Basics of Technical Analysis

 

What is Technical Analysis ?

Technical Analysis (TA) is one of the methods used to predict the movement of the price of a stock or an index in the future. The prediction is derived based on a careful analysis of the previous price movements of the stock or index. To put is simply, the future trend is derived based on the past movements of the stock.

Technical Analysis does not yield absolute results always. As is the case with any forecasting system, the TA can give you a hint on what might be expected. But the expectations might prove to be false in extreme market conditions.

So TA will not help you totally overcome the risks involved in the markets, but if used properly, it can help you to predict and take precautionary measures to a large extent.

 

What are Charts ? Why do we need them ?

Charts are graphical representations of the movement of the stock price or the index value, over a period of time. Along with the price or value, the charts can also be used to depict other related indicators such as the Volume or total traded quantity of stocks. Based on the stock prices or values, statistical indicators are used to obtain values, which can also be plotted on the charts.

Charts offer a very convenient way to visually analyze the movement of the stock price or value. Rising and Falling trends can be easily found out looking at the charts. Repeating Visual Patterns in the charts are also used to forecast the movement. Charts can also be used to spot and trace the effect of key events in the history of the price of the stock.

 

How are Charts Plotted ?

Financial Charts are generally 2D Charts. There are of course 3D and other higher dimensional charts used in advanced analysis.

The X-axis (Horizontal axis) is generally used to depict the Time Frame. The Y-Axis (Vertical Axis) is used to depict the price or the value that varies with time.

 

What are Technical Indicators ?

Technical Analysts often rely on some Statistical and Mathematical functions that are applied on the price or value of the stock. These are generally called as ‘Technical Indicators’ . The resultant values, after applying these functions to the price of the stock, are again plotted on the Chart. Analysts can get further hints from analyzing the movement of these indicator values.

There is no consensus or a prescribed set of indicators that have to be used. Each Technical Analyst uses a custom set of these indicators depending upon his / her Trading strategy.

Some of the most commonly used indicators include Relative Strength Index (RSI), Moving Averages (MA), Moving Average Convergence Divergence (MACD) and others.

 

Moving Averages

Moving Average (MA)

Moving Average is probably one of the most frequently used indicators in technical analysis. This is a statistical indicator which indicates the average movement of the price of the stock for a specified period. This can be calculated for any time series. Generally this will be used to indicate the overall movement of the stock price for the specified time frame range and thus smoothes out the short term variations and fluctuations.

Simple Moving Average (SMA)

The Simple Moving Average (SMA) is one of the simplest indicators to calculate. It gives the average price of stock over a specified period of time. Generally Moving Averages are calculated for the closing prices of the stocks at the end of the day. But you may also calculate for the High, Low, Close and even on the traded Volumes of the stock.

For example, the 9 period SMA gives the average closing price of the stock for the past 9 days. It is calculated as follows:

If P1 represents the price on day 1; P2 represents the price on day 2 and so on, then SMA for period n is calculated as follows:

SMA (for period n) = ( P1 + P2 + P3 + …… + Pn ) / n

So for example, if the close prices of a stock for 4 consecutive days are as follows: 120, 121, 122 and 123.

Then the SMA (for period 4) = (120 + 121 + 122 +123) / 4

So SMA (for period 4) becomes 486/4 = 121.5

Exponential Moving Average (EMA)

Exponential Moving Average (EMA) statistically applies exponentially decreasing weighting factor to the data. Thus EMA results in providing more importance to the recent variations in the data. So EMA reacts sharply to the recent data when compared to the SMA.

EMA for the Close price of a security is calculated as follows:

EMAc = (ClosePrice x Factor) + ( EMAp x (1-Factor) )

where:

EMAc = Current EMA

EMAp = Previous EMA

ClosePrice = Current Closing Price

Factor = 2 / (n+1) , where n is the period for which EMA is calculated

 

How to make profit with Moving averages

How to trade with Moving Averages ?

Moving Averages are particulary useful in identifying the direction of an uptrend or downtrend of stocks and markets in general. They are based on the previous data and hence are generally referred to as lagging indicators which help us in locating the trend and following on in the trend . Since they do not allow you to predict the trend, you have to use other technical indicators in conjunction with them during trading.

Generally, the most common way to trade with the Moving averages is this - If the price crosses above the moving average, it means that a buying interest has set in - and thus indicates a buy signal. Similarly when the price crosses down the moving average, it means that a selling pressure has set in - thus indicates a sell signal.

Although it helps in indicating the current trend, it does not indicate for how long this trend would continue or when does the reverse trend begin. So traders should be cautious about this when using the moving averages for planning trades. It is also important to consider the volume for the security in question before trading. Sporadic movements with low volumes can generate erratic signals.

Example :

Look at this chart of Reliance capital shown below. The bold yellow line indicates the price and the thin blue line indicates the 9-day Simple Moving Average of the Close price of this stock.

moving-average-example

As you can see from the above chart, when the price has crossed above the SMA, then it indicates that buying interest has set in. From then on, the stock price is on a rise with minor dips. The downtrend is indicated at the point after the price crosses down the MA line. This indicates a down trend and becomes a candidate for sell signal. As can be seen the prices come down in the downtrend.

Longer and shorter Moving Averages

Moving averages can be configured any period of your choice. The most common ones are 9 Day, 30 Days, 50 days and the 200 Day Moving averages. The longer the period, smoothing will be more. Thus in stocks which display a great deal of sharp glitches and breaks, longer moving averages would make sense, as smoothing would be better. Choosing short period moving averages in such cases would result in erratic signals.

Short trends are identified by short period MAs - like the 9 day and 15 day MAs. A medium term trend is given by the 30 - 50 day moving averages. 100 and 200 day moving averages can indicate the intermediate long term trends.

Trading with Moving average Crossovers

Plotting both long term and short term Moving averages for the same security can lead to crossovers. This can also indicate some trading signals in some cases. A buy signal is generally assumed if the short term moving average crosses over the long term moving average. Similarly a sell signal can be indicated when the short moving average falls down the long term moving average.

Example: Look at this chart of the stock ABB in the NSE. The bold yellow line signifies the price movement of the stock. The blue line is the 30 day EMA and the brown line is the 200 day EMA.

moving-average-crossover-example

As can be seen from the chart, when the short term MA i.e the 30 day EMA (blue line) crosses over the long term MA ( 200 day EMA - brown line), then an uptrend is identified and thus a buy signal is generated.

As indicated earlier, MA can help in identifying trends and can give late trading signals. When used with other technical indicators, they can be very helpful in determining trading strategies.

 

Relative Strength Index (RSI)

RSI Definiton and Calculation

RSI is a popular technical indicator that was developed by Welles Wilder. It is very popular because its very simple to interpret this indicator. It is an oscillator indicating the overbought and oversold conditions of the stock.

RSI is based on the comparison of the magnitude of the gain to the loss. It is the ratio of the EMA of Upward(U) and Downward(D) movements, which is then normalized to values between 0 to 100.

So, if

Pc represents the current Closing price

Pp represents the previous Closing price,

then on a day when the stock has closed up, U = Pc - Pp and D = 0

Similarly on a day when the stock has closed down, D = Pp - Pc and U = 0

Then EMA is calculated for U and D for a period n , represented respectively by EMAup and EMAdn.

Now RSI is calculated as follows:

RSI = 100 x (EMAup / (EMAup + EMAdn) )

 

How to make profit using RSI

How to trade with RSI ?

Generally a 14 period RSI is plotted for the close prices of the stock. RSI Value of 70 and above is considered to indicate that the stock is in Over Bought condition. Similarly an RSI value of 30 and below is considered to indicate that the stock is in Over Sold condition.

The Over Bought condition indicates that the stock price may be getting over valued and in the next trend may be a candidate for pullback in the downward direction. Similarly the over sold condition indicates that the stock may be getting under valued and in the next trend may be a potential candidate for a pullback rally in the upward direction.

Example : Consider this chart of the Infosys Technologies stock in the NSE:

rsi-example

The yello line at the top indicates the Close price of the stock over a period of time. The bottom line in torquoise blue indicates the 14 day RSI for the Close price of the stock.

As you can see in the chart, when the RSI values have crossed the 70 value, the stock enters the Overbought zone and becomes a candidate for pulldown thus giving a sell signal. Thus a downtrend in the price of the stock is seen after this condition.

Similarly when the RSI values have come below 30, the stock enters the Oversold zone and becomes a candidate for pullback thus giving a buy signal. Thus an uptrend in the price of the stock is seen after this condition.

However large surge and drops in the price of the stock will affect the RSI heavily and can lead to erratic buy and sell signals. So RSI should always be used in conjunction to other technical indicators to confirm the buy and sell signals.