibonacci ratios. In fact, the 5 impulse waves (1-2-3-4-5) and 3 correctives (A-B-C) are also Fibonacci numbers.

So any correction will be limited to 50% or 61.8% retracement of the earlier rally. Similarly, any rally will always meet resistance at 61.8% or 161.8% retracement of the prior correction.

Refer following animation of HINDALC0 (10 second frame change).