Define Technical Tools

Generally used technical tools are Dow Theory, volume of trading, short selling, odd lot trading, bars and line charts, moving averages and oscillators. In this section some of the above mentioned tools are analyzed.

Dow Theory

Dow developed his theory to explain the movement of the indices of Dow Jones Averages. He developed the theory on the basis of certain hypotheses. The first hypothesis is that, no single individual or buyer can influence the major trend of the market.

However, an individual investor can affect the daily price movement by buying or selling huge quantum of particular scrip. The intermediate price movement also can be affected to a lesser degree by an investor.

His second hypothesis is that the market discounts everything. Even natural calamities such as earthquake, plague and fire also get quickly discounted in the market. The Pokhran blast affected the share market for a short while and then the market returned back to normalcy.

His third hypothesis is that the theory is not infallible. It is not a tool to beat the market but provides a way to understand it better.

The theory According to Dow Theory the trend is divided into primary, intermediate and short term trend. The primary trend may be the broad upward or downward movement that may last for a year or two. The intermediate trends are corrective movements, which may last for three weeks to three months. The primary trend may be interrupted by the intermediate trend. The short term trend refers to the day to day price movement. It is also known as oscillators or fluctuations. These three types of trends are compared to tide, waves and ripples of the sea.

Trend

Trend is the direction of movement. The share prices can either increase or fall or remain flat. The three directions of the share price movements are called as rising, falling and flat trends. The point to be remembered is that share prices do not rise or fall in a straight line. Every rise or fall in price experiences a counter move. If a share price is increasing, the countermove will be a fall in price and vice-versa. The share prices move in zigzag manner.

The trend lines are straight lines drawn connecting either the tops or bottoms of the share price movement. To draw a trend line, the technical analyst should have at least two tops or bottoms. The following figure shows the trend lines.

Trend Reversal

The rise or fall in share price cannot go on forever. The share price movement may reverse its direction. Before the change of direction, certain pattern in price movement emerges. The change in the direction of the trend is shown by violation of the trend line. Violation of the trend line means the penetration of the trend line.

If a scrip price cuts the rising trend line from above, it is a violation of trend line and signals the possibility of fall in price. Like – wise if the scrip pierces the trend line from below this signal the rise in price.

Primary Trend

The security price trend may be either increasing or decreasing. When the market exhibits the increasing trend, it is called bull market. The bull market shows three clear cut peaks. Each peak is higher than the previous peak. The bottoms are also higher than the previous bottoms. The reactions following the peak used to halt before the previous bottoms.

The phases leading to the three peaks are revival, improvement in corporate profit and speculation. The revival period encourages more and more investors to buy scrip’s their expectations about the future being high. In the second phase, increased profits of corporate would result in further price rise. In the third phase, prices advance due to inflation and speculation. The figure gives the three phases of bull market.

The reverse is true with the bear market. Here, the first phase of fall starts with the abandonment of hopes. The chances of prices moving back to the previous high level seemed to be low. This would result in the sale of shares. In the second phase, companies are reporting lower profits and dividends. This would lead to selling pressure.

The final phase is characterized 1’ the distress sale of shares. During the bear phase of 1996, in the Bombay Stock Exchange more than 2/3 of stocks were inactive. Most of the scrip’s were sold below their par values. The figure gives the bear market. Here the tops and bottoms are lower than the previous ones. The bull and bear phases of the Indian stock market are given in Figure.

The Secondary Trend

The secondary trend or the intermediate trend moves against the main trend and leads to correction. In the bull market the secondary trend would result in the fall of about 33-66% of the earlier rise. In the bear market, the secondary trend carries the price upward and corrects the main trend. The correction ivu1d be 33% to 66% of the earlier fall. Intermediate trend corrects the overbought and oversold condition. It provides the space to the market. Compared to the time taken for the primary trend, secondary trend is swift and quicker.

Minor Trends

Minor trends or tertiary moves are called random wriggles. They are simply the daily price fluctuations. Minor trend tries to correct the secondary trend movement. It is better for the investors to concentrate on the primary or secondary trends than on the minor trends. The chartist plots the scrip’s price or the market index each day to trace the primary and secondary trend.

Support and Resistance Level

Anybody interested in the technical analysis should know the support and resistance level. A support level exists at a price where considerable demand for that stock is expected to prevent further fall in the price level. The fall in the price may be halted for the time being or it may result even in price reversal. In the support level, demand for the particular scrip is expected.

In the resistance level, the supply of scrip would be greater than the demand and further rise in price is prevented. The selling pressure is greater and the increase in price is halted for the time being.

Support and resistance usually occur whenever the turnover of a large number of shares tends to be concentrated at several price levels. When the stock touches a certain level and then drops, this is called resistance and if the stock reaches down to certain level and then rises there exists a support. The levels constantly switch from one to another i.e. from support to resistance, or from resistance to support. The figures show the support and resistance level.

This can be explained numerically say, for example, if a scrip price hovers around 150 for some weeks then it may rise and reach ` 210. At this point the price halts and then falls back. The scrip keeps on falling back to around its original price ` 150 and halts. Then it moves upward. In this case ` 150 becomes the support level. At this point, the scrip is cheap and investors buy it and demand makes the price move upward. Whereas ` 210 becomes the resistance level, the price is high and there would be selling pressure resulting in the decline of the price.

If the scrip price reverses the support level and moves downward, it means that the selling pressure has overcome the potential buying pressure, signaling the possibility of a further fall in the value of the scrip. It indicates the violation of the support level and bearish market.

If the scrip penetrates the previous top and moves above, it is the violation of resistance level. At this point, buying pressure would be more than the selling pressure. If the scrip was to move above the double top or triple top formation, it indicates bullish market.

The support and the resistance level need not be formed only on tops or bottoms. They can be on the trend lines or gaps of the chart. Gaps are defined as those points or price levels where the scrip has not changed hands. In the rising or falling price level gaps are formed. If the prices are in the upward move and the high of any day is lower than the next day’s low, the gap is said to have occurred.

For example, if the high price of the Instant Company’s scrip on March 1st is ` 200 and on March 2nd low is 225, a gap is said to have occurred on the bar chart. This indicates that the stock is not traded between the level ` 200 and ` 225. This gap indicates further rise in price level. Likewise in a falling price, a gap is formed if the low price on day 1 is higher than the high price of day 2. Suppose the low price on Monday is ` 150 and the high price on the Tuesday is ` 130, a gap is said to have occurred and indicates that there was no transaction between the level of ` 150 and ` 130.

Indicators

Technical indicators are used to find out the direction of the overall market. The overall market movements affect the individual share price. Aggregate forecasting is considered to be more reliable than the individual forecasting. The indicators are price and volume of trade. The volume of trade is influenced by the behavior of price.

Volume of Trade

Dow gave special emphasis on volume. Volume expands along with the bull market and narrows down in the bear market. If the volume falls with rise in price or vice—versa, it4s-a matter of concern for the investor and the trend may not persist for a longer time. Technical analyst used volume as an excellent method of confirming the trend. The market is said to be bullish when small volume of trade and large volume of trade follow the fall in price and the rise in price.

Large rise in price or large fall in price leads to large increase in volume.

Large volume with rise in price indicates bull market and the large volume with fall in price indicates bear market.

If the volumes decline for five consecutive days, then it will continue for another four days and the same is true in increasing volume.

The Breadth of the Market

The breadth of market is the term often used to study the advances and declines that have occurred in the stock market. Advances mean the number of shares whose prices have increased from the previous day’s trading. Declines indicate the number of shares whose prices have fallen from the previous day’s trading. This is easy to plot and watch indicator because data are available in all business dailies.

The net difference between the number of stock advanced and declined during the same period is the breadth of the market. A cumulative index of net differences measures the market breadth. The following table gives the breadth of the market.

The advance/decline can be drawn as a graph. The.ID line does not exactly show when a reaction will occur but it indicates that it will occur soon. The A/D line is compared with the market index. Generally in a bull market, a bearish signal is given when the AID line slopes down while the BSE Sensex is rising. In a bear market, a bullish signal is given when the AID line begins rising as the Sensex is declining to a new low.

Harvey A.Krow has computed advances and declines as a ratio. He divided the advances by the declines. Any number greater than 1.00 indicates advances are exceeding de-cline. Values below 0.99 indicate declines are more than the advances. Ten day and 200 day moving average of the AID ratios are also computed. A ratio of 0.75 signals short term buy-ing opportunity and there will be intermediate rally in the beginning of the bearish trend.

In the later stages of bear market the ratio declines below 0.5.

Except in the first phase of bull market a rise above 1.25 indicates selling opportunities.

Short Sales

Short selling is a technical indicator known as short interest. Short sales refer to the selling of shares that are not owned. The bears are the short sellers who sell now in the hope of purchasing at a lower price in the future to make profits. The short sellers have to cover up their positions. Short positions of scrips are published in the business newspapers. When the demand for a particular share increases, the outstanding short positions also increase and it indicates future rise of prices. These indications cannot be exactly correct, but they show the general situations.

Short sales of a particular month is selected and compared with the average daily volume of the preceding month. This ratio shows, how many days of trading it would take to use up total short sales. If the ratio is less than 1, market is said to be weak or overbought and a decline can be expected. The value between 1 and 0.5 shows neutral condition of the market. Values above I indicate bullish trend and if it is above 2 the market is said to be oversold. At market tops, short selling is high and at market bottoms short selling is low.

Odd Lot Trading

Shares are generally sold in a lot of hundred. Shares, sold in smaller lots, fewer than 100 are called odd lot. Such buyers and sellers are called odd lotters. Odd lot purchases to odd lot sales (Purchase % Sales) is the odd lot index. The increase in odd lot purchase results in an increase in the index. Relatively more selling leads to fall in the index. It is generally considered that the professional investor is more informed and stronger than the odd lotters. When the professional investors dominate the market, the stock market is technically strong. If the odd lotters dominate the market, the market is considered to be technically weak. The notion behind is that odd lot purchase is concentrated at the top of the market cycle and selling at the bottom. High odd lot purchase forecasts fall in the market price and low purchases/sales ratios are presumed to occur toward the end of bear market.

Several studies have indicated that the odd lotters do not move into the market at the peak and move out at bottom. In October 1987, Newyork stock market crashed. During the weeks prior to the crash contrary to the odd lot theory, odd lotters were selling more shares than they bought when market prices increased. After the crash, odd-lotters sensibly became big buyers when stock prices were near their lows. These rational trading patterns defy the opinion about odd lot theory.

Moving Average

The market indices do not rise or fall in straight line. The upward and downward movements are interrupted by counter moves. The underlying trend can be studied by smoothening of the data. To smooth the data moving average technique is used.

The word moving means that the body of data moves ahead to include the recent observation. If it is five day moving average, on the sixth day the body of data moves to include the sixth day observation eliminating the first day’s observation. Likewise it continues. In the moving average calculation, closing price of the stock is used.

The moving averages are used to study the movement of the market as well as the individual scrip price. The moving average indicates the underlying trend in the scrip. The period of average determines the period of the trend that is being identified. For identifying short-term trend, 10 day to 30 day moving averages are used. In the case of medium term trend 50 day to 125 day are adopted. 200 day moving average is used to identify long term trend.

Index and Stock Price Moving Average

Individual stock price is compared with the stock market indices. The moving average of the stock and the index are plotted in the same sheet and trends are compared. If NSE or BSE index is above stock’s roving average line the particular stock has bullish trend. The price may increase above the market average. If the Sensex or Nifty is below the stock’s moving average, the bearish market can be expected for the particular stock. 

If the moving average of the stock penetrates the stock market index from above, it generates sell signal. Unfavorable market condition prevails for the particular scrip. If the stock line pushes up through the market average, it is a buy signal.

Stock Price And Stock Prices’ Moving Average

Buy and sell signals are provided by the moving averages. Moving averages are used along with the price of the scrip. The stock price ma intersects the moving average at a particular point. Downward penetration of the rising average indicates the possibility of a further fall. Hence sell signal is generated in the figure Upward penetration of a falling average would indicate the possibility of the further rise and gives the buy signal. As the average indicates the underlying trend, its violation may signal trend reversal that is shown in Figure

Comparison of the Two Moving Averages

When long term and short term moving averages are drawn, the intersection of two moving averages generates buy or sell signal. When the scrip price is falling and if the short term average intersects the long term moving average from above and falls below it, the sell signal is generated.

If the scrip price is rising, the short term average would be above the long term average. The short term average intersects the long term average from below indicating a further rise in price, gives a buy signal. The sell and buy signals are given in figures.

But, if the short term average move above the long term average and the long term average is falling, investor should treat intersection with suspicion. The short term movement may not hold long.

Hence, the investor should wait for the long term average to turn up before buying the scrip. Similarly, if the short term average moves below the long term average before the long term average has flattened out or before it reverses its direction, the investor should wait for the fall in the long term average for reversal of direction before moving out of the scrip.

Oscillators

Oscillators indicate the market momentum or scrip momentum. Oscillator shows the share price movement across a reference point from one extreme to another. The momentum indicates:

Overbought and oversold conditions of the scrip or the market.

Signaling the possible trend reversal.

Rise or decline in the momentum.

Generally, oscillators are analyzed along with the price chart. Oscillators indicate trend reversals that have to be confirmed with the price movement of the scrip. Changes in the price should be correlated to changes in the momentum, and then only buy and sell signals can be generated. Actions have to be taken only when the price and momentum agree with each other. With the daily, weekly or monthly closing prices oscillators are built. For short term trading, daily price oscillators are useful.

Relative Strength Index (RSI)

Relative strength index (RSI) RSI was developed by Wells Wilder. It is an oscillator used to identify the inherent technical strength and weakness of a particular scrip or market. RSI can be calculated for scrip by adopting the following formula.

The RSI can be calculated for any number of days depending on the wish of the technical analyst and the tune frame of trading adopted in a particular stock market. RSI is calculated for 5, 7, 9 and 14 days. If the time I period taken for calculation is more, the possibility of getting wrong signals is reduced. Reactionary or L1 rise or fall in the price of the scrip is foretold by the RSI.

The broad rule is, if the RSI crosses seventy there may be downturn and it is time to sell. If the RSI falls below thirty it is time to pick up the scrip. The figure show the buy and sell signals of a RSI chart.

If the share price is falling and RSI is rising, a divergence is said to have occurred. Divergence indicates the turning point of the market. If the RSI is rising in the overbought zone, it would indicate the downfall of the price. If RSI falls in the overbought zone, it gives a clear signal of ‘sell’. The term ‘overbought’ describes the price level at which momentum can no longer be maintained and the price has to go down. This condition occurs after a sharp rise in price during a period of heavy buying. When the RSI is in the oversold region, it generates the buy signal. The term oversold is used to describe a security or market that has declined to an unreasonably low level. This condition is characterized by an increase in sales and excess of net declines.

Rate of Change

Rate of change indicator or the ROC measures the rate of change between the current price and the price ‘n’ number of days in the past. ROC helps to find out the overbought and oversold positions in a scrip. It is also useful in identifying the trend reversal. Closing prices are used to calculate the ROC. Daily closing prices are used for the daily ROC and weekly closing prices for weekly ROC. Calculation of ROC for 12 week or 12 month is most popular.

Procedure

Procedure ROC can be calculated by t methods. In the first method, current closing price is expressed as a percentage of the twelve days or weeks in past. Suppose the price of mpany’hars ` 12 and price twelve days ago was ` 10 then the ROC is obtained by using the equation: 12/10 x 100 120%. In the second method, the percentage variation between the current price and the price twelve days in the past is calculated. It is nothing but 12/10 x 100—100 = 20%. By this method both positive and negative values can be arrived.

Roc Graph

ROC graph ROC can be plotted in a graph, x-axis representing days or months and y-axis the values of ROC. If the first method is adopted, ROC oscillates across the hundred lines. If the second method is used, the ROC oscillates around the zero line.

The main advantage of ROC is the identification of overbought and oversold region. The historic high and low values of the ROC should be identified at first to locate the overbought and oversold region. If the scrip’s values, the scrip is in the overbought region n4:fall in the value can be anticipated. Likewise, if the scrip’s ROC reaches the historic low value, the scrip is m the oversold region, a rise in the scrip’s price can be anticipated. Investor can sell the scrip in the overbought region and buy it in the orsold region. The figure shows the overbought and the oversold region.

Charts

Charts are the valuable and easiest tools in the technical analysis. The graphic presentation of the data helps the investor to find out the trend of the price without any difficulty. The charts also have the following uses

Spots the current trend for buying and selling.

Indicates the probable future action of the market by projection

Shows the past historic movement

Indicates the important areas of support and resistance.

The charts do not lie but interpretation differs from analyst to analyst according to their skills and experience. A leading technician, James Dines said, “Charts are like fire or electricity they are brilliant tools if intelligently controlled and handled but dangerous to a novice”.

Point and Figure Charts

Technical analyst to predict the extent and direction of the price movement of a particular stock or the stock market indices uses point and figure charts. This PF charts are of one-dimensional and there is no indication of time or volume. The price changes in relation to previous prices are shown. The change of price direction can be interpreted. The charts are drawn in the ruled paper. The following figure shows the P and F chart.

The prices are given in the left of the figure as shown. The numbers represent the price of the stock at 2 point interval. The interval of price changes can be 1,2,3,5 or 10 points.

It depends on the analyst’s preference further; it depends upon the stock price movement. Higher points are chosen for high priced stocks and vice versa. Only whole number prices are entered. In figure, the initial price 53 was entered in column 1 a X. The next mark X will be made only if the stock moves up to 55. As long as the price moves up, the Xs a drawn in the vertical column. Here the stock price has moved to 57. When the stock price declines by two points or more the chartist records the change by placing the ‘o’ in the next column. Then the movements are interpreted. The trend reversals can be spotted easily. The figure shows the trend reversals in the point and figure chart.

As long as the price moves between points A and B, there is little indication of price rise. As the price raj.is1an4evel, it generates a buy signal. The market may turn out to be bullish. Likewise, when the price pierces the down the support level C indicates that the stock should be sold and the market may turn out to be bearish.

In spite of the simplicity in thawing the PF charts, they have some inherent disadvantages also.

They do not show the intra- day price movement.

Whole numbers are only taken into consideration. This may result in the loss of information regarding U minor fluctuations.

Vo1um is not mentioned in the chart. Volume and trend of transactions are an important guide to make investment decision. In a bull market, price rise is accompanied by high volume of trading. The bear market is related to low volume of trading.

Bar Charts

The bar chart is the simplest and most commonly used tool of a technical analyst. To build a bar a dot is entered to represent the highest price at which the stock is traded on that day, week or month. Then another dot is entered to indicate the lowest price on that particular date.

A line is drawn to connect both the points a horizontal nub is drawn to mark the closing price. Line charts are used to indicate the price movements. The line chart is a simplification of the bar chart. Here a line is drawn to connect the successive closing prices.

Chart Patterns

Charts reveal certain patterns that are of predictive value. Chart patterns are used as a supplement to other information and confirmation of signals provided by trend lines. Some of the most widely used and easily recognizable chart patterns are discussed here.

V Formation The name itself indicates that in the ‘V’ formation there is a long sharp decline and a fast reversal. The ‘V’ pattern occurs mostly in popular stocks where the market interest changes quickly from hope to fear and vice-versa. In the case of inverted ‘A’ the rise occurs first and declines. There are extended ‘V’s.

In it, the bottom or top moves more slowly over a broader area.

Tops and Bottoms

Top and bottom formation is interesting to watch but what is more important, is the middle portion of it. The investor has to buy after up trend has started and exit before the top is reached. Generally tops and bottoms are formed at the beginning or end of the new trends. The reversal from the tops and bottoms indicate sell and buy signals.

Double Top and Bottom

This type of formation signals the end of one trend and the beginning of another. If the double top is formed when a stock price rises to a certain level, falls rapidly, again rises to the same height or more, and turns down. Its pattern resembles the letter ‘M’. The double top may indicate the onset of the bear market. But the results should be confirmed with volume and trend.

In a double bottom, the price of the stock falls to a certain level and increase with diminishing activity. Then it falls again to the same or to a lower price and turns up to a higher level. The double bottom resembles the letter ‘W’. Technical analysts view double bottom as a sign for bull market. The double top and bottom figures are given below with illustrations.

Head and Shoulders

This pattern is easy to identify and the signal generated by this pattern is considered to be reliable. In the head and shoulder pattern there are three rallies resembling the left shoulder, a head and a right shoulder A neckline is drawn connecting the lows of the tops. When the stock price cuts the neckline from above, it signals the bear market.

The upward movement of the price for some duration creates the left shoulder At the top of the left shoulder people who bought during the uptrend begin to sell resulting in a dip.

Near the bottom there would be reaction and people who have not bought in the first up trend start buying at relatively low prices thus pushing the price upward. The alternating forces of demand and supply create new ups and lows. The following figures explain the head and shoulders pattern.

Inverted Head and Shoulders

Here the reverse of the previous pattern holds true. The price of stock’s falls and rises that makes a inverted right shoulder. As the process of fall and rise in price continues the head and left shoulders are created. Connecting the tops of the inverted head and shoulders gives the neckline. When the price pierces the neckline from beloç it indicates the end of bear market and the beginning of the bull market. These patterns have to be confirmed with the volume and trend of the market.

Triangles

The triangle formation is easy to identify and popular in technical analysis. The triangles are of symmetrical, ascending, descending and inverted.

Symmetrical Triangle

This pattern is made up of series of fluctuations, each fluctuation smaller than the previous one. ‘1bps do not attain the height of the previous tops. Likewise bottoms are higher than the previous bottoms. Connecting the lower tops that are slanting downward forms a symmetrical triangle. Connecting the rising bottom, which is slanting upward, becomes the lower trend line. It is not easy to predict the breakaway either way. The symmetrical triangle does not have any bias towards the bull and bear operators. It indicates the slow down or temporary halt in the direction of the original trend. A probability of the original trend to continue after the completion of the triangle is always there.

Ascending Triangle

The upper trend line is almost a horizontal trend line connecting the tops arid the lower trend line is a rising trend line connecting the rising bottoms. When the demand for the scrip overcomes the supply for it, then there will be a break out.

The break will be in favor of the bullish trend. This pattern is generally spotted during an up move and the probability of the upward move is high here.

Descending Triangle

Connecting the lower tops forms the upper trend line. The upper trend line would be a falling one. The lower trend line would be almost horizontal connecting the bottoms. The lower line indicates the support level. The possibility for a downward breakout is high in this pattern. The pattern indicates that the bear operators are more powerful than the bull operators. This pattern is seen during the trend.

Flags

Flag pattern is commonly seen on the price charts. These patterns emerge either before a fall or rise in the value of the scrip These patterns show the market corrections of the over bought or oversold situations. The time taken to form these patterns is quick. Each rally and setback may last only three to four days. If the pattern is wider it may take three weeks to complete the pattern.

A flag resembles a parallelogram. A bullish flag is formed by two trend lines that stoop downwards. The break Out would occur on the upper side of the trend line. In a bearish flag both the trend lines would be stooping upwards. The breakout occurs in the downward trend line.

Pennant

Pennant looks like a symmetrical triangle. Here also there is bullish and bearish pennant. In the bullish pennant, the lower tops form the upper trend line. The lower trend line connects the rising bottoms. The bullish trend occurs when the value of scrip moves above the upward trend line. Likewise in the bearish pennant, upward trend line is falling and the lower trend line is rising.