Technical Analysis SAPM

Table of Contents

1) Introduction Pg no. 2
2) The Basic Assumptions Pg no. 2
3) Fundamental Vs. Technical Analysis Pg no. 3
4) The Use Of Trend Pg no. 6
5) Support And Resistance Pg no.10
6) The Importance Of Volume Pg no.12
7) Chart Types (Techniques) Pg no.14
8) Chart Patterns Pg no.24
9) Moving Averages Pg no.30
10) Indicators And Oscillators Pg no.34
11) Conclusion Pg no.39

Note: Students are required to read this booklet in alignment with Book on Security
Analysis & Portfolio Management. Do not circulate this material to students of any
other colleges.

For any queries: contact (M) 9824074763. mayurfinance@gmail.com

Guidelines to Students

This topic of technical analysis can be explored in following segments:

1. What is technical analysis?

2. Basic concepts
3.
4.
Charting techniques
Technical indicators
MAYUR SHAH
1. What is technical analysis: this segment includes Introduction part (chap-1),
Basic assumptions (chap-2), Fundamental vs. Technical analysis (chap-3)

2. Basic concepts include chapters on The use of trend (chap-4), Support and
Resistance (chap –5), The Importance of volume (chap-6)

3. Charting techniques (chap –8) include Dow theory, bar chart, line chart, point
& figure chart, moving average analysis, and relative strength analysis.

4. Technical indicators segment is not included in this booklet. (Refer book)

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 Technical Analysis SAPM

1. Technical Analysis: Introduction

The methods used to analyze securities and make investment decisions fall into two
very broad categories: fundamental analysis and technical analysis. Fundamental
analysis involves analyzing the characteristics of a company in order to estimate its
value. Technicians (sometimes called chartists) are only interested in the price
movements in the market.

Despite all the fancy and exotic tools it employs, technical analysis really just studies
supply and demand in a market in an attempt to determine what direction, or trend,
will continue in the future. In other words, technical analysis attempts to understand
the emotions in the market by studying the market itself, as opposed to its
components. If you understand the benefits and limitations of technical analysis, it can
give you a new set of tools or skills that will enable you to be a better trader or
investor.

In this booklet, you are learning the subject of technical analysis. It's a broad topic, so
it just cover the basics, providing you with the foundation you'll need to understand
more advanced concepts down the road.

2. Technical Analysis: The Basic Assumptions

What Is Technical Analysis?

Technical analysis is a method of evaluating securities by analyzing 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.

Just as there are many investment styles on the fundamental side, there are also many
different types of technical traders. 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.

The field of technical analysis is based on three assumptions:

1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.

1. The Market 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

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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.

3. History Tends To Repeat 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.

3. Fundamental Vs. Technical Analysis

Technical analysis and fundamental analysis are the two main schools of thought in
the financial markets. As we've mentioned, technical analysis looks at the price
movement of a security and uses this data to predict its future price movements.
Fundamental analysis, on the other hand, looks at economic factors, known as
fundamentals. Let's get into the details of how these two approaches differ, the
criticisms against technical analysis and how technical and fundamental analysis can
be used together to analyze securities.

The Differences
ϖ 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
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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).

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.

ϖ 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.

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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.
(For more insight, read Warren Buffett: How He Does It and What Is Warren Buffett's
Investing Style?)
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.

ϖ 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.

The Critics
Some critics see technical analysis as a form of black magic. Don't be surprised to see
them question the validity of the discipline to the point where they mock its
supporters. In fact, technical analysis has only recently begun to enjoy some
mainstream credibility. While most analysts on market focus on the fundamental side,
just about any major brokerage now employs technical analysts as well.

Much of 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.

There are three versions of EMH. In the first, called weak form efficiency, all past
price information is already included in the current price. According to weak form
efficiency, technical analysis can't predictfuture movements because all past
information has already been accounted for and, therefore, analyzing the stock'spast
price movements will provide no insight into its future movements. In the second,
semi-strong form efficiency, fundamental analysis is also claimed to be of little use in
finding investment opportunities. The third is strong form efficiency, which states that

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all information in the market is accounted for in a stock's price andneither

technical nor fundamental analysis can provide investors with an edge. The vast
majority of academics believe in at least the weak version of EMH, therefore, from
their point of view, if technical analysis works, market efficiency will be called into
question.

There is no right answer as to who is correct. There are arguments to be made on both
sides and, therefore, it's up to you to do the homework and determine your own
philosophy.

Although technical analysis and fundamental analysis are seen by many as polar
opposites - the oil and water of investing - many market participants have experienced
great success by combining the two. For example, some fundamental analysts use
technical analysis techniques to figure out the best time to enter into an undervalued
security. Oftentimes, this situation occurs when the security is severely oversold. By
timing entry into a security, the gains on the investment can be greatly improved.

Alternatively, some technical traders might look at fundamentals to add strength to a

technical signal. For example, if a sell signal is given through technical patterns and
indicators, a technical trader might look to reaffirm his or her decision by looking at
some key fundamental data. Oftentimes, having both the fundamentals and technicals
on your side can provide the best-case scenario for a trade

While mixing some of the components of technical and fundamental analysis is not
well received by the most devoted groups in each school, there are certainly benefits
to at least understanding both schools of thought.

MAYUR SHAH

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4. Technical Analysis: 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 differentfrom 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:

Figure 1

It isn't hard to see that the trend inFigure 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.

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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.

Figure 3 is an example of an uptrend. Point 2 in the chart is the first high, which is
determined after the price falls from this point. Point 3 is the low that is established as
the price falls from the high. For this to remain an uptrend, each successive low must
not fall below the previous lowest point or the trend is deemed a reversal.

Types of Trend
There are three types of trend:

ϖ Uptrends
ϖ Downtrends
ϖ 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 theresi 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 well-defined trend in either
direction. In any case, the market can really only trend in these three ways: up,
down or nowhere.

Trend Lengths
Along with these three trend directions, there are three trend classifications. A trend
of any direction can be classified as a long-term trend, intermediate trend or a short-
term trend. In terms of the stock market, a major trend is generally categorized as one
lasting longer than a year. An intermediate trend is considered to last between one and
three months and a near-term trend is anything less than a month. A long-term trend is
composed of several intermediate trends, which often move against the direction of
the major trend. If the major trend is upward and there is a downward correction in
price movement followed by a continuation of the uptrend, the correction is
considered to be an intermediate trend. The short-term trends are components of both

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major and intermediate trends. Take a look a Figure 4 to get a sense of how these
three trend lengths might look.

When analyzing trends, it is important that the chart is constructed to best reflect the
type of trend being analyzed. To help identify long-term trends, chartists to get a
better idea of the long-term trend use weekly charts or daily charts spanning a five-
year period. Daily data charts are best used when analyzing both intermediate and
short-term trends. It is also important to remember that the longer the trend, the more
important it is; for example, a one-month trend is not as significant as a five-year
trend.

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.

MAYUR SHAH

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Figure 5

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 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.

Figure 6

Figure 6 illustrates a descending channel on a stock chart; the upper trendline has
been placed on the highs and the lower trendline is on the lows. The price has
bounced off of these lines several times, and has remained range-bound for several
months. As long as the price does not fall below the lower line or move beyond the
upper resistance, the range-bound downtrend is expected to continue.

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The Importance of Trend

It is important to be able to understand and identify trends so that you can trade with
rather than against them. Two important sayings in technical analysis are "the trend is
your friend" and "don't cash the trend," illustrating how important trend analysis is for
technical traders.

5. Technical Analysis: 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 ongoing 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).

Figure 7

As you can see in Figure 7, 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).

Why does it happen?

These support and resistance levels are seen as important in terms of market
psychology and supply and demand. Support and resistance levels are the levels at
which a lot of traders are willing to buy the stock (in the case of a support) or sell it
(in the case of resistance). When these trendlines are broken, the supply and demand
and the psychology behind the stock's movementsis thought to have shifted, in which
case new levels of support and resistance will likely be established.

Round Numbers and Support and Resistance

One type of universal support and resistance that tends to be seen across a large
number of securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and
1,000 tend be important in support and resistance levels because they often represent

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the major psychological turning points at which many traders will make buy or sell
decisions.

Buyers will often purchase large amounts of stock once the price starts to fall toward
a major round number such as Rs.50, which makes it more difficult for shares to fall
below the level. On the other hand, sellers start to sell off a stock as it moves toward a
round number peak, making it difficult to move past this upper level as well. It is the
increased buying and selling pressure at these levels that makes them important points
of support and resistance and, in many cases, major psychological points as well.

Role Reversal

Once a resistance or support level is broken, its role is reversed. If the price falls
below a support level, that level will become resistance. If the price rises above a
resistance level, it will often become support. As the price moves past a level of
support or resistance, it is thought that supply and demand has shifted, causing the
breached level to reverse its role. For a true reversal to occur, however, it is important
that the price make a strong move through either the support or resistance.

For example, as you can see in Figure 8, the dotted line is shown as a level of
resistance that has prevented the price from heading higher on two previous occasions
(Points 1 and 2). However, once the resistance is broken, it becomes a level of support
(shown by Points 3 and 4) by sustaining the price and preventing it from heading
lower again.

Many traders who begin using technical analysis find this concept hard to believe and
don't realize hat
t this phenomenon occurs rather frequently, even with some of the
most well-known companies. For example, as you can see in Figure 9, this
phenomenon is evident on the TISCO Inc. chart between 2003 and 2006. Notice how
the role of the Rs. 51 level changes from a strong level of support to a level of
resistance.
In almost every case, a stock will have both a level of support and a level of resistance
and will trade in this range as it bounces between these levels. This is most often seen
when a stock is trading in a generally sideways manner as the price moves through
successive peaks and troughs, testing resistance and support.

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

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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.

Figure 9

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 importa nt
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.

6. Technical Analysis: 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.

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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.
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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.

Volume and Chart Patterns

The other use of volume is to confirm chart patterns. Patterns such as head and
shoulders, triangles, flags and other price patterns can be confirmed with volume, a
process that we'll describe in more detail later in this booklet. In most chart patterns,
there are several pivotal points that are vital to what the chart is able to convey to
chartists. Basically, if the volume is not there to confirm the pivotal moments of a
chart pattern, the quality of the signal formed by the pattern is weakened.

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Volume Precedes Price

Another important idea in technical analysis is that price is preceded by volume.
Volume is closely monitored by technicians and chartists to form ideas on upcoming
trend reversals. If volume is starting to decrease in an uptrend, it is usually a sign that
the upward run is about to end.

Now that we have a better understanding of some of the important factors of technical
analysis, we can move on to charts, which help to identify trading opportunities in
prices movements.

7. Technical Analysis: Chart Techniques (Types)

7.1 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 11

Figure 11 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 Rs.245, whereas in
June 2005 (Point 2), the stock's price is around Rs.265. This tells us that the stock has
risen between October 2004 and June 2005.

Chart Properties
There are several things that you 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

ϖ The Time Scale

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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.

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 day’s 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 five-year 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.

ϖ The Price Scale and Price Point Properties

The price scale is on the right-hand side of the chart. It shows a stock'scurrent price
and compares it to past data points. This may seem like a simple concept in that the
price scale goes from lower prices to higher prices as you move along the scale from
the bottom to the top. The problem, however, is in the structure of the scale
itself. A scale can either be constructed in a linear (arithmetic) or logarithmic way,
and both of these options are available on most charting services.

If a price scale is constructed using a linear scale, the space between each price point
(10, 20, 30, 40) is separated by an equal amount. A price move from 10 to 20 on a
linear scale is the same distance on the chart as a move from 40 to 50. In other words,
the price scale measures moves in absolute terms and does not show the effects of
percent

Figure 12

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If a price scale is in logarithmic terms, then the distance between points will be equal
in terms of percent change. A price change from 10 to 20 is a 100% increase in the
price while a move from 40 to 50 is only a 25% change, even though they are
represented by the same distance on a linear scale. On a logarithmic scale, the
distance of the 100% price change from 10 to 20 will not be the same as the 25%
change from 40 to 50. In this case, the move from 10 to 20 is represented by a larger
space one the chart, while the move from 40 to 50, is represented by a smaller space
because, percentage-wise, it indicates a smaller move. In Figure 12, the logarithmic
price scale on the right leaves the same amount of space between 10 and 20 as it does
between 20 and 40 because these both represent 100% increases.

7.2 Chart Types (Techniques)

Here 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,
moving average analysis, relative strength analysis. 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

Dow Theory

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.

Dow theory identifies three trends within the market: primary, secondary and minor.
A primary trend is the largest trend lasting for more then a year, while a secondary
trend is an intermediate trend that lasts three weeks to three months and is often
associated with a movement against the primary trend. Finally, the minor trend often
lasts less than three weeks and is associated with the movements in the intermediate
trend.

Primary Trend
In Dow theory, the primary trend is the major trend of the market, which makes it the
most important one to determine. This is because the overriding trend is the one that
affects the movements in stock prices. The primary trend will also impact the
secondary and minor trends within the market.

Dow determined that a primary trend will generally last between one and three years
but could vary in some instances. Regardless of trend length, the primary trend
remains in effect until there is a confirmed reversal.

For example, if in an uptrend the price closes below the low of a previously
established trough, it could be a sign that the market is headed lower, and not higher.

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When reviewing trends, one of the most difficult things to determine is how long the
price movement within a primary trend will last before it reverses. The most
important aspect is to identify the direction of this trend and to trade with it, and not
against it, until the weight of evidence suggests that the primary trend has reversed.

Secondary, or Intermediate, Trend

In Dow theory, a primary trend is the main direction in which the market is moving.
Conversely, a secondary trend moves in the opposite direction of the primary trend, or
as a correction to the primary trend.

For example, an upward primary trend will be composed of secondary downward

trends. This is the movement from a consecutively higher high to a consecutively
lower high. In a primary downward trend the secondary trend will be an upward
move, or a rally. This is the movement from a consecutively lower low to a
consecutively higher low.

Below is an illustration of a secondary trend within a primary uptrend. Notice how the
short-term highs (shown by the horizontal lines) fail to create successively higher
peaks, suggesting that a short-term downtrend is present. Since the retracement does
not fall below the October low, traders would use this to confirm the validity of the
correction within a primary uptrend

In general, a secondary, or intermediate, trend typically lasts between three weeks and
three months, while the retracement of the secondary trend generally ranges between
one-third to two-thirds of the primary trend's movement. For example, if the primary
upward trend moved the Sensex from 10,000 to 12,500 (2,500 points), the secondary
trend would be expected to send the sensex down at least 833 points (one-third of
2,500).

Another important characteristic of a secondary trend is that its moves are often more
volatile than those of the primary move.

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Minor Trend
The last of the three trend types in Dow theory is the minor trend, which is defined as
a market movement lasting less than three weeks. The minor trend is generally the
corrective moves within a secondary move, or those moves that go against the
direction of the secondary trend.

Due to its short-term nature and the longer-term focus of Dow theory, the minor trend
is not of major concern to Dow theory followers. But this doesn't mean it is
completely irrelevant; the minor trend is watched with the large picture in mind, as
these short-term price movements are a part of both the primary and secondary trends.

Most proponents of Dow theory focus their attention on the primary and secondary
trends, as minor trends tend to include a considerable amount of noise. If too much
focus is placed on minor trends, it can to lead to irrational trading, as traders get
distracted by short-term volatility and lose sight of the bigger picture.
Stated simply, the greater the time period a trend comprises, the more important the
trend.

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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.

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 colored 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).

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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'strading range. The difference comes in the formation of a
wide bar on the vertical line, which illustrates the difference between the open and
close. And, like bar charts, candlesticks also rely heavily on the use of colors to
explain what has happened during the trading period.

A major problem with the candlestick color 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 color 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 day’s close but below the day's open, the candlestick will
be black or filled with the color that is used to indicate an up day.

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Point and Figure Charts

The point and figure chart is not well known or used by the average investor but it has
had a long history of use dating back to the first technical traders. This type of chart
reflects price movements and is not as concerned about time and volume in the
formulation of the points. The point and figure chart removes the noise, or
insignificant price movements, in the stock, which can distort traders' views of the
price trends. These types of charts also try to neutralize the skewing effect that time
has on chart analysis.

When first looking at a point and figure chart, you will notice a series of Xs and Os.
The Xs represent upward price trends and the Os represent downward price trends.
There are also numbers and letters in the chart; these represent months, and give
investors an idea of the date. Each box on the chart represents the price scale, which
adjusts depending on the price of the stock: the higher the stock's price the more each
box represents. On most charts where the price is between Rs.20 and Rs.100, a box

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represents Rs.1, or 1 point for the stock. The other critical point of a point and figure
chart is the reversal criteria. This is usually set at three but it can also be set according
to the chartist's discretion. The reversal criteria set how much the price has to move
away from the high or low in the price trend to create a new trend or, in other words,
how much the price has to move in order for a column of Xs to become a column of
Os, or vice versa. When the price trend has moved from one trend to another, it shifts
to the right, signaling a trend change.

Moving Average Analysis

Among the most popular technical indicators, moving averages are used to gauge the
direction of the current trend. Every type of moving average is a mathematical result
that is calculated by averaging a number of past data points. Once determined, the
resulting average is then plotted onto a chart in order to allow traders to look at
smoothed data rather than focusing on the day-to-day price fluctuations that are
inherent in all financial markets.

The simplest form of a moving average, appropriately known as a simple moving

average (SMA), is calculated by taking the arithmetic mean of a given set of values.
For example, to calculate a basic 10-day moving average you would add up the
closing prices from the past 10 days and then divide the result by 10. In Figure 1, the
sum of the prices for the past 10 days (110) is divided by the number of days (10) to
arrive at the 10-day average. If a trader wishes to see a 50-day average instead, the
same type of calculation would be made, but it would include the prices over the past
50 days. The resulting average below (11) takes into account the past 10 data points in
order to give traders an idea of how an asset is priced relative to the past 10 days.

Perhaps you're wondering why technical traders call this tool a "moving" average and
not just a regular mean? The answer is that as new values become available, the oldest
data points must be dropped from the set and new data points must come in to replace
them. Thus, the data set is constantly "moving" to account for new data as it becomes
available. This method of calculation ensures that only the current information is
being accounted for. In Figure 2, once the new value of 5 is added to the set, the red
box (representing the past 10 data points) moves to the right and the last value of 15 is
dropped from the calculation. Because the relatively small value of 5 replaces the high
value of 15, you would expect to see the average of the data set decrease, which it
does, in this case from 11 to 10.

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What Do Moving Averages Look Like? (Refer chapter 9)

Once the values of the MA have been calculated, they are plotted onto a chart and
then connected to create a moving average line. These curving lines are common on
the charts of technical traders, but how they are used can vary drastically. It is
possible to add more than one moving average to any chart by adjusting the number
of time periods used in the calculation. These curving lines may seem distracting or
confusing at first, but you'll grow accustomed to them as time goes on.

Now that you understand what a moving average is and what it looks like, we'll
introduce a different type of moving average and examine how it differs from the
previously mentioned simple moving average. The simple moving average is
extremely popular among traders, but like all technical indicators, it does have its
critics. Many individuals argue that the usefulness of the SMA is limited because each
point in the data series is weighted the same, regardless of where it occurs in the
sequence. Critics argue that the most recent data is more significant than the older
data and should have a greater influence on the final result. In response to this
criticism, traders started to give more weight to recent data, which has since led to the
invention of various types of new averages, the most popular of which is the
exponential moving average (EMA).

Relative Strength Analysis (refer the book)

The analyst calculates ratios for the returns of the stock to those of its industry group,
returns of the stock to those of general market, and returns of the industry group to
those of general market.
Now users of relative strength analysis plot the 3 ratios mentioned above and prepare
graph to see relative strengths.

Conclusion
Charts are one of the most fundamental aspects of technical analysis. It is important
that you clearly understand what is being shown on a chart and the information that it
provides. Now that we have an idea of how charts are constructed, we can move on to
the different types of chart patterns.

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8. Technical Analysis: 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 booklet, 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 patters 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.

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 20, 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 20

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Figure 17: 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.

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.

Figure 21

As you can see in Figure 21, 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.

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Figure 22

Figure 19: 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 22, 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. MAYUR SHAH
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.

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The symmetrical triangle in Figure 23 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.

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 24, 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.

Wedge
The wedge chart pattern can be either a continuation or reversal pattern. It is similar to
a symmetrical triangle except that the wedge pattern slants in an upward or downward
direction, while the symmetrical triangle generally shows a sideways movement. The
other difference is that wedges tend to form over longer periods, usually between
three and six months.

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The fact that wedges are classified as both continuation and reversal patterns can
make reading signals confusing. However, at the most basic level, a falling wedge is
bullish and a rising wedge is bearish. In Figure 25, we have a falling wedge in which
two trendlines are converging in a downward direction. If the price was to rise above
the upper trendline, it would form a continuation pattern, while a move below the
lower trendline would signal a reversal pattern.

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 Rs.25 and
Rs.30 and the next trading period opens at Rs.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
better-than-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.

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.

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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 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.

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9. Technical Analysis: 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'saverage
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 favor.

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.

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 28, 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.

Figure 28

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.

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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 irst
f day in
the period range is reached. These numbers are then added together and divided by
the sum of the multipliers.

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 29, a 15-period EMA rises
and falls faster than a 15-period SMA. This slight difference doesn’t 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 27, 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.

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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 31, it is a sign that the uptrend may be
reversing.

Figure 31

The other signal of a trend reversal is when one moving average crosses through
another. For example, as you can see in Figure 32, 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.

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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.

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

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section, we'll look at some other techniques us

ed to confirm price movement and
patterns.

10. Technical Analysis: Indicators And Oscillators

Indicators are calculations based on the price and the volume of a security that
measure such things as money flow, trends, volatility and momentum. Indicators are
used as a secondary measure to the actual price movements and add additional
information to the analysis of securities. Indicators are used in two main ways: to
confirm price movement and the quality of chart patterns, and to form buy and sell
signals.

There are two main types of indicators: leading and lagging. A leading indicator
precedes price movements, giving them a predictive quality, while a lagging indicator
is a confirmation tool because it follows price movement. A leading indicator is
thought to be the strongest during periods of sideways or non-trending trading ranges,
while the lagging indicators are still useful during trending periods.

There are also two types of indicator constructions: those that fall in a bounded range
and those that do not. The ones that are bound within a range are called oscillators -
these are the most common type of indicators. Oscillator indicators have a range, for
example between zero and 100, and signal periods where the security is overbought
(near 100) or oversold (near zero). Non-bounded indicators still form buy and sell
signals along with displaying strength or weakness, but they vary in the way they do
this.

The two main ways that indicators are used to form buy and sell signals in technical
analysis is through crossovers and divergence. Crossovers are the most popular and
are reflected when either the price moves through the moving average, or when two
different moving averages cross over each other. The second way indicators are used
is through divergence, which happens when the direction of the price trend and the
direction of the indicator trend are moving in the opposite direction. This signals to
indicator users that the direction of the price trend is weakening.

Indicators that are used in technical analysis provide an extremely useful source of
additional information. These indicators help identify momentum, trends, volatility
and various other aspects in a security to aid in the technical analysis of trends. It is
important to note that while some traders use a single indicator solely for buy and sell
signals, they are best used in conjunction with price movement, chart patterns and
other indicators.

Accumulation/Distribution Line

The accumulation/distribution line is one of the more popular volume indicators that
measures money flows in a security. This indicator attempts to measure the ratio of
buying to selling by comparing the price movement of a period to the volume of that
period.

Calculated as:

Acc/Dist = [(Close - Low) - (High - Close)] / (High - Low) * Period's Volume

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This is a non-bounded indicator that simply keeps a running sum over the period of
the security. Traders look for trends in this indicator to gain insight on the amount of
purchasing compared to selling of a security. If a security has an
accumulation/distribution line that is trending upward, it is a sign that there is more
buying than selling.

Average Directional Index

The average directional index (ADX) is a trend indicator that is used to measure the
strength of a current trend. The indicator is seldom used to identify the direction of the
current trend, but can identify the momentum behind trends.

The ADX is a combination of two price movement measures: the positive directional
indicator (+DI) and the negative directional indicator (-DI). The ADX measures the
strength of a trend but not the direction. The +DI measures the strength of the upward
trend while the -DI measures the strength of the downward trend. These two measures
are also plotted along with the ADX line. Measured on a scale between zero and 100,
readings below 20 signal a weak trend while readings above 40 signal a strong trend.

Aroon

The Aroon indicator is a relatively new technical indicator that was created in 1995.
The Aroon is a trending indicator used to measure whether a security is in an uptrend
or downtrend and the magnitude of that trend. The indicator is also used to predict
when a new trend is beginning.

The indicator is comprised of two lines, an "Aroon up" line (blue line) and an "Aroon
down" line (red dotted line). The Aroon up line measures the amount of time it has
been since the highest price during the time period. The Aroon down line, on the other
hand, measures the amount of time since the lowest price during the time period. The
number of periods that are used in the calculation is dependent on the time frame that
the user wants to analyze.

Figure 31

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Aroon Oscillator

An expansion of the Aroon is the Aroon oscillator, which simply plots the difference
between the Aroon up and down lines by subtracting the two lines. This line is then
plotted between a range of -100 and 100. The centerline at zero in the oscillator is
considered to be a major signal line determining the trend. The higher the value of the
oscillator from the centerline point, the more upward strength there is in the security;
the lower the oscillator's value is from the centerline, the more downward pressure. A
trend reversal is signaled when the oscillator crosses through the centerline. For
example, when the oscillator goes from positive to negative, a downward trend is
confirmed. Divergence is also used in the oscillator to predict trend reversals. A
reversal warning is formed when the oscillator and the price trend are moving in an
opposite direction.

The Aroon lines and Aroon oscillators are fairly simple concepts to understand but
yield powerful information about trends. This is another great indicator to add to any
technical trader's arsenal.

Moving Average Convergence

The moving average convergence divergence (MACD) is one of the most well-known
and used indicators in technical analysis. This indicator is comprised of two
exponential moving averages, which help to measure momentum in the security. The
MACD is simply the difference between these two moving averages plotted against a
centerline. The centerline is the point at which the two moving averages are equal.
Along with the MACD and the centerline, an exponential moving average of the
MACD itself is plotted on the chart. The idea behind this momentum indicator is to
measure short-term momentum compared to longer term momentum to help signal the
current direction of momentum.

MACD= shorter term moving average - longer term moving average

When the MACD is positive, it signals that the shorter term moving average is above
the longer term moving average and suggests upward momentum. The opposite holds
true when the MACD is negative - this signals that the shorter term is below the
longer and suggest downward momentum. When the MACD line crosses over the
centerline, it signals a crossing in the moving averages. The most common moving
average values used in the calculation are the 26-day and 12-day exponential moving
averages. The signal line is commonly created by using a nine-day exponential
moving average of the MACD values. These values can be adjusted to meet the needs
of the technician and the security. For more volatile securities, shorter term averages
are used while less volatile securities should have longer averages.

Another aspect to the MACD indicator that is often found on charts is the MACD
histogram. The histogram is plotted on the centerline and represented by bars. Each
bar is the difference between the MACD and the signal line or, in most cases, the
nine-day exponential moving average. The higher the bars are in either direction, the
more momentum behind the direction in which the bars point.

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As you can see in Figure 35, one of the most common buy signals is generated when
the MACD crosses above the signal line (blue dotted line), while sell signals often
occur when the MACD crosses below the signal.

Figure 35

Relative Strength Index

The relative strength index (RSI) is another one of the most used and well-known
momentum indicators in technical analysis. RSI helps to signal overbought and
oversold conditions in a security. The indicator is plotted in a range between zero and
100. A reading above 70 is used to suggest that a security is overbought, while a
reading below 30 is used to suggest that it is oversold. This indicator helps traders to
identify whether a security’s price has been unreasonably pushed to current levels and
whether a reversal may be on the way.

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The standard calculation for RSI uses 14 trading days as the basis, which can be
adjusted to meet the needs of the user. If the trading period is adjusted to use fewer
days, the RSI will be more volatile and will be used for shorter term trades.

On-Balance Volume

The on-balance volume (OBV) indicator is a well-known technical indicator that

reflects movements in volume. It is also one of the simplest volume indicators to
compute and understand.

The OBV is calculated by taking the total volume for the trading period and assigning
it a positive or negative value depending on whether the price is up or down during
the trading period. When price is up during the trading period, the volume is assigned
a positive value, while a negative value is assigned when the price is down for the
period. The positive or negative volume total for the period is then added to a total
that is accumulated from the start of the measure. It is important to focus on the trend
in the OBV - this is more important than the actual value of the OBV measure. This
measure expands on the basic volume measure by combining volume and price
movement.

Stochastic Oscillator

The stochastic oscillator is one of the most recognized momentum indicators used in
technical analysis. The idea behind this indicator is that in an uptrend, the price should
be closing near the highs of the trading range, signaling upward momentum in the
security. In downtrends, the price should be closing near the lows of the trading range,
signaling downward momentum.

The stochastic oscillator is plotted within a range of zero and 100 and signals
overbought conditions above 80 and oversold conditions below 20. The stochastic
oscillator contains two lines. The first line is the %K, which is essentially the raw
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measure used to formulate the idea of momentum behind the oscillator. The second
line is the %D, which is simply a moving average of the %K. The %D line is
considered to be the more important of the two lines as it is seen to produce better
signals. The stochastic oscillator generally uses the past 14 trading periods in its
calculation but can be adjusted to meet the needs of the user.

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11. Brief Notes

Here's a brief summary of what is covered:

• Technical analysis is a method of evaluating securities by analyzing the

statistics generated by market activity. It is based on three assumptions: 1) the
market discounts everything, 2) price moves in trends and 3) history tends to
repeat itself.
• Technicians believe that all the information they need about a stock, can be
found in its charts.
• Technical traders take a short-term approach to analyzing the market.
• Criticism of technical analysis stems from the efficient market hypothesis,
which states that the market price is always the correct one, making any
historical analysis useless.
• One of the most important concepts in technical analysis is that of a trend,
which is the general direction that a security is headed. There are three types
of trends: uptrends, downtrends and sideways/horizontal trends.
• A trendline is a simple charting technique that adds a line to a chart to
represent the trend in the market or a stock.
• A channel, or channel lines, is the addition of two parallel trendlines that act as
strong areas of support and resistance.
• Support is the price level through which a stock or market seldom falls.
Resistance is the price level that a stock or market seldom surpasses.
• Volume is 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.
• A chart is a graphical representation of a series of prices over a set time frame.
• 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 price scale is on the right-hand side of the chart. It shows a stock's current
price and compares it to past data points. It can be either linear or logarithmic.
• There are four main types of charts used by investors and traders: line charts,
bar charts, candlestick charts and point and figure charts.
• A chart pattern is a distinct formation on a stock chart that creates a trading
signal, or a sign of future price movements. There are two types: reversal and
continuation.
• A head and shoulders pattern is reversal pattern that signals a security is likely
to move against its previous trend.
• A cup and handle pattern is a bullish continuation pattern in which the upward
trend has paused but will continue in an upward direction once the pattern is
confirmed.
• Double tops and double bottoms 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.
• A triangle is a technical analysis pattern created by drawing trendlines along a
price range that gets narrower over time because of lower tops and higher
bottoms. Variations of a triangle include ascending and descending triangles.
• Flags and pennants are short-term continuation patterns that are formed when
there is a sharp price movement followed by a sideways price movement.

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• The wedge chart pattern can be either a continuation or reversal pattern. It is

similar to a symmetrical triangle except that the wedge pattern slants in an
upward or downward direction.
• 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.
• Triple tops and triple bottoms are reversal patterns that are formed when the
price movement tests a level of support or resistance three times and is unable
to break through, signaling a trend reversal.
• A rounding bottom (or saucer bottom) is a long-term reversal pattern that
signals a shift from a downward trend to an upward trend.
• A moving average is the average price of a security over a set amount of time.
There are three types: simple, linear and exponential.
• 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.
• Indicators are calculations based on the price and the volume of a security that
measure such things as money flow, trends, volatility and momentum. There
are two types: leading and lagging.
• The accumulation/distribution line is a volume indicator that attempts to
measure the ratio of buying to selling of a security.
• The average directional index (ADX) is a trend indicator that is used to
measure the strength of a current trend.
• The Aroon indicator is a trending indicator used to measure whether a security
is in an uptrend or downtrend and the magnitude of that trend.
• The Aroon oscillator plots the difference between the Aroon up and down
lines by subtracting the two lines.
• The moving average convergence divergence (MACD) is comprised of two
exponential moving averages, which help to measure a security'smomentum.
• The relative strength index (RSI) helps to signal overbought and oversold
conditions in a security.
• The on-balance volume (OBV) indicator is one of the most well-known
technical indicators that reflects movements in volume.
• The stochastic oscillator compares a security's closing price to its price range
over a given time period.

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