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Technical Analysis
Presented By:
Hitesh Punjabi
Technical Indicators
Technical Indicators broadly serve three functions: To alert, to confirm and to predict. Indicator acts as an alert t
o study price action, sometimes it also gives a signal to watch for a break of support. A large positive divergence
can act as an alert to watch for a resistance breakout.
Indicators can be used to confirm other technical analysis tools. Some investors and traders use indicators to pre
dict the direction of future prices.
There are a large number of Technical Indicators that can be used to assist you in selection of stocks and in tracki
ng the right entry and exit points.
In short, indicators indicate, but it doesnt mean that traders should ignore the price action of a stock and focus s
olely on the indicator.
Indicators just filter price action with formulas. As such, they are derivatives and not direct reflections of the pric
e action.
While applying the indicators, the analyst should consider: What is the indicator saying about the price action of
a security? Is the price action getting stronger? Is it getting weaker?
The buy and sell signals generated by the indicators, should be read in context with other technical analysis tools
like candlesticks, trends, patterns etc.
Types of indicators
Indicators can broadly be divided into two types LEADING and LAGGING.
Leading indicators
Leading indicators are designed to lead price movements. Benefits of leading indicators are early signaling for en
try and exit, generating more signals and allow more opportunities to trade.
They represent a form of price momentum over a fixed look-back period, which is the number of periods used to
calculate the indicator. Some of the popular leading indicators include Commodity Channel Index (CCI), Moment
um, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Technical Indicators
Lagging Indicators
Lagging Indicators are the indicators that would follow a trend rather then predicting a reversal. A lagging indicator fo
llows an event.
These indicators work well when prices move in relatively long trends. They dont warn you of upcoming changes in p
rices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly.
These trend following indicators makes you buy and sell late and, in exchange for missing the early opportunities, the
y greatly reduce your risk by keeping you on the right side of the market. Moving averages and the MACD are exampl
es of trend following, or lagging, indicators.
Moving averages
One of the most common and familiar trend-following indicators is the moving averages. They smooth a data series a
nd make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building
blocks for many other technical indicators and overlays.
Trend-following indicator:- Moving averages are used to determine the direction of trend and are basis of many tren
d following systems. Moving averages smooth out a data series and make it easier to identify the direction of the tre
nd. Instead of predicting a change in trend, moving averages follow behind the current trend because past price data
is used to form moving averages, they are considered lagging or trend following. Therefore, you can use moving aver
ages for trend identification and trend following purposes, not for prediction.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving A
verage (EMA).
Moving Average
Simple moving average (SMA)
A simple moving average is formed by computing the average (mean) price of a security over a specified number
of periods. It places equal value on every price for the time span selected.
While it is possible to create moving averages from the Open, the High, and the Low data points, most moving av
erages are created using the closing price. For example: a 5-day simple moving average is calculated by adding th
e closing prices for the last 5 days and dividing the total by 5.
Eg:10+11+12+13+14=60
60/5=12
The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curvin
g line - the moving average line. Continuing our example, if the next closing price in the average is 15, then this
new period would be added and the oldest day, which is 10, would be dropped
The new 5-day simple moving average would be calculated as follows:
11+12+13+14+15=65
65/5=13
Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will be subtracted and t
he moving average will continue to move over time.
Exponential moving average (EMA)
Exponential moving average also called as exponentially weighted moving average is calculated by applying more
weight to recent prices relative to older prices.
In order to reduce the lag in simple moving averages, technicians often use exponential moving averages. The we
ighting applied to the most recent price depends on the specified period of the moving average.
The shorter the EMAs period, weight is applied to the most recent price.
Moving Average
The important thing to remember is that the exponential moving average puts more weight on recent prices. As su
ch, it will react quicker to recent price changes than a simple moving average.
A moving average is an average of the stock price plotted over a period of time
The moving average smoothes out daily price fluctuations to allow the Technical Analyst to better understand the
trend of the security
Tracks data (usually stock price) as average value over time
Used to smooth out daily fluctuations and focus on underlying trends
Usually calculated over periods ranging from 10 to 200 days
P ri c e
50-D ay Movi ng A verage
200-D ay Movi ng A verage
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MACD stands for Moving Average Convergence / Divergence. It is a technical analysis indicator created by Geral
d Appel in the late 1970s. The MACD indicator is basically a refinement of the two moving averages system and
measures the distance between the two moving average lines.
What is the MACD and how is it calculated?
The MACD does not completely fall into either the trend-leading indicator or trend following indicator; it is in fa
ct a hybrid with elements of both. The MACD comprises two lines, the fast line and the slow or signal line.
These are easy to identify as the slow line will be the smoother of the two
Step1. Calculate a 12 period exponential moving average of the close price.
Step2. Calculate a 26 period exponential moving average of the close price.
Step3. Subtract the 26 period moving average from the 12 period moving average. This is the fast MACD line o
r MACD Line
Step4. Calculate a 9 period exponential moving average of the fast MACD line calculated above. This is the slo
w or Signal MACD line.
MACD benefits
The importance of MACD lies in the fact that it takes into account the aspects of both momentum and trend in
one indicator.
As a trend-following indicator, it will not be wrong for very long. The use of moving averages ensures that the in
dicator will eventually follow the movements of the underlying security. By using exponential moving averages,
as opposed to simple moving averages, some of the lag has been taken out.
As a momentum indicator, MACD has the ability to foreshadow moves in the underlying security. MACD diverge
nces can be key factors in predicting a trend change.
MACD
The set of moving averages used in MACD can be tailored for each individual security. For weekly charts, a faste
r set of moving averages may be appropriate. For volatile stocks, slower moving averages may be needed to hel
p smooth the data. No matter what the characteristics of the underlying security, each individual can set MACD
to suit his or her own trading style, objectives and risk tolerance.
To Summarize
The MACD is a hybrid trend following and trend leading indicator.
The MACD consists of two lines; a fast line and a slow signal line.
A long position is indicated by a cross of the fast line from below to above the slow line.
A short position is indicated by a cross of the fast line from above to below the slow line.
MACD should be avoided in trading markets
The MACD is useful for determining the presence of divergences with the price data.
Example of MACD
Bollinger Bands
The main ratio used is .618, this is found by dividing one Fibonacci number into the next in sequence Fibonacci numb
er (55/89=0.618). The logic most often used by Fibonacci based traders is that since Fibonacci numbers occur in
nature and the stock, futures, and currency markets are creations of nature - humans. Therefore, the Fibonacci
sequence should apply to the financial markets.
By identifying a prior down trend and drawing Fibonacci Lines from the absolute high to the absolute low we can pr
oject future levels of support and resistance.
Application of Fibonacci:
Note that a trendline was drawn from a significant low (beginning of trend) to a significant high (e
nd of trend); the trading software calculated the retracement levels.
Fibonacci Analysis
Fibonacci Arcs
Fibonacci Arcs are percentage arcs
based on the distance between m
ajor price highs and price lows. Th
erefore, with a major high, major l
ow distance of 100 units, the 31.8
% Fibonacci Arc would be a 31.8 u
nit semi-circle.
As is seen in the chart above, after
the significant bear market, the ral
ly was stopped by the 50% arc; the
50% arc retracement acted as resis
tance. The S&P 500 then used the
38.2% arc as support, bouncing be
tween the 50% arc and the 38.2%
arc for many months.
After price broke through the resis
tance arc at 50%, price moved up t
o the next significant Fibonacci rati
o, 61.8%, where it found a new res
istance level. The prior resistance l
evel at 50%, after being broken, be
came a new support level. The nex
t Fibonacci arc was at 100%, wher
e price met resistance.
Fibonacci Fans
Dow defined an uptrend as a situation in which each successive rally high closes higher than the previous ral
ly high and each successive rally low closes higher than the previous rally low.
In other words, an uptrend has a pattern of rising peaks and troughs and a downtrend has a pattern of lowe
r peaks and troughs
Three parts to a Dow Theory Trend
1. Primary represents the tide (if it keeps getting higher)
- at least a year
2. Secondary represents the waves that make up the tide
- 3 weeks to 3 months
- usually retrace 1-2 thirds of previous trend movement, or half the previous move
3. Minor represent the ripples on the waves
- less than 3 weeks
Dow Theory
3. Major Trends have Three Phases
Dow focused his analysis mostly on the Major Trends
Accumulation Phase represents informed buying by the most astute investors. They believe all the bad ne
ws has been priced in.
Public Participation Phase Where technical trend followers begin to participate, a time of rapidly increasing
prices and business news improves
Distribution Phase begins when newspapers begin to print increasingly bullish stories, when economic new
s is better than ever, and when speculative volume and public participation increase. The accumulation inv
estors begin to distribute their positions
4. The Averages must confirm each other
No important bull or bear market could take place unless the averages confirmed each other.
Confirmation = If one index makes a new high, so does the other. If one makes a new low, so does the other.
Otherwise there is a divergence in the market place and the prior trend is still intact.
5. Volume must confirm trend
An object in motion remains in motion until acted upon by a strong enough force.
The study of moving averages, support and resistance, price patterns, trend lines, etc are just some of the ind
ications that there may be a strong enough force.
Theory on Dow Theory for Reference
Any attempt to trace the origins of technical analysis would inevitably lead to Dow theory. While more than 100
years old, Dow theory remains the foundation of much of what we know today as technical analysis.
Dow theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 190
0 until the time of his death in 1902.
Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the
economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the
direction of major market trends and the likely direction of individual stocks.
Dow first used his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index (now Transporta
tion Index), which were originally compiled by Dow for The Wall Street Journal. Dow created these indexes becau
se he felt they were an accurate reflection of the business conditions within the economy because they covered t
wo major economic segments: industrial and rail (transportation). While these indexes have changed over the las
t 100 years, the theory still applies to current market indexes.
Theory on Dow Theory for Reference
That information includes everything from the emotions of investors to inflation and interest-rate data, along wit
h pending earnings announcements to be made by companies after the close. Based on this tenet, the only infor
mation excluded is that which is unknowable, such as a massive earthquake. But even then the risks of such an e
vent are priced into the market.
It's important to note that this is not to suggest that market participants, or even the market itself, are all knowin
g, with the ability to predict future events. Rather, it means that over any period of time, all factors - those that h
ave happened, are expected to happen and could happen - are priced into the market. As things change, such as
market risks, the market adjusts along with the prices, reflecting that new information.
The idea that the market discounts everything is not new to technical traders, as this is a major premise of many
of the tools used in this field of study. Accordingly, in technical analysis one need only look at price movements, a
nd not at other factors such as the balance sheet.
Like mainstream technical analysis, Dow theory is mainly focused on price. However, the two differ in that Dow t
heory is concerned with the movements of the broad markets, rather than specific securities.
For example, a follower of Dow theory will look at the price movement of the major market indexes. Once they h
ave an idea of the prevailing trend in the market, they will make an investment decision. If the prevailing trend is
upward, it follows that an investor would buy individual stocks trading at a fair valuation. This is where a broad u
nderstanding of the fundamental factors that affect a company can be helpful.
Theory on Dow Theory for Reference
An upward trend is broken up into several rallies, where each rally has a high and a low. For a market to be consi
dered in an uptrend, each peak in the rally must reach a higher level than the previous rally's peak, and each lo
w in the rally must be higher than the previous rally's low.
A downward trend is broken up into several sell-offs, in which each sell-off also has a high and a low. To be consi
dered a downtrend in Dow terms, each new low in the sell-off must be lower than the previous sell-off's low an
d the peak in the sell-off must be lower then the peak in the previous sell-off.
Theory on Dow Theory for Reference
Dow theory identifies three trends within the market: primary, secondary and minor. A primary trend is the lar
gest trend lasting for more then a year, while a secondary trend is an intermediate trend that lasts three weeks
to three months and is often associated with a movement against the primary trend. Finally, the minor trend o
ften lasts less than three weeks and is associated with the movements in the intermediate trend.
Primary Trend In Dow theory, the primary trend is the major trend of the market, which makes it the most i
mportant one to determine. This is because the overriding trend is the one that affects the movements in sto
ck prices. The primary trend will also impact the secondary and minor trends within the market.
Dow determined that a primary trend will generally last between one and three years but could vary in some i
nstances.
Theory on Dow Theory for Reference
Regardless of trend length, the primary trend remains in effect until there is a confirmed reversal
For example, if in an uptrend the price closes below the low of a previously established trough, it could be a sig
n that the market is headed lower, and not higher. When reviewing trends, one of the most difficult things to d
etermine is how long the price movement within a primary trend will last before it reverses. The most importa
nt aspect is to identify the direction of this trend and to trade with it, and not against it, until the weight of evi
dence suggests that the primary trend has reversed .
Minor Trend
The last of the three trend types in Dow theory is the minor trend, which is defined as a market movement las
ting less than three weeks. The minor trend is generally the corrective moves within a secondary move, or tho
se moves that go against the direction of the secondary trend
Theory on Dow Theory for Reference
Due to its short-term nature and the longer-term focus of Dow theory, the minor trend is not of major concern t
o Dow theory followers. But this doesn't mean it is completely irrelevant; the minor trend is watched with the lar
ge picture in mind, as these short-term price movements are a part of both the primary and secondary trends.
Most proponents of Dow theory focus their attention on the primary and secondary trends, as minor trends tend
to include a considerable amount of noise. If too much focus is placed on minor trends, it can to lead to irrational
trading, as traders get distracted by short-term volatility and lose sight of the bigger picture .
who bought during accumulation phase begin to sell in anticipation of a decline in the market. This is time wh
en Technical Analyst should look for reversal in the trend to initiate sell side position in the stock market.
Theory on Dow Theory for Reference
Accumulation phase from April 2003 to June 2003 during which nobody believed that markets could rally but int
elligent investor took buy side positions in the stock market.
Participation phase from July 2003 to January 2004 during which largest and longest price movement occurred.
Distribution phase from February 2004 to May 2004 during which smart money closed buy side positions in the
market.
(b) The divergence in these two indexes is a warning signal. Under Dow Theory, a reversal from a bull market to
bear market or vice versa is not signaled until and unless both indexes i.e. Industrial Index and Transportation In
dex confirm the same.
In simple words, if one index is confirming a new primary uptrend but another index remains in a primary down
trend, then there is no clear trend.
Basically Dow Theory says that stock market will rise if business conditions are good and stock market would de
cline if business conditions are poor.
Sixth Principle: Trend Remains Intact Until and Unless Clear Reversal Signals Occur
As we are dealing in stock market which is controlled by only one M i.e. Money and this money flows very fast
across borders. Hence stock prices do not move smoothly in a single line, one day its up next day it might be do
wn.
Basically Dow Theory suggests that one should never assume reversal of the trend until and unless clear reversa
l signals are there and one should always trade in the direction of the primary trend.
Theory on Dow Theory for Reference
Significance of Dow Theory
Its Dow Theory which gave birth to concept of higher top-higher bottom formations and lower top-lower bottom f
ormations which is the basic foundation of Technical Analysis. This helps investors to improve their understanding
on the market so that they could succeed in their investment/trading decisions. Most of the technical analysts follo
w this concept and if you go through any technical write up, you would definitely find this concept.
Problems with Dow Theory
a. One misses the large gain due to conservative nature of a trend reversal signal i.e. uptrend would reverse when s
tock prices make lower top-lower bottom formation and downtrend would reverse when stock prices make higher
top-higher bottom formation.
b. Charles Dow considered only two indexes namely Industrial and Transportation which is not major part of the ec
onomy today. Technology and financial services i.e. banking constitutes major part of the economy today. We have
seen in 1998-1999, one sided rally in Nifty led by technology stocks. In this rally none of industrial stock participate
d and if one waited for buy confirmation from Industrial and Transportation indexes then one must have missed th
e classic bull run of technology stocks.
Thank You