Technical Analysis

Jeet R.Shah M.Com,CFP

CM

Approaches to Investment Decision Making

Fundamental Approach Psychological / Technical Approach Academic Approach Eclectic Approach

Jeet R.Shah

Fundamental Approach
It is a method of forecasting the future price movements of a financial instrument based on economic ,social , political and other relevant factors and the statistics that will affect the basic supply and demand of whatever underlines the financial instrument. It is an answer to the question of what to buy and why to buy.

Jeet R.Shah

Technical Approach /Analysis

TA is an art that helps you to invest/trade along with the direction of the trend and make the most of it. TA can be defined as an art of identifying the trend reversal at a very early stage and to take position at the right time in the direction of the reversal to ride the trend until there is enough evidence to suggest that there will again be a change in the trend.

Jeet R.Shah

Technical Analysis Definition Contd.

In his book Technical Analysis Explained , Martin Ping explains : The TA approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors towards a variety of economic,monetary, political & psychological forces.The art of TA for it is an art is to identify trend changes at an early stage & to maintain an investment posture until the weight of the evidence indicates that the trend has been reversed.

Jeet R.Shah

Foundations of Technical Analysis: What are the assumptions?

Price is determined solely by the interaction of supply & demand . Supply and demand are governed by numerous factors both rational and irrational. The market continually and automatically weighs all these factors. (A random walker would have no qualms about this assumption either. He would point out that any irrational factors are just as likely to be one side of the market as on the other.)
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Assumptions contd.
Disregarding minor fluctuations in the market, stock prices tend to move in trends which persist for an appreciable length of time. (Random walker would disagree with this statement. For any trend to persist there has to be some collective 'irrationality') Changes in trend are caused by shifts in demand and supply. These shifts no matter why they occur, can be detected sooner or later in the action of the market itself. (In the financial economist's view the market (through the price) will instantaneously reflect any shifts in the demand and supply.
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Assumptions contd.
Because of the persistence of trends and patterns,analysis of the past market data can be used to predict future price behaviour.

Jeet R.Shah

Fundamental v Technical Analysis

Fundamental Analysis
Focuses on what ought to happen in the market. It looks forward. It regards stock market behaviour as 90 % logical and 10 % psychological

Technical Analysis
Focuses on what actually happens in the market. It looks backwards. It regards stock market behaviour as 10 % logical and 90 % psychological

Jeet R.Shah

Strengths Of Technical Analysis

It can be used to follow a wide range of instruments in almost any market place. Charts can be used to analyse data for time periods ranging from hours to a century Dow Jones Industrial Average has been in constant use since May 26 ,1896. There are many Technical Analysis tools and techniques available which have been developed to cater to the needs of different market sectors.

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Strengths Of Technical Analysis contd..

The basic principles of TA are easy to understand and have been developed from the way markets operate TA is concerned with what is actually happening in markets. TA relies on the use of accurate and timely data, which is available real-time or with only a short time delay when necessary.

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Weakness Of Technical Analysis

Because TA has an element of subjectivity , it is possible for even experienced analysts to disagree on what data means and it is easy for undisciplined analysts to see what they want to see in a chart or to choose evidence selectively. TA is based on the idea that human nature is constant and therefore that patterns tend to repeat themselves; however,there are limits to the extent to which the future can be simply extrapolated from the past. TA is concerned with the degree of probability that an event will happen not the certainty of the event.
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Weakness Of Technical Analysis contd.

Some modern TA techniques are based on complex mathematical and statistical concepts. Computerised analysis software has largely overcome the difficulties of calculation , but understanding the output and applying it correctly is not easy. It is vital for the success of technical analysis that the data used is both accurate and timely.

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To Sum up
Neither FA nor TA should be used in isolation. It is better to use The Eclectic Approach. This meansConduct FA to establish certain value anchors. Do TA to assess the state of the market psychology . Combine FA and TA to determine which securities are worth- buying, holding and disposing off. Respect Market Price and do not show excessive zeal in beating the market Accept that for higher return there are higher risk.
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Trading Theories

Theory A- Market Equilibrium

Indicators Oscillators, eg, Relative Strength Index (RSI) Number Theory Fibonacci numbers, Gann numbers Waves Elliott Wave Theory Gaps High/low , Open/Closing

Favoured by experts
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Theory B- Classical Technical Analysis

Trends- following moving averages, etc Chart Formations Triangles ,Head & Shoulders etc Trend Lines Channels Cycles

Favoured by Public Advisors

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Theory C- Supply And Demand Fundamentals

Spreads Months,Exchanges, cash/futures Flow of funds Volume and open interest Seasonals Weather , economy Reports Expectations versus reality

Favoured by Floor Traders

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The Dow Theory

Charles Henry.Dow (1851 1902 ) Was a reporter in an financial news service. 1882 He and Edward D Jones founded Dow Jones and company. July 1884 Dow produced his first market measure from the average of eleven stocks known as Railroad Average

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The Dow Theory contd.

Dow realised that two separate measures of the economy would provide confirmation of any broad market trend. Hence on May 26 th 1896 Dow Jones Industrial Average(Average of the closing prices of 12 stocks) was published in the Wall Street Journal (published by Dow )along with the Railroad Average Dow never wrote a book about his theories but he published them as a series of Wall Street Journal editorials.
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The Dow Theory contd.

Dow had noted that a simple line plot of average price against time gave rise to zig-zag patterns which defined market Trends.It is these basic patterns which Technical Analysts still use today, albeit with many refinements.

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Six Principles of The Dow Theory

1 .Average prices discounts everything

Dow used Closing prices exclusively to calculate his averages .He also assumed that the prices dicounted everything still an underlying assumption of TA.

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2. The Market move in Trends

Uptrends have a pattern of rising peaks and troughs- downtrends have the opposite. Dow identified three distinct types of trends : 1. Primary or major trend- These last for a year or more and could be considered to be like a tide 2. Secondary or intermediate trend These are like waves and last for 3 weeks or 3 months. 3. Minor trends These are like ripples and lasted for less than than 3 weeks

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The Dow Theory -Trends

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3.Major trends have Three Phases

Phase 1 This is an accumulation phase that moves side ways. Phase 2 This is an up trend period.Although the trend is up , the market prices zig-zag during correction or pullbacks. Phase 3 After a Peak there is another accumulation phase . Fig 1
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4.Averages must confirm each other

Dow was convinced that both the Industrial and the Railroad Average had to be moving in the same direction to confirm the market trend.

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5.

Volume must confirm the trend

Volume represents the total trading activity for a financial instrument in a particular time period.Dow considered volume to be important additional information in confirming market signals. Volume should expand in the direction of the major trend. Fig 2

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6. A trend is assumed to be in effect until it

gives definite signals that it has reversed
This is the basis of trend analysis but it is not always easy to identify a trend reversal. Major tools to identify Key Reversals-Support and resistance levels -Trend Lines -Moving Averages

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