Workshop on Technical Analysis and its

basic application

- Gurucharan H S 99015-00443

What is Technical Analysis???

Technical Analysis is a study of Price & Volume. It is a study of past price & volume behavior, in order to forecast the future prices.

Basic Assumptions in Technical Analysis

• Market prices discounts everything• History Repeats• Price moves in Trends

Price – Volume relationship

Price Volume Relationship

Up Up Bullish

Down Down Bullish

Down Up Bearish

Up Down Bearish

Charts Charts are pictorial or graphical presentation of

prices that makes the job of Analysis easier. In general, prices and time periods are considered as popular scales of its construction.

Types of Charts

1. Line chart – is formed by a simple straight line that joins the closing prices of all the time periods.

2. Bar chart / OHLC chart – is a chart in which the price is represented by a bar for each time period. Unlike Line chart, the Bar chart shows all the four important price points of the time period (open, high, low, close).

3. Candle-stick chart – in simple words is a body built around the Bar chart. The Bar chart is the skeleton and the Candle-stick chart has a

body around it. As the name suggests it resembles a candle.

Dow TheoryEssence of the theory:

Markets moves in Trends

Trends can be classified into:-

a. Primary Trend :- As the name suggests, primary trend is the underlying basic

trend that indicates the basic & overall direction of the market. Primary trend is today more popularly called the long-term trend. Primary trend takes birth at the accumulation phase, then moves into a public participation phase and ends with the maturity of the distribution phase. Primary trends may remain intact for a few years or some times even decades.

b. Secondary Trend :–

Can generally be classified as corrections within the primary trend. These trends do not last for a long time, and eventually pulls-back to follow the Primary trend.

c. Daily Fluctuations: –

They can be misleading and dangerous when considered individually and in isolation. It is better not taken seriously, considering the overall volatility and uncertainty in the market behaviour in general. They have very less importance when not considered in the context of the whole or the overall picture. They should be considered as components, that has very less significance individually, but collectively responsible to build the whole structure.

Corrections in the Trend generally ends around the 1/3rd, 1/2 or 2/3rd of the existing trend measurement. If the correction exceeds 2/3rd of the existing trend measurement, then the chances of trend reversal must be considered seriously.

Basic assumptions to the Theory -

Manipulation of the primary trend is impossible.

Market Averages Discount everything.

Key takeaways from the Dow theory

Market moves in trends Trends generally last long Always trade with the primary trend in consideration Larger picture should always be respected, even

while attaching importance to the study of small fluctuation and swings.

Following the trend is often easier and more profitable, than getting into assumptions and forecasts.

Supports and Resistances

• Supports are places or price zones on the chart where buying interest generally dominates selling pressure.

• Resistances are places or price zones on the

chart where selling pressure generally dominates buying interest.

(However it should be noted that a Support once

broken, will act as Resistance and a Resistance once broken will act as Support.)

Moving Averages

There are 2 popular types of Moving Averages – 1.Simple moving Average – is a Moving Average

that is calculated by adding the closing prices of all the periods and then divided by the number of periods.

For example – a 5 day moving average is the ( sum total of closing prices of the last 5 days / 5 )

2. Exponential moving Average – reduce the lag by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the moving average.

There are three steps to calculating an exponential moving average. First, calculate the simple moving average. An exponential moving average (EMA) has to start somewhere so a simple moving average is used as the previous period's EMA in the first calculation. Second, calculate the weighting multiplier. Third, calculate the exponential moving average. The formula below is for a 10-day EMA.

SMA: 10 period sum / 10 Multiplier: (2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)EMA: {Close - EMA(previous day)} x multiplier + EMA(previous day).

• Moving Averages are important to remove the noise or volatility in the prices. Thus moving averages gives you a smoothening effect. A rising Moving average in-turn indicates that the direction of the prices are up, and a falling Moving average indicates that the direction of the prices are down. Since Moving averages take the average of the prices for a particular period; it is obvious that shorter term Moving averages follow prices more closely than the longer term Moving averages.

• Hence one of the most basic implications of Moving averages is their crossover. If a shorter term Moving average crosses over a longer term average on the up-side, the basic implication is bullishness, and when a shorter term Moving average crosses over a longer term moving average on the downside, the basic implication is bearishness.

Moving Average Convergence-Divergence (MACD)

Moving Average Convergence-Divergence (MACD) indicator is one of the simplest and most effective momentum indicators available. The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, the MACD offers the best of both worlds: trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals.

• Calculation MACD Line: (12-day EMA - 26-day EMA) Signal Line: 9-day EMA of MACD Line

Interpretation

• As its name implies, the MACD is all about the convergence and divergence of the two moving averages. Convergence occurs when the moving averages move towards each other. Divergence occurs when the moving averages move away from each other. The shorter moving average (12-day) is faster and responsible for most MACD movements. The longer moving average (26-day) is slower and less reactive to price changes in the underlying security.

• The MACD Line oscillates above and below the zero line, which is also known as the center-line. These crossovers signal that the 12-day EMA has crossed the 26-day EMA. The direction, of course, depends on the direction of the moving average cross. Positive MACD indicates that the 12-day EMA is above the 26-day EMA. Positive values increase as the shorter EMA diverges further from the longer EMA. This means upside momentum is increasing. Negative MACD values indicates that the 12-day EMA is below the 26-day EMA. Negative values increase as the shorter EMA diverges further below the longer EMA. This means downside momentum is increasing.

Signal Line Crossovers

• Signal line crossovers are the most common MACD signals. The signal line is a 9-day EMA of the MACD Line. As a moving average of the indicator, it trails the MACD and makes it easier to spot MACD turns. A bullish crossover occurs when the MACD turns up and crosses above the signal line. A bearish crossover occurs when the MACD turns down and crosses below the signal line. Crossovers can last a few days or a few weeks, it all depends on the strength of the move.

• Due diligence is required before relying on these common signals. Signal line crossovers at positive or negative extremes should be viewed with caution. Even though the MACD does not have upper and lower limits, chartists can estimate historical extremes with a simple visual assessment. It takes a strong move in the underlying security to push momentum to an extreme. Even though the move may continue, momentum is likely to slow and this will usually produce a signal line crossover at the extremities. Volatility in the underlying security can also increase the number of crossovers.

Centre-line Crossovers

• Centre-line crossovers are the next most common MACD signals. A bullish centre-line crossover occurs when the MACD Line moves above the zero line to turn positive. This happens when the 12-day EMA of the underlying security moves above the 26-day EMA. A bearish centre-line crossover occurs when the MACD moves below the zero line to turn negative. This happens when the 12-day EMA moves below the 26-day EMA.

• Centre-line crossovers can last a few days or a few months. It all depends on the strength of the trend. The MACD will remain positive as long as there is a sustained uptrend. The MACD will remain negative when there is a sustained downtrend.

Divergences

• Divergences form when the MACD diverges from the price action of the underlying security. A bullish divergence forms when a security records a lower low and the MACD forms a higher low. The lower low in the security affirms the current downtrend, but the higher low in the MACD shows less downside momentum. Despite less downside momentum, downside momentum is still outpacing upside momentum as long as the MACD remains in negative territory. Slowing downside momentum can sometimes foreshadows a trend reversal or a sizable rally.

• A bearish divergence forms when a security records a higher high and the MACD Line forms a lower high. The higher high in the security is normal for an uptrend, but the lower high in the MACD shows less upside momentum. Even though upside momentum may be less, upside momentum is still outpacing downside momentum as long as the MACD is positive. Waning upward momentum can sometimes foreshadow a trend reversal or sizable decline.

Conclusions

• The MACD indicator is special because it brings together momentum and trend in one indicator. This unique blend of trend and momentum can be applied to daily, weekly or monthly charts. The standard setting for MACD is the difference between the 12 and 26-period EMAs. Chartists looking for more sensitivity may try a shorter short-term moving average and a longer long-term moving average. MACD(5,35,5) is more sensitive than MACD(12,26,9) and might be better suited for weekly charts. Chartists looking for less sensitivity may consider lengthening the moving averages. A less sensitive MACD will still oscillate above/below zero, but the centreline crossovers and signal line crossovers will be less frequent.

• The MACD is not particularly good for identifying overbought and oversold levels. Even though it is possible to identify levels that are historically overbought or oversold, the MACD does not have any upper or lower limits to bind its movement. During sharp moves, the MACD can continue to over-extend beyond its historical extremes.

Thank you