ROLE OF TECHNICAL ANALYSIS AS A TOOL FOR TRADING DECISIONS

A Report based on Summer Internship at

SUNIDHI SECURITIES & FINANCE LTD.

Submitted by

KEVIN GOYAL
PGDM B 75 BATCH 2011-13

THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH KANDIVALI (EAST) MUMBAI 400 101

ACKNOWLEDGEMENT

I am grateful to Thakur Institute of Management Studies & Research to have introduced this final project in our curriculum. Many people have helped me on this project and each of their contribution was of a great use and value for me. I would like to thank Prof. Pooja Dave, Assistant Professor in Finance at Thakur Institute of Management Studies & Research for giving me an opportunity to work on this project. I would also like to express my profound gratitude to my guide Mr. Hansraj Modi, Technical Analyst at Sunidhi Securities & Finance Ltd. without whose valuable guidance the project would not have been fully completed. And final thanks to my parents and sister who always stood by my side during the project.

Kevin Goyal

DECLARATION

I, Mr. Kevin Goyal hereby declare that this project report entitled Role of Technical Analysis as a Tool for Trading Decisions is the record of authentic work carried out by me during the period from May 2012 to June 2012 and has not been submitted to any other University or Institute for the award of any degree / diploma etc.

______________ (Prof. Pooja Dave) Date: 8-8-2012 Place: Mumbai

__________ (Kevin Goyal)

TABLE OF CONTENTS
Chapter No.
1 2 3 4 5 6 7 8 Introduction Company Profile Technical Analysis Dow Theory Metastock Technical Analysis Software Learnings Challenges Conclusion References

Topic

Page No.
1 2 4 25 28 33 34 35 36

EXECUTIVE SUMMARY

In todays scenario every sector needs working precisely as corporates cannot afford the cost of mistakes. Finance is a vast field and every specialisation in it very useful to forecast the market sentiments. In two months duration of summer internship to gain the knowledge of stock markets and its functioning is not possible. The company Sunidhi Securities & Finance Ltd. is a Broking Firm which offers various financial services to individuals, high networth individuals (HNI), and corporates. Technical Analyst is a person who studies the market action, primarily through the use of charts, for the purpose of forecasting future price trends. They do not believe in company fundamentals which Fundamental Analysts do believe. They believe that the market price of a stock is the actual position of a company in the stock market. They use various techniques and software to predict the market sentiments. They also keep a track of markets functioning abroad as it does impact the other economy in a positive or negative way. The Technical Analysis as a subject is fundamentally built on theory Technicians call Dow Theory. Initially, Charles Dow used to publish his articles in the Wall Street Journal but never published his book. So this theory has undergone various changes as markets today also have changed. Technicians further use software such as Metastock, ODIN, and others to predict market sentiments. Combining the work of Fundamental Analysts and Technical Analysts it has been proved that the predictions of stocks can be done precisely.

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 1 INTRODUCTION

In todays world companies become known or considered big when they are listed on reputed Stock Exchanges namely NSE (NIFTY) & BSE (SENSEX) for India, Dow Jones Industrial Average (DJIA) for USA, HANGSENG for Hong Kong, NIKKEI for Japan, etc. Once the company is listed everything a company does / doesnt is reacted upon by the public and the prices of the share of the respective company fluctuate. Now the company would always want a true picture of the company to be represented by share price, they wouldnt mind if its overvalued but it hurts when the stocks get undervalued. But this uncertainty of the price gives people a chance to make money both in long term and short term. Long term investment is mainly based upon studying fundamentals of the company and its growth potential. But the real piece of magic lies in making money by trading shares either Intraday or holding for a short term. If one wants to make money in this way he / she needs to know the technical side of the stock i.e. charts, trends etc. Its not hard to guess how fascinating it is and so I decided to unlock the mystery as far as possible in this two months time. This field is very difficult to be taught in classroom perhaps beyond scope, one has to see to believe, understand and implement it and that was my main objective after all who doesnt want to know the answers of following questions: 1. Where will NIFTY go from here? 2. Which stock will rise today and which ones will fall? 3. Why is hedging required / how is it done? To find the answer of the above questions and many more I chose to do my summers in the field of Technical Analysis for Capital Market.

P ag e | 1

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 2 COMPANY PROFILE

2.1 OUR MISSION "To become the most preferred financial services provider.

2.2 OUR VISION "To help stake holders create, protect and enhance their wealth using our experience, knowledge, expertise and cutting edge technology in a transparent and ethical manner."\

2.3 SERVICES We recognise that every client is unique and has distinct goals. We can safely vouch that our interactions with thousands of customers have helped us in developing processes that identify and understand individual needs. Thus, we could create financial services that suit every requirement. Once we know your financial goals & needs, we work with you to the best of our abilities to achieve them. Our policy of 'Constant Evaluation and Evolution' in the fields of research and technology helps us in identifying the emerging trends and opportunities at the earliest possible.

2.4 NAVIGATORS Director & Principal Officer Jayesh Parekh is the founder & director of Sunidhi. He has built a formidable reputation as an investor over the past 25 years. He has been a significant long-term investor in various Indian listed companies, which have performed exceedingly well.

P ag e | 2

Role of Technical Analysis as a Tool for Trading Decisions

Chief Investment Officer & Fund Manager Pradeep Nimani has over 11 years of research and investing experience, mainly on the buy-side, including venture capital. He has researched companies across various sectors. He is a qualified Chartered Accountant Head - Equities Amit Mehta is a qualified Chartered Accountant and Certified Financial Planner. He has over 18 years of varied experience in the Indian equity markets.

2.5 FINANCIAL BOUQUET Equity & Derivatives Broking Internet Trading Institutional Forex Broking Commodities Derivatives Broking Depository Services (CDSL) Research (Fundamental) Margin Funding Structured Financial Products Initial Public Offerings (IPOs) Debt Broking Mutual Funds Distribution Insurance Broking Re-insurance Broking Portfolio Management Services (PMS) Research (Quantitative & Technical) Private Equities Real Estate Funds Distribution IPO-Underwriting

P ag e | 3

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 3 TECHNICAL ANALYSIS

Technical Analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. In other words, technical analysis is a method of evaluating securities by analysing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Some rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued the only thing that matters is a security's past trading data and what information this data can provide about where the security might move in the future. 3.1 PHILOSOPHY There are three premises on which the technical approach is based: 1. Market action discounts everything 2. Price moves in trends 3. History repeat itself

1. Market action discounts everything: A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

2. Price moves in trends: In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.

P ag e | 4

Role of Technical Analysis as a Tool for Trading Decisions

3. History repeats itself: Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

4. Not just for stocks: Technical analysis can be used on any security with historical trading data. This includes stocks, futures and commodities, fixed-income securities, forex, etc. In fact, technical analysis is more frequently associated with commodities and forex, where the participants are predominantly traders. 3.2 FUNDAMENTAL V/S TECHNICAL ANALYSIS Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. Technical analysis looks at the price movement of a security and uses this data to predict its future price movements; whereas Fundamental analysis looks at economic factors, known as fundamentals. The Differences 1. Charts vs. Financial Statements At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements. By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries to determine a company's value. In financial terms, an analyst attempts to measure a company's intrinsic value. In this approach, investment decisions are fairly easy to make if the price of a stock trades below its intrinsic value, it's a good investment. Although this is an oversimplification (fundamental analysis goes beyond just the financial statements) for the purposes of this tutorial, this simple tenet holds true. Technical traders, on the other hand, believe there is no reason to analyze a company's fundamentals because these are all accounted for in the stock's price. Technicians believe that all the information they need about a stock can be found in its charts.

P ag e | 5

Role of Technical Analysis as a Tool for Trading Decisions

2. Time Horizon Fundamental analysis takes a relatively long-term approach to analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years. The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company's value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock's market price rises to its "correct" value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This "long run" can represent a timeframe of as long as several years, in some cases. Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share don't emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management can't implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts. 3. Trading Versus Investing Not only is technical analysis more short term in nature that fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools. 3.3 THE CRITICS The criticism of technical analysis has its roots in academic theory specifically the efficient market hypothesis (EMH). This theory says that the market's price is always the correct one any past trading information is already reflected in the price of the stock and, therefore, any analysis to find undervalued securities is useless.

P ag e | 6

Role of Technical Analysis as a Tool for Trading Decisions

3.4 THE USE OF TREND One of the most important concepts in technical analysis is that of trend. The meaning in finance isn't all that different from the general definition of the term - a trend is really nothing more than the general direction in which a security or market is headed. Take a look at the chart below:

It isn't hard to see that the trend in Figure 1 is up. However, it's not always this easy to see a trend:

There are lots of ups and downs in this chart, but there isn't a clear indication of which direction this security is headed.

P ag e | 7

Role of Technical Analysis as a Tool for Trading Decisions

A More Formal Definition Unfortunately, trends are not always easy to see. In other words, defining a trend goes well beyond the obvious. In any given chart, you will probably notice that prices do not tend to move in a straight line in any direction, but rather in a series of highs and lows. In technical analysis, it is the movement of the highs and lows that constitutes a trend. For example, an uptrend is classified as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs. Types of Trend There are three types of trend: 1. Uptrends 2. Downtrends 3. Sideways/Horizontal Trends As the names imply, when each successive peak and trough is higher, it's referred to as an upward trend. If the peaks and troughs are getting lower, it's a downtrend. When there is little movement up or down in the peaks and troughs, it's a sideways or horizontal trend. If you want to get really technical, you might even say that a sideways trend is actually not a trend on its own, but a lack of a welldefined trend in either direction. In any case, the market can really only trend in these three ways: up, down or nowhere. Trendlines A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock. Drawing a trendline is as simple as drawing a straight line that follows a general trend. These lines are used to clearly show the trend and are also used in the identification of trend reversals. As you can see in Figure 5, an upward trendline is drawn at the lows of an upward trend. This line represents the support the stock has every time it moves from a high to a low. Notice how the price is propped up by this support. This type of trendline helps traders to anticipate the point at which a stock's price will begin moving upwards again. Similarly, a downward trendline is drawn at the highs of the downward trend. This line represents the resistance level that a stock faces every time the price moves from a low to a high. Channels A channel, or channel lines, is the addition of two parallel trendlines that act as strong areas of support and resistance. The upper trendline connects a series of highs, while the lower trendline connects a

P ag e | 8

Role of Technical Analysis as a Tool for Trading Decisions

series of lows. A channel can slope upward, downward or sideways but, regardless of the direction, the interpretation remains the same. Traders will expect a given security to trade between the two levels of support and resistance until it breaks beyond one of the levels, in which case traders can expect a sharp move in the direction of the break. Along with clearly displaying the trend, channels are mainly used to illustrate important areas of support and resistance.

3.5 SUPPORT AND RESISTANCE Once you understand the concept of a trend, the next major concept is that of support and resistance. You'll often hear technical analysts talk about the on-going battle between the bulls and the bears, or the struggle between buyers (demand) and sellers (supply). This is revealed by the prices a security seldom moves above (resistance) or below (support).

P ag e | 9

Role of Technical Analysis as a Tool for Trading Decisions

As you can see in Figure 1, support is the price level through which a stock or market seldom falls (illustrated by the blue arrows). Resistance, on the other hand, is the price level that a stock or market seldom surpasses (illustrated by the red arrows). The Importance of Support and Resistance Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times but never broken, he or she may decide to take profits as the security moves toward this point because it is unlikely that it will move past this level. Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis. As long as the price of the share remains between these levels of support and resistance, the trend is likely to continue. It is important to note, however, that a break beyond a level of support or resistance does not always have to be a reversal. For example, if prices moved above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price appreciation is expected to be faster than it was in the channel. Being aware of these important support and resistance points should affect the way that you trade a stock. Traders should avoid placing orders at these major points, as the area around them is usually marked by a lot of volatility. If you feel confident about making a trade near a support or resistance level, it is important that you follow this simple rule: do not place orders directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number, but flirts with it instead. So if you're bullish on a stock that is moving toward an important support level, do not place the trade at the support level. Instead, place it above the support level, but within a few points. On the other hand, if you are placing stops or short selling, set up your trade price at or below the level of support.

3.6 THE IMPORTANCE OF VOLUME To this point, we've only discussed the price of a security. While price is the primary item of concern in technical analysis, volume is also extremely important. What is Volume? Volume is simply the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security. To determine the movement of the volume (up or down), chartists look at the volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show trends in the same way that prices do.

P ag e | 10

Role of Technical Analysis as a Tool for Trading Decisions

Why Volume is Important Volume is an important aspect of technical analysis because it is used to confirm trends and chart patterns. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume. Therefore, if you are looking at a large price movement, you should also examine the volume to see whether it tells the same story. Say, for example, that a stock jumps 5% in one trading day after being in a long downtrend. Is this a sign of a trend reversal? This is where volume helps traders. If volume is high during the day relative to the average daily volume, it is a sign that the reversal is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true trend reversal. Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end. When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators. The simplest example of divergence is a clear upward trend on declining volume.

P ag e | 11

Role of Technical Analysis as a Tool for Trading Decisions

3.7 WHAT IS A CHART? In technical analysis, charts are similar to the charts that you see in any business setting. A chart is simply a graphical representation of a series of prices over a set time frame. For example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the closing price for each day the stock is traded:

Figure 1 provides an example of a basic chart. It is a representation of the price movements of a stock over a 1.5 year period. The bottom of the graph, running horizontally (x-axis), is the date or time scale. On the right hand side, running vertically (y-axis), the price of the security is shown. By looking at the graph we see that in October 2004 (Point 1), the price of this stock was around $245, whereas in June 2005 (Point 2), the stock's price is around $265. This tells us that the stock has risen between October 2004 and June 2005. Chart Properties There are several things an analyst should be aware of when looking at a chart, as these factors can affect the information that is provided. They include the time scale, the price scale and the price point properties used. The Time Scale The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually. The shorter the time frame, the more detailed the chart. Each data point can represent the closing price of the period or show the open, the high, the low and the close depending on the chart used.

P ag e | 12

Role of Technical Analysis as a Tool for Trading Decisions

Intraday charts plot price movement within the period of one day. This means that the time scale could be as short as five minutes or could cover the whole trading day from the opening bell to the closing bell. Daily charts are comprised of a series of price movements in which each price point on the chart is a full days trading condensed into one point. Again, each point on the graph can be simply the closing price or can entail the open, high, low and close for the stock over the day. These data points are spread out over weekly, monthly and even yearly time scales to monitor both short-term and intermediate trends in price movement. Weekly, monthly, quarterly and yearly charts are used to analyze longer term trends in the movement of a stock's price. Each data point in these graphs will be a condensed version of what happened over the specified period. So for a weekly chart, each data point will be a representation of the price movement of the week. For example, if you are looking at a chart of weekly data spread over a fiveyear period and each data point is the closing price for the week, the price that is plotted will be the closing price on the last trading day of the week, which is usually a Friday.

3.8 CHART TYPES There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart. In the following sections, we will focus on the S&P 500 Index during the period of January 2006 through May 2006. Notice how the data used to create the charts is the same, but the way the data is plotted and shown in the charts is different. Line Chart The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts.

P ag e | 13

Role of Technical Analysis as a Tool for Trading Decisions

Bar Charts The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. A bar that is coloured red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).

Candlestick Charts The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the

P ag e | 14

Role of Technical Analysis as a Tool for Trading Decisions

difference between the open and close. And, like bar charts, candlesticks also rely heavily on the use of colours to explain what has happened during the trading period. A major problem with the candlestick colour configuration, however, is that different sites use different standards; therefore, it is important to understand the candlestick configuration used at the chart site you are working with. There are two colour constructs for days up and one for days that the price falls. When the price of the stock is up and closes above the opening trade, the candlestick will usually be white or clear. If the stock has traded down for the period, then the candlestick will usually be red or black, depending on the site. If the stock's price has closed above the previous days close but below the day's open, the candlestick will be black or filled with the colour that is used to indicate an up day.

3.9 CHART PATTERNS A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. In the first section of this tutorial, we talked about the three assumptions of technical analysis, the third of which was that in technical analysis, history repeats itself. The theory behind chart patterns is based on this assumption. The idea is that certain patterns are seen many times, and that these patterns signal a certain high probability move in a stock. Based on the historic trend of a chart pattern setting up a certain price movement, chartists look for these patterns to identify trading opportunities. While there are general ideas and components to every chart pattern, there is no chart pattern that will tell you with 100% certainty where a security is headed. This creates some leeway and debate as to what a good pattern looks like, and is a major reason why charting is often seen as more of an art than a science.

P ag e | 15

Role of Technical Analysis as a Tool for Trading Decisions

There are two types of patterns within this area of technical analysis, reversal and continuation. A reversal pattern signals that a prior trend will reverse upon completion of the pattern. A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any timeframe. In this section, we will review some of the more popular chart patterns. Head and Shoulders This is one of the most popular and reliable chart patterns in technical analysis. Head and shoulders is a reversal chart pattern that when formed, signals that the security is likely to move against the previous trend. As you can see in Figure 1, there are two versions of the head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end. Head and shoulders bottom, also known as inverse head and shoulders (shown on the right) is the lesser known of the two, but is used to signal a reversal in a downtrend.

Figure 1: Head and shoulders top is shown on the left. Head and shoulders bottom, or inverse head and shoulders, is on the right. Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of a high and a low. For example, in the head and shoulders top image shown on the left side in Figure 1, the left shoulder is made up of a high followed by a low. In this pattern, the neckline is a level of support or resistance. Remember that an upward trend is a period of successive rising highs and rising lows. The head and shoulders chart pattern, therefore, illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows.

P ag e | 16

Role of Technical Analysis as a Tool for Trading Decisions

Cup and Handle A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.

As you can see in Figure 2, this price pattern forms what looks like a cup, which is preceded by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price. Once the price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year. Double Tops and Bottoms This chart pattern is another well-known pattern that signals a trend reversal - it is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.

P ag e | 17

Role of Technical Analysis as a Tool for Trading Decisions

Figure 3: A double top pattern is shown on the left, while a double bottom pattern is shown on the right. In the case of the double top pattern in Figure 3, the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom (shown on the right), the price movement has tried to go lower twice, but has found support each time. After the second bounce off of the support, the security enters a new trend and heads upward. Triangles Triangles are some of the most well-known chart patterns used in technical analysis. The three types of triangles, which vary in construct and implication, are the symmetrical triangle, ascending and descending triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months.

The symmetrical triangle in Figure 4 is a pattern in which two trendlines converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. In an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout. In a descending triangle, the lower trendline is flat and the upper trendline is descending. This is generally seen as a bearish pattern where chartists look for a downside breakout.

P ag e | 18

Role of Technical Analysis as a Tool for Trading Decisions

Flag and Pennant These two short-term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. This pattern is then completed upon another sharp price movement in the same direction as the move that started the trend. The patterns are generally thought to last from one to three weeks.

As you can see in Figure 5, there is little difference between a pennant and a flag. The main difference between these price movements can be seen in the middle section of the chart pattern. In a pennant, the middle section is characterized by converging trendlines, much like what is seen in a symmetrical triangle. The middle section on the flag pattern, on the other hand, shows a channel pattern, with no convergence between the trendlines. In both cases, the trend is expected to continue when the price moves above the upper trendline. Gaps A gap in a chart is an empty space between a trading period and the following trading period. This occurs when there is a large difference in prices between two sequential trading periods. For example, if the trading range in one period is between $25 and $30 and the next trading period opens at $40, there will be a large gap on the chart between these two periods. Gap price movements can be found on bar charts and candlestick charts but will not be found on point and figure or basic line charts. Gaps generally show that something of significance has happened in the security, such as a betterthan-expected earnings announcement. There are three main types of gaps, breakaway, runaway (measuring) and exhaustion. A breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trend and an exhaustion gap forms near the end of a trend.

P ag e | 19

Role of Technical Analysis as a Tool for Trading Decisions

Triple Tops and Bottoms Triple tops and triple bottoms are another type of reversal chart pattern in chart analysis. These are not as prevalent in charts as head and shoulders and double tops and bottoms, but they act in a similar fashion. These two chart patterns are formed when the price movement tests a level of support or resistance three times and is unable to break through; this signals a reversal of the prior trend.

Confusion can form with triple tops and bottoms during the formation of the pattern because they can look similar to other chart patterns. After the first two support/resistance tests are formed in the price movement, the pattern will look like a double top or bottom, which could lead a chartist to enter a reversal position too soon. Rounding Bottom A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that signals a shift from a downward trend to an upward trend. This pattern is traditionally thought to last anywhere from several months to several years. A rounding bottom chart pattern looks similar to a cup and handle pattern but without the handle. The long-term nature of this pattern and the lack of a confirmation trigger, such as the handle in the cup and handle, makes it a difficult pattern to trade. We have finished our look at some of the more popular chart patterns. You should now be able to

P ag e | 20

Role of Technical Analysis as a Tool for Trading Decisions

recognize each chart pattern as well the signal it can form for chartists. We will now move on to other technical techniques and examine how they are used by technical traders to gauge price movements. 3.10 MOVING AVERAGES Most chart patterns show a lot of variation in price movement. This can make it difficult for traders to get an idea of a security's overall trend. One simple method traders use to combat this is to apply moving averages. A moving average is the average price of a security over a set amount of time. By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favour. Types of Moving Averages There are a number of different types of moving averages that vary in the way they are calculated, but how each average is interpreted remains the same. The calculations only differ in regards to the weighting that they place on the price data, shifting from equal weighting of each price point to more weight being placed on recent data. The three most common types of moving averages are simple, linear and exponential. 1. Simple Moving Average (SMA) This is the most common method used to calculate the moving average of prices. It simply takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation. For example, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10. As you can see in Figure 1, a trader is able to make the average less responsive to changing prices by increasing the number of periods used in the calculation. Increasing the number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse. Many individuals argue that the usefulness of this type of average is limited because each point in the data series has the same impact on the result regardless of where it occurs in the sequence. The critics argue that the most recent data is more important and, therefore, it should also have a higher weighting. This type of criticism has been one of the main factors leading to the invention of other forms of moving averages.

P ag e | 21

Role of Technical Analysis as a Tool for Trading Decisions

2. Linear Weighted Average This moving average indicator is the least common out of the three and is used to address the problem of the equal weighting. The linear weighted moving average is calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the data point and then dividing by the sum of the number of periods. For example, in a five-day linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers. 3. Exponential Moving Average (EMA) This moving average calculation uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient than the linear weighted average. Having an understanding of the calculation is not generally required for most traders because most charting packages do the calculation for you. The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders. As you can see in Figure 2, a 15-period EMA rises and falls faster than a 15-period SMA. This slight difference doesnt seem like much, but it is an important factor to be aware of since it can affect returns. Major Uses of Moving Averages Moving averages are used to identify current trends and trend reversals as well as to set up support and resistance levels. Moving averages can be used to quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average. As you can see in Figure 3, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward sloping moving average with the price below can be used to signal a downtrend.

P ag e | 22

Role of Technical Analysis as a Tool for Trading Decisions

Another method of determining momentum is to look at the order of a pair of moving averages. When a short-term average is above a longer-term average, the trend is up. On the other hand, a long-term average above a shorter-term average signals a downward movement in the trend. Moving average trend reversals are formed in two main ways: when the price moves through a moving average and when it moves through moving average crossovers. The first common signal is when the price moves through an important moving average. For example, when the price of a security that was in an uptrend falls below a 50-period moving average, like in Figure 4, it is a sign that the uptrend may be reversing.

The other signal of a trend reversal is when one moving average crosses through another. For example, as you can see in Figure 5, if the 15-day moving average crosses above the 50-day moving average, it is a positive sign that the price will start to increase.

If the periods used in the calculation are relatively short, for example 15 and 35, this could signal a short-term trend reversal. On the other hand, when two averages with relatively long time frames cross over (50 and 200, for example), this is used to suggest a long-term shift in trend.

P ag e | 23

Role of Technical Analysis as a Tool for Trading Decisions

Another major way moving averages are used is to identify support and resistance levels. It is not uncommon to see a stock that has been falling stop its decline and reverse direction once it hits the support of a major moving average. A move through a major moving average is often used as a signal by technical traders that the trend is reversing. For example, if the price breaks through the 200-day moving average in a downward direction, it is a signal that the uptrend is reversing.

Moving averages are a powerful tool for analyzing the trend in a security. They provide useful support and resistance points and are very easy to use. The most common time frames that are used when creating moving averages are the 200-day, 100-day, 50-day, 20-day and 10-day. The 200-day average is thought to be a good measure of a trading year, a 100-day average of a half a year, a 50-day average of a quarter of a year, a 20-day average of a month and 10-day average of two weeks. Moving averages help technical traders smooth out some of the noise that is found in day-to-day price movements, giving traders a clearer view of the price trend. So far we have been focused on price movement, through charts and averages. In the next section, we'll look at some other techniques used to confirm price movement and patterns.

P ag e | 24

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 4 DOW THEORY

INTRODUCTION 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 1900 until the time of his death in 1902. These editorials reflected Dows beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment. Due to his death, Dow never published his complete theory on the markets, but several followers and associates have published works that have expanded on the editorials. Some of the most important contributions to Dow Theory were William P. Hamilton's "The Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory" (1932), E. George Schaefer's "How I Helped More Than 10,000 Investors to Profit in Stocks" (1960) and Richard Russell's "The Dow Theory Today" (1961). 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 Transportation Index). Dow created these indexes because he felt they were an accurate reflection of the business conditions within the economy because they covered two major economic segments: industrial and rail (transportation). While these indexes have changed over the last 100 years, the theory still applies to current market indexes. Much of what we know today as technical analysis has its roots in Dows work. For this reason, all traders using technical analysis should get to know the six basic tenets of Dow Theory. 1. The Market Discounts Everything: The first basic premise of Dow Theory suggests that all information - past, current and even future is discounted into the markets and reflected in the prices of stocks and indexes. The Averages reflect all information, experience, knowledge, opinions, and activities of all stock market investors, everything that could possibly affect the demand for or supply of stocks is discounted by the Averages.

P ag e | 25

Role of Technical Analysis as a Tool for Trading Decisions

Like mainstream technical analysis, Dow Theory is mainly focused on price. However, the two differ in that Dow Theory is concerned with the movements of the broad markets, rather than specific securities. 2. The Market has Three Trends There are three trends in stock prices. 1) The Primary Tide is the major long-term trend. But no trend moves in a straight line for long, and 2) Secondary Reactions are the intermediate-term corrections that interrupt and move in an opposite direction against the Primary Tide. 3) Ripples are the very minor day-to-day fluctuations that are of concern only to short-term traders and not at all to Dow Theorists.

3. Major Trends have Three Phases 1) Primary Tides going up, also known as Bull Markets, typically unfold in three up moves in stock prices. The first move up is the result of far-sighted investors accumulating stocks at a time when business is slow but anticipated to improve. The second move up is a result of investors buying stocks in reaction to improved fundamental business conditions and increasing corporate earnings. The third and final up move occurs when the general public finally notices that all the financial news is good. During the final up move, speculation runs rampant. 2) Primary Tides going down, also known as Bear Markets, typically unfold in three down moves in stock prices. The first move down occurs when far-sighted investors sell based on their experienced judgement that high valuations and booming corporate earnings are unsustainable. The second move down reflects panic as a now fearful public dumps at any price the same stock they just recently bought at much higher prices. The final move down results from distress selling and the need to raise cash. 4. The averages must confirm each other To signal a Primary Tide Bull Market major trend, both averages must rise above their respective highs of previous upward Secondary Reactions. To signal a Primary Tide Bear Market major trend, both the Dow-Jones Industrial Average and the Dow-Jones Transportation Average must drop below their respective lows of previous Secondary Reactions. A move to a new high or low by just one average alone is not meaningful. Also, it is not uncommon for one average to signal a change in trend before the other. The Dow Theory does not stipulate any time limit on trend confirmation by both averages.

P ag e | 26

Role of Technical Analysis as a Tool for Trading Decisions

5. Volume Must Confirm The Trend Volume is also used as a secondary indicator to help confirm what the price movement is suggesting. From this tenet it follows that volume should increase when the price moves in the direction of the trend and decrease when the price moves in the opposite direction of the trend.

6. A trend is assumed to be in effect until it gives definite signals that it has reversed The reason for identifying a trend is to determine the overall direction of the market so that trades can be made with the trends and not against them.

In Dow Theory, the sixth and final tenet states that a trend remains in effect until the weight of evidence suggests that it has been reversed. Traders wait for a clear picture of a trend reversal because the goal is not to confuse a true reversal in the primary trend with a secondary trend or brief correction. Remember that a secondary trend is a move in the opposite direction of the primary trend that will not continue. For example, imagine that the primary trend is up, but the indexes are currently selling off. If an investor were to take a short position, concluding that the sell-off is the start of a new primary downward trend, they could get burned when the primary trend continues. Unless you can safely conclude, based on the weight of evidence, that the trend has changed, you will be trading against the trend. As a general rule, this is not a wise idea, as many have been hurt by trading against the market.

P ag e | 27

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 5 METASTOCK TECHNICAL ANALYSIS SOFTWARE

P ag e | 28

Role of Technical Analysis as a Tool for Trading Decisions

ABOUT METASTOCK MetaStock is a proprietary computer program created by Equis

International used for charting and technical analysis of stock prices. It has both real-time and end-of-day versions. It is a tool for traders to analyze the markets on a sector, industry group, and security level. It uses charts and indicators to help you decide when to take and when to exit trades. A product of Thomson Reuters.

The above technical concepts have been applied on few charts given below.

P ag e | 29

Role of Technical Analysis as a Tool for Trading Decisions

1. Nifty 50 Stock GAIL Trendline [Screenshot October 2011 to June 2012]

P ag e | 30

Role of Technical Analysis as a Tool for Trading Decisions

2. Nifty 50 Stock Ranbaxy Labs Trendline [Screenshot 2012]

P ag e | 31

Role of Technical Analysis as a Tool for Trading Decisions

3. Nifty 50 Stock Trendline Ambuja Cement [Screenshot 2012]

P ag e | 32

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 6 LEARNINGS

From this study one can able to extract out the fundamental aspects of Technical Analysis as well as its applicability. Some of the major learnings of the study are mentioned below: 1. Unlike Fundamental Analysis, Technical Analysis is also very much important to play in the stock market. 2. Fundamental Analysis tells about right choice whereas Technical Analysis tells about the right time to enter or exit from the market. 3. Technical Analysis assumes that history tends to repeat itself, but it is not wise to believe that the same trend will occur next. 4. Support and Resistance levels are the levels at which a lot of traders are willing to buy the stock or sell it. So, an investor has to keep its eyes and ears open at this point of time. 5. Among the various types of charts the Candle-Stick Chart is the most effective and acceptable tool to evaluate the performance of a stock and forecast the future. 6. When an investor looks in to the numerous types of chart patterns, it creates a lot of confusion and expectations in the minds of the investors. 7. The Moving Average Convergence Divergence (MACD) is the most well-known and used indicator in Technical Analysis as it is based on real facts of past performance. 8. In trading, volumes have equal importance along with price to confirm the formulation of a trend or a technical pattern. With the help of volumes we can easily determine whether the demand side is greater or supply side is greater for stocks at any given point of time. 9. Most of the investors are not aware of the sophisticated and well-designed tools of technical analysis. They invest without going through the technical analysis. 10. Though Technical Analysis plays a lions role to decide investment pattern as Fundamental Analysis, it cannot be treated as a substitute to Fundamental Analysis.

P ag e | 33

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 7 CHALLENGES

The challenges I faced are as follows: 1. Fundamentals about the subject must be clearly understood then only a technical Analyst can do the best analysis. 2. An expert guide is a must to make the trainee understand various concepts and its applications. 3. Revision of the subject is a must to apply the concepts in real-time trading. 4. One has to be constantly updated about current affairs in the economy as it drives the market sentiments. 5. Basic knowledge of stock market helps in to understand the Technical Analysis.

P ag e | 34

Role of Technical Analysis as a Tool for Trading Decisions

CHAPTER 8 CONCLUSION

A large number of new investors think that there is easy and quick money in investing and day trading. They think that they can buy at bottoms and sell at tops very easily. They think that since they can analyse the chart patterns and use technical analysis very well, they can trade consistently with 90% accuracy. They think that they can invest small amount and trade for large amounts to earn big profits by utilizing multiple exposure on their margin amount and fail to understand the real market behaviour. They fail to understand that investing is not like GO..STOP game. Here, only disciplined investors well equipped with sophisticated technical tools having presence of mind can sustain and make the indices favourable for them irrespective of market trends whether bull or bear. The only thing that matters in investment is Right Time and Right Choice which can be tamed through proper analysis and understanding of the whole game as the NSE has rightly narrated.

SOCH KAR, SAMAJH KAR, INVEST KAR

P ag e | 35

Role of Technical Analysis as a Tool for Trading Decisions

REFERENCES
WEBSITES Sunidhi Securities & Finance Ltd. Profile. [ONLINE] Available at: http://www.sunidhi.com/CompProfile.aspx?Menu=Profile#network. [Last Accessed 1 July 2012]. Sunidhi Securities & Finance Ltd. Services. [ONLINE] Available at: http://www.sunidhi.com/Services.aspx?Menu=Service. [Last Accessed 5 July 2012]. Sunidhi Securities & Finance Ltd. PMS. [ONLINE] Available at: http://www.sunidhi.com/PMSAdv.aspx?Menu=PMS. [Last Accessed 5 June 2012]. Cory Janssen, Chad Langager, and Casey Murphy ( ). Technical Analysis: Introduction. [ONLINE] Available at: http://www.investopedia.com/university/technical/#axzz22wcCxuta. [Last Accessed 10 May 2012].

P ag e | 36