2. Objective: (Module 4)
Understand Technical Analysis
Chart Patterns
Moving Averages
RSI / ROC /MACD
Learn of the Efficient Market Hypothesis and
the Random walk theory
References: SAPM texts by
Punithavathy Pandian
Prassana Chandra
2
Jaissy@gmail.com
3. Fundamental Vs. Technical
Analysis
Fundamental Analysis looks at analysis the
stock’s ‘intrinsic value’ ( using valuation
techniques & EIC methodologies).
If intrinsic value < market price – BUY,
If intrinsic > market price – SELL
Technical Analysis – Analysis only of the
stock’s market price trends
BUY if the stock price shows an ‘upward’ trend
SELL if the stock prices shows a downward trend
Technical Analysis
3
Jaissy@gmail.com
4. Technical Analysis: Intro
Based on the assumption that there are
trends in the market prices – upward trend
shows market is on the rise & vice versa
Assumes that the markets prices
movements incorporates all information
about the stock and reflects sentiments of
investors ( hope & fear) – reflects supply
and demand of shares
Technical Analysis
4
Jaissy@gmail.com
5. DOW Theory: Assumptions
Father of technical Analysis: Charles Dow
Analyzed stock movement charts, computed
moving averages to develop the ‘DOW
theory’ ( now implemented using computers)
1. Assumption 1: No single investor can influence
market trends ( only a stock trend if traded in
large quantities)
2. Assumption 2: Market factors in everything –
natural calamities, global recession etc
3. Assumption 3: Theory can only be used to
understand market, not beat it
Technical Analysis
5
Jaissy@gmail.com
6. Dow theory
Trend = direction of movement
Share prices moves up & down in a zigzag;
trend lines connect either 2 tops / bottom
There are 3 types of trends
1. Primary ( upward / downward – 1 / 2 years)…
( like TIDES of the sea)
2. Intermediary ( corrective movements – 1 – 3
months)…(like WAVES of the sea)
3. Short term ( day to day oscillations)…RIPPLES
Technical Analysis
6
Jaissy@gmail.com
7. Trend Lines
Rising trend line : BULL market
Falling Trend line : BEAR market
Prices rises, then
falls then rises even
more.. B2 > B1
Indicates revival,
growth in profitsB1
B2
Prices falls, then
rises, then falls even
more & rises again..
B2 < B1
Indicates decline
B1
B2
speculation
Distress selling
Decline in profit
Good profit
Loss of faith
Hope!
Technical Analysis
7
Jaissy@gmail.com
9. Support & Resistance Levels
Prices will go up / down till there is a
demand / supply correction at that price
Support level – lowest price the stock will
drop to before rising again
Resistance level – highest price the stock
will rise before falling again
Resistance level
Support level
Technical Analysis
9
Jaissy@gmail.com
10. Chart Patterns - 1
Capture stock price movements over time
Stock price is plotted over days
Distinct patterns based on the trend:
1. V formation ( and inverted V)
Technical Analysis
10
Jaissy@gmail.com
14. INDICATORS & OSCILLATORS
Indicator is a set of data points obtained by
applying a formula to the price data ( Open,
close price, volume) of a stock / index.
Technical indicators – used to find the overall
direction of the market.
Oscillator – shows the stock price movement
between two points
Oscillators show stock momentum &
indication on a possible trend reversal
Technical Analysis
14
Jaissy@gmail.com
15. Indicators: Volume of trade
indicates trend – bull or bear
Indicator 1: Volume; Volumes expand in a bull
market & narrow in bear market
Indicator 2: Breadth of market : Diff between
advance & declines
Advances (# of shares that have risen in price)
Declines (# of shares that have declined in
price) in volume
Indicator 3: Short sales ( in bear market) –
selling shares that you don’t have hoping for
future price decrease. # of short sales of a
months compared with avg daily volume for
previous month ( >1..oversold – bull trend)
Technical Analysis
15
Jaissy@gmail.com
16. Indicator 4: Moving Averages
Moving averages = ( average of a body
of data ( price) over time)
Short term ( 10-30 days)/ medium term (50
– 125 days) / long term ( 200 days) trends
of moving average studied to identify
trends
Stock price moving avg. compared with
index moving avg. to identify trends
Technical Analysis
16
Jaissy@gmail.com
18. Types of moving averages
Simple moving average – equal
weightage to each days price
Exponential moving average – higher
weightage to more recent prices.
Moving averages are studied for ‘buy’
and ‘sell’ signals.
Rising moving average- rising trends and
declining moving average -declining
trend
Technical Analysis
18
Jaissy@gmail.com
19. MACD ( Moving Average
convergence & divergence
Oscillator 1: MACD= difference between 2
exponential moving averages
MACD – difference between Short Term (
SEMA - 12 days) & Long Term (LEMA - 26 days)
exponential moving averages
MACD = SEMA - LEMA
Convergence = when the difference-> 0
Divergence = when the difference-> high
MACD: + = rising trend
MACD: - = declining trend
Technical Analysis
19
Jaissy@gmail.com
20. RSI- Relative Strength Index
: Oscillator 2: RSI shows inherent strength or weakness
of a particular stock
RSI = 100 – 100
1 + avg. daily gain
avg. daily loss
RSI avg. Gain / loss can be calculated for 9, 14 days
or more.. Higher the better.
RSI >70 likely downturn – sell, RSI<30 likely upturn- buy
Technical Analysis
20
Jaissy@gmail.com
21. ROC ( Rate of change)
Oscillator 3: ROC measures rate of change between
current price & price a number of days in past (could be 12
days/ 12 weeks / 12 months)
Used to indicate trend reversal
ROC = % change of current price vs. earlier price
ROC = Todays price * 100 - 100
Price ‘n’ days ago
Current price – 210 and price 12 weeks ago – 230,
ROC = 210/230 * 100 – 100= -8.69( negative sign means
decline)
ROC plotted against time: highest peak – overbought
region ( sell here) , lowest point – oversold region( buy here)
Overbought / oversold points indicate trend reversals
Technical Analysis
21
Jaissy@gmail.com
22. Efficient Market Theory
Introduced by Fama – Efficient market theory
states that stock price movements are random
and without any pattern ( unlike technical analysis
which identifies chart patterns)
This theory assumes that any information regarding
the stock will be factored into the stock prices.
Higher the market efficiency, quicker will be the
incorporation of future expectations / any
information into the stock price.
Arbitrageurs look to make a quick profit in the time
before the market prices adjust to new
information; their actions cause the market to
adjust.
Intense competition will ensure a fair price for securities in the market
Efficient Markets
22
Jaissy@gmail.com
23. Efficient Markets
This is a market in which market price of a security
is an unbiased estimate of its intrinsic value
This means any deviation of market price from
intrinsic value is unbiased & random.
What leads to efficient markets?
Investor rationality (investors respond rationally to
new information)
Independent deviation from rationally ( even if
some investors don’t behave rationally – this is
random & not correlated – will be net off finally)
Arbitrage: Rational investors will try to exploit any
inefficiencies in the market – thereby correcting
the inefficiency.
Efficient Markets
23
Jaissy@gmail.com
24. Random Walk Theory
Introduced by Maurice Kendall, a statistician who
studied stock & commodity prices looking for
regular cycles.
He found that the security price movements are
random and that the stock price movements
follow a series of ‘random’ walks.
At each point of time, the stock price is
independent of what it was before.
The theory deals with successive changes in price
(looks at absolute price delta for that security not
relative to other securities price delta)
Efficient Markets
24
Jaissy@gmail.com
25. Random Walk & Efficient
Markets
Academicians state that the randomness of
stock prices is the result of the efficient
market. i.e.:
All information is freely & quickly available to all
market participants
Keen competition ensures that in time the
market prices will reflect ‘intrinsic values’
Prices change only in response to new
information
New information cannot be predicted so prices
cannot be forecast & hence prices behave like
a ‘random walk’
Efficient Markets
25
Jaissy@gmail.com
26. Sem
Three forms of efficient market
hypothesis
Efficient Market Hypothesis
Weak form
efficiency
Semi strong form efficiency
Strong form efficiency
Security prices
factor in all security
market info
Security prices factor
in all public market
info as well as non
market info
Security prices factor
in all available info –
pubic & private
26
Jaissy@gmail.com
27. Stock price factors in the
following info:
Weak Market Hypothesis
All security market info: prices, trading volumes,
rate of return, insider transactions, block trades,
odd lot transactions
Semi Strong Market Hypothesis
All public info– market & non market: macro-
economic data, industry reports, corporate
announcements, P:E ratio, div yield
Strong Market Hypothesis
All available info – public & private. Assumes that
no investor has monopolistic access to info that
would lead to higher risk adjusted returns.
This means no one can getter returns than the market using info!
Efficient Market Hypothesis
27
Jaissy@gmail.com
28. Contradiction to concept of
‘efficient markets’
1. Over reactions of the market – Stock
prices decline dramatically after bad
results - and take time to come to
‘normal’ – during which time investor
can buy at low rates & sell at high rates
making abnormal profit – against
efficient market theory
Efficient Market Hypothesis
28
Jaissy@gmail.com
29. Contradiction to concept of
‘efficient markets’
2. Stock price will go back to ‘average’
return after low or high returns – thereby
giving an investor a chance to ‘predict’
price : against random walk theory
3. Delayed adjustment to new information:
stock prices tend to continue to rise /
decline for some time after corporate
announcements are positive / negative.
Efficient Market Hypothesis
29
Jaissy@gmail.com
30. Contradiction to concept of
‘efficient markets’
4. Small firm: A theory that says small firms give
better returns than large firms – confirmed by
a study done on the NYSE
5. Weekend effect: Stock prices tend to rise all
week reaching a peak on Friday. So it makes
sense to buy on Monday and sell on Friday –
the ‘weekend’ effect contradicts the
efficient market hypothesis
Efficient Market Hypothesis
30
Jaissy@gmail.com