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Understanding Technical Analysis
Stock market analysis has been classified into two major categories - FUNDAMENTAL ANALYSIS AND TECHNICAL ANALYSIS. (There may be others, but those aren’t followed much.)  

A person following fundamental analysis, studies P&L accounts, balance sheets, sales data, production data, market conditions, macro economic factors and so on.

From different types of data that he collects, he tries to forecast the earnings of the company and thus tries to give a valuation to a particular share.  

On the other hand, Technical analysis (TA) is the study of the market and not of the goods traded in the market. A PURE technical analyst is least bothered about the business a company is in.  

The price of a stock is result of how strong the demand and supply is for a stock. If demand is greater than supply the price goes up and vice versa.  

TA believes that the best judge of Demand and Supply is the price of stock itself.  Thus TA tries to analyse Demand and Supply from the price action and extrapolate it into the future.  

TA is the study of recording market behaviour (Price, Volume etc) in the form of charts and trying to forecast the future based on past actions.

 

DOW THEORY - The Foundation of TA:  

Charles Dow made brilliant observations about market behaviour, which were later reorganised into the DOW THEORY by W.P. Hamilton.  

Before the Dow theory, it is essential to understand the importance of averages (Indices as we call them in India ).  

Why do we need an Index?  

Everyone of you must have understood from market experience, that in Bull markets most stocks move up and in bear market most stocks move down. Indices are nothing but the Basic indicators that give us an idea about the general markets or a group of stocks.  

Originally Dow theory was related to Market averages (indices) but it is also found to work well with Individual Stocks.  

DOW THEORY:

Charles Dow wrote a series of articles in The Wall Street Journal, which later formed, what we call the “Dow Theory”.  

 IN 1897 Dow separated the railroads and industrials into two different indices – 12 stock industrial average and 20 stock rail index. The industrial average is used even today by the New York Stock Exchange (NYSE) and is known as DJIA (Dow Jones Industrial Average). DJIA has comprised of 30 stocks since 1928 and is world’s best known Index today.  

Dow theory comprises of some basic tenets:  

  1. The Averages Discount Everything:  

There are millions of investors involved in the markets. All with different opinions and abilities. The prices of stocks are sum total of opinions of all the people involved in the markets.   The markets already discount all factors that can affect prices of stocks.   In short, prices of Averages and Individual Stocks include the opinions of all involved in the markets and there is no need to consider individual opinions. Price tells the entire story.  

  1. The three trends:  

Prices of stocks move in three trends – Primary (Major), Secondary (Intermediate) and Minor trends.   You must have heard analysts use Long term, Medium term and short term while referring to trends. The Primary or Long Term Trend usually last a year to many years. Bulls markets are the periods when the Primary trend is up and most stocks move up together.  On the other hand Bear Markets are the periods in which the Primary trend is down and most stocks are moving lower.  

Intermediate or medium term trends are periods of correction lasting few weeks to few months that go against the Major trend. In bull markets we can intermediate trends as corrections and in bear markets we call them recoveries.  

Minor or short term trends are very brief, lasting only a few days (sometimes 2-3 weeks) and are of little use to the Investor.  

The chart given above is of NSE Nifty from Feb 2000 (End of IT Led Bull Market) to Sept 2001 (Post WTO Attacks Sell Off).   During this period the Stock Markets were in a Bear Phase – that is- the main trend of the market was down. The Blue line indicates the Major Trend.   The Green line indicates an Intermediate up trend and the White line indicates a minor trend.

 

Now the question arises: How to recognise the main trend?

  Dow had observed that in Up trends rallies always went higher than peaks of previous rallies and corrections always stopped at lows higher than lows of previous corrections. In short all Major up trends are characterised by HIGHER TOPS AND HIGHER BOTTOMS.  Similarly all major down trends are characterised by LOWER TOPS AND LOWER BOTTOMS

Take a look at the NSE Nifty chart again-

  Note how the Major downtrend resulted in series of LOWER TOPS (T4<T3<T2<T1) AND LOWER BOTTOMS (B4<B3<B2<B1).  

 

  1. Three phase of Major trends:  

Dow had observed that all Bull Markets have three phases:

In the first there is gloom and doom everywhere. Financial reports are negative and people are sure that stocks markets will close down.  No one wants to talk stocks.  Slowly the economic activity begins to improve but people still believe it is temporary and worst is still to come. Farsighted and Shrewd players start getting in. Slowly markets pick up speed.  

In the second phase economy is growing.  People now think stocks are less risky than they were when markets were down and start getting in. Good news keeps coming and earnings keeping increasing. This is the phase when a technical trader gets in as he is now sure the Major trend is up.  

In the last phase everyone is buying stocks. Economy is in overdrive and people buy as if there is no tomorrow. Your Paanwala recommends you stocks and every stock is going up- doesn’t matter if the company doesn’t exists. DSQs and Pentamedias start hitting upper circuits. No one cares what the company does. Volumes reach their peak and more and more stocks make new highs. Smart money starts to get out here. First-time investors rush into the markets having heard stories of profits made overnight.

This is when the peak comes. Suddenly investors are trapped. There are no buyers at higher levels. Few start selling. A correction begins.

 

Three Phases of Bear Markets:  

The first phase appears to be just a correction. Most people are still bullish and are willing to buy at lower levels. After an initial correction markets rise again. But somehow they fail to cross the previous highs. News flow slowly turns negative. Bulls now start getting nervous. Another phase of selling begins.  

The second phase starts. Buyers keep vanishing as news flow grows worse and earnings disappoint. More and more of investors want to sell and prices keep falling. Every rise is short lived and selling comes again.  

The final phase is of total panic (Remember Post Sept 11 Selling). Many times triggered by some event. People get totally frustrated with stocks and sell at what ever price they get. All are scared to buy. “Stock Market” becomes the most hated word.  

In midst of all doom and gloom another bull market starts and the cycles continue.

 

  1. Two averages must confirm:  

At the time Dow studied the markets, the markets were divided into two main averages Industrial and Railroad. Thus Dow concluded that Bull and Bear markets can only be confirmed when both indices signal them i.e. both are making higher tops and higher bottoms or both are making lower tops and lower bottoms.  

At present in India we have two Major Indices too - Sensex and Nifty. Thus roughly we can apply the same principle to Indian markets too. But unlike DJIA and Railroad average which consisted of different stocks Sensex and Nifty have more or less same composition, thus in most cases they will confirm each other.  

  1. Volume goes with the trend:  

See the chart below. It is the chart of BSE Sensex 2003 Rally. Concentrate in regions between Thick Blue lines (The rectangles). According to Charles Dow, Volumes always increases when prices move in the direction on the main trend. See the first rectangle. Note how volumes were high when prices moved up and volumes were low when prices moved down.  

After the 6250-index peak, in January 2004,a correction came. Again price started moving up again. BUT THIS TIME VOLUMES DIDN’T PICK UP. THIS WAS THE FIRST SIGNAL THAT SOMETHING WAS WRONG. THE UPTREND HAD REVERSED.  

In downtrends volume is more when prices are decreasing and volume is less when price goes up. This is what was happening in rectangle 2.

 

   

  1. A trend is assumed to be in effect until it gives definite signals that it has reversed:  

This tenet is simple to understand.  

It only says DON’T ASSUME A TREND REVERSAL UNLESS SUPPORTED BY FACTS. That’s is DON’T ASSUME A TOP JUST BECAUSE ACCORDING TO YOU, PRICES ARE TOO HIGH. After a bull run, a bear market can only be assumed if a LOWER TOP AND LOWER BOTTOM are seen.  

As seen in above chart the actual Bear Market was signalled when prices went below the green line – THAT IS AFTER A SERIES OF HIGHER TOPS AND HIGHER BOTTOMS, A NEW SERIES OF LOWER TOP AND LOWER BOTTOM WAS FORMED.

Dow Theory: Why do we have higher tops, higher bottoms?  

Think of how a stock (stock price) behaves when people start noticing that the company is doing well. First the price starts rising.  

After prices rise for a while, people get doubtful whether their assessment of the stock is true and if facts justify the rise. Few start selling. Also short-term traders start booking profits. People are hesitant to buy as they think prices are too high.  

Correction starts.  

After the correction proceeds for a while, again buying emerges as people waiting for lower levels buy and sellers stop selling thinking prices have fallen too far. New up trend emerges and short-term traders again rush in.

 

 

IN BULL MARKETS BUYING STOPS CORRECTIONS MIDWAY AND NEW HIGHS ARE AGAIN MADE.  

(IN BEAR MARKETS RECOVERIES ARE STOPED BY SELLING PRESSURE AND NEW LOWS ARE MADE.)  

Thus a series of higher tops ands higher bottoms is formed. (For more on higher tops and bottoms refer earlier article.)

Use of closing prices:  

Dow considered the closing prices most important. He believed that intra day fluctuations were just result of extreme emotions of the day. The closing prices are still considered most important as THEY ARE THE PRICES ON WHICH TRADERS AGREE TO TAKE POSITIONS HOME.  

CLOSING PRICES ARE THE PRICES THAT ALL TRADERS AGREE TO, AFTER A DAY OF TRADING.  

THUS IN DOW THEORY AN INTRA DAY HIGH IS NOT A NEW HIGH. ONLY A NEW HIGH CLOSING IS A NEW HIGH.  

 

Types of Charts:  

Charting is representation of the trading activity of a stock (/commodity/financial instrument) in pictorial form. There are many chart types.   Some of the basic types are line charts, bar charts, and candle sticks.   The importance of closing prices was discussed in last article.

  A line chart is a simple representation of ONLY THE CLOSING PRICES of a stock.

If we connect all closing prices by a line we get a line chart.  

So simple!

 

 

This is the chart of NSE Nifty in Nov/Dec 2004 updated till today.   The line simply shows closing prices of each day.

 

Bar Chart is next step into charting. A bar in a bar chart shows not only the closing prices, but also the open, high and low. Obviously it is more useful to a technician than a simple line chart. In a bar, a vertical line represents the day’s trading range. The opening price is indicated by a tic on the left of the bar and the closing price is indicated by a tic at the right of the bar.  

See the chart below and things will become clear. The three bars represent trading activity of three days in Usha Martin.

 

  Note how in second bar the opening price is also the low price and thus the left tick is at the bottom of the bar. On first and third day, the close was less then open and on second day the close was higher than the open.

  The Nifty bar chart of same period as the line chart is shown below:

 

  Note how bar chart gives us better understanding of intra day price movement, which is absent in simple line chart. 

Candlestick Charts – Unlike the other common TA tools, Candlestick charting developed in Japan and not the western world. Therefore they are also known as Japanese candlesticks. Candlesticks are NOT JUST A TYPE OF CHART BUT ALSO A TRADING GUIDANCE SYSTEM. Japanese futures traders used candlesticks for decades for futures trading, before the western world noticed and accepted them.
Just like the bar charts, candlesticks require O, H, L, and C of the stock.  

The open and close make up the “Body“ of the candlestick. In the figure below the boxes are made between the O and C prices of the stock for the day. The height of the candlestick represents the trading range (high and low) of the price.  

  The line above the body (Open –Close box) is called the upper shadow (hair) and the line below the body (Open –Close box) is called the lower shadow (tail).

  Notice on the second day the Open and Low are same and thus there is no lower shadow (tail) of the candlestick.

  The body of candlestick is Solid (Black) when OPEN > CLOSE i.e. CLOSE IS LESS THAN OPEN and the body of the candlestick is Hollow (White) when CLOSE > OPEN i.e. CLOSE IS MORE HIGHER THEN OPEN.

  Thus Day 2 has Hollow (White) body, as the close is higher than the open. Day 1 and Day 3 have Solid (Black) bodies, as the close is lower than the open.

  The Nifty candlestick chart for period of Nov, Dec and Jan 2005 is shown below. Today’s close was higher than open and thus today’s candlestick has a white (hollow) body.

 

Candlestick charting is a very popular and useful charting system. Different candlestick chart patterns are very useful to traders. Candlesticks will be discussed in depth, in later articles.

  Time Frames: All the above discussion is done on basis of daily charts.   But charts can be made of any time frame.

  We can have Daily, Weekly, Monthly, Quarterly, Yearly  charts. Also short-term traders use Intra day charts, which may be Tick-by-tick, 1 Min, 5 Min etc.

  To get a chart of any time frame, all we need is the O, H, L, and C of the period. If we want a weekly chart we need O, H, L, and C of all weeks and if we want 5 Min charts, we need O, H, L, and C of every 5-minute period in a day.  

Volume: The quantity of shares traded in a stock is known as volume of the stock. Vertical lines usually represent the volume in any particular stock and these are drawn below each day (bar/candlestick).

  Given Below is Dr Reddy’s daily chart. The red bars represent the volume.  

Note today’s volume was abnormally high at BSE due to a block trade that took place at BSE.

 

 

Price Scales - Arithmetic and Logarithmic:

  There are two types of price scales used by chartists.

  First is the simple or arithmetic scale. All of you must have used a simple graph paper. The scale of Y-axis is arithmetic in nature.

  E.g. 1 cm = RS. 10

  The second kind is the logarithmic scale. Students of engineering will be well versed with such a scale.

  In such a scale price is measured in term of percentage and not in absolute value.

  Lets say a price moves from RS 10 to RS 20. For those who bought at 10, their stock has gained 100%. Now suppose the stock moves from 20 to 30. The stock has also moved RS 10 this time. But in percentage terms it has only gained 50%.

  The logarithmic price scale measures the percentage moves in stocks and not the absolute moves.

  See the charts below –

  The first chart is BSE Sensex from 1970 to 2004 Quarterly chart. The price scale used (Y- AXIS) is a simple scale.

  On seeing this chart, what do you feel?

  Most of you will feel that the index has become more volatile in the recent years.

  BUT THAT IS NOT THE CASE.

 

  Look at the second chart.

  In this chart the price scale used is a logarithmic one.

 

  The three blue lines represent 500 1000 and 2000. In the first chart distance between 2000 and 1000 is twice that of the distance between 500 and 1000.

  But in the second chart the distances are same.

  That is because 2000 is 200% of 1000 and 1000 is 200% of 500.

  NOW YOU KNOW WHAT IS MEANT BY MEASUREING PRICES IN PERCENTAGE.

  Nowadays log scale has become much more popular than the simple scale. The reason is obvious – PRICES MOVE IN PERCENTAGES.

  Even the exchanges impose upper and lower circuits at 20% and not 20 or 2 rupees.

  Using a log scale also makes it easier to see price patterns easily.

  I recommend that everyone should use a log scale for price; I will also be using a log scale in all my articles.

  Support and Resistance:

  What is a support and what is a resistance?

  A Support is a price level at which collective buying (actual or potential) from market participants halts a downtrend in prices for an appreciable period.

  Similarly a resistance is a price level at which collective selling (actual or potential) from market participants halts an up trend in prices for an appreciable period.

  We will focus out attention on supports  (resistances are exactly opposite case.)

  Think of a stock moving up. Stocks don’t move up in a single line. Most move up in zigzag fashion  - rising and falling alternately.

  Take the example of Tata Teleservices.

  It moved from 20 to 35 in almost a single move. Many people noticed it but a few actually were able to buy.

  So what happens now?

  People want to get in, but also want lower prices. As the people who had got in earlier start selling and profit booking, those waiting for lower prices start buying and slowly the selling gets absorbed.

  THUS IN THIS CASE SELLING GOT ABSORBED AT AROUND 30, WHICH IS A ROUND FIGURE – MANY PEOPLE WERE WILLING TO BUY AT 30 AND HALT THE DOWNTREND. THE STOCK BOUNCED BACK AND TOUCHED 33.

  So how does a Technical Analyst determine a good support level?

  There are many levels where support can be expected –

  Historical Highs and Lows

Round Figures

Trend lines

Pattern Targets

Moving Averages and so on.

IT IS NOT DIFFICULT TO FIND 100s of SUPPORTS FOR A STOCK –WHAT IS IMPORTANT IS TO PREDICT WHICH SUPPORT WILL HOLD AND WHICH WONT AND THIS IS WHAT SEPARATES AN AMATEUR CHARTIST FROM A SEASONED TECHNICAL ANALYST.

 

  Role reversal of Resistance and Support:

  One of the most fascinating aspects of Technical Analysis is how Supports and Resistances reverse their roles.

  Consider a stock stuck between 15 and 20. People observe it for a few days. Then every time it comes near 20 people sell it and when it comes close to 15 they buy it.

  Then one day the stock goes above 20.

  Day traders are forced to cover – taking prices higher. Now as it is above 20 people start buying. But those who had sold out at 20 regret their decision. THEY THINK I WILL BUY IT IF IT COME TO THE PRICE I SOLD.

  This mentality makes 20 a good support for the next correction.

  Look at the above chart.

  Between January and June 2004 Bharat Rasayan failed to cross 27- 28.

Finally in September it managed to go above 29.

  Short-term traders jumped in taking the stock to 45 within days.

  Then a correction began.

  When the stock came to 29 the EARLIER RESISTANCE LEVEL NOW BECAME THE SUPPORT.

  Similarly trend lines show conversion of Resistances and Supports. The stock took support at 50 just above it’s earlier resistance trend line.