Technical Analysis¶

1. Identify trend changes at early stage through predicting stock price patterns, using historical data (volume/price)
2. Identify when to buy/sell
3. Maintain investment position until evidence indicates that trend has reversed

Notes¶

1. Probabilistic modelling; always uncertain, never deterministic
2. Continued success is dependent on keeping successful strategies known only to a few

Premises¶

Market action determines everything

1. Everything will continue in state of rest/uniform motion unless compelled by external force
2. Market price is solely dependent on forces of demand and supply
3. Prices have a tendency to move in trends that persist for appreciable duration
4. Reversals of trends are caused by shifts in demand & supply
5. There is a time gap b/w technicians perceiving a change and when investors assesses the change

Tools¶

• Typical
• Variables
  • Price
  • Volume
  • Rate of change
• Charts & graphs
  • Line charts
  • Linear scale
  • Log scale
  • Bar charts: OHLC - Open High Low Close
  • Candle chart:
  • Point & figure chart
• Dow Theory Measures
• Moving averages
• Momentum and oscillators
• Breadth
• Market indicators
• Investors’ sentiments
• Contrary opinion
• Professional investors’ behavior
• Economic indicators

Typical¶

OHLC
Candlestick chart	Candle color: Red/black: close>open Green/Blue: close>open

Dow Theory¶

Assumes that most shares follow the trend of the market most of the time

It intends to show the general trend/direction of the market as a whole and does not predict the direction of change in a particular security

In order to measure the “market”, two indices are used

• Industrial average: combination of blue-chip shares from industry
• Transportation average: shares of transport companies
• To reinforce the conclusions obtained from Industrial Average

Trends¶

Principle of Confirmation¶

Whatever trends emerge in Industrial average must be confirmed by Transportation average

If trends in share prices are contradictory to industrial production/transportation of goods, then one should not design a trading strategy in shares and must wait until one gets confirmation of trends

Price-Volume¶

Volume is the ‘fuel’ to move prices

Usually, \(\text{Volume} \propto \text{Price}\) , ie volume

• contracts on decline
• expands on rallies/advances

If it is against this normal relationship, it is an indicator of an upcoming trend reversal. However, it should only be used as background information, since the actual reversals would be signaled by averages

Price Actions¶

Price actions determine the trend

• Bullish indications: successive rallies penetrate peaks while the trough of an intervening decline is above the preceding trough
• Bearish indications: series of declining peaks and troughs

Averages¶

Time Series Filters

Usually uses the closing prices

Convention is to use 2 averages

• Slower average: larger window
• Faster average: smaller window

Notes

• Normally, an average moves along with a trend; but a reversal in trend may be captured by a crossover of 2 averages

• Signals to buy/sell are generated when the

• price crosses the moving average

  or

• one MA crosses the another

• Doubtful about this

• Buy

  • price > moving average
  • Faster average > Slower average

• Sell

  • price < moving average
  • Faster average < Slower average

• MA is a lagging indicator –> crossover will usually signal a trend reversal well after new trend has begin and is used mainly for confirmation

Trend Channels¶

Trends have to be bounded

• Trend channels
• When prices trend between 2 parallel lines, this is referred to a channel
  • It is created by drawing 2 parallel lines
  • Line 1: Basic/main trendline
  • Line 2: Return/channel line

Use-case

• Represents area of support/resistance depending on direction of underlying trend
• Helps identify potential trend acceleration/reversal

Bullish
Bearish

Envelops¶

2 symmetrical parallel lines to moving average

This is based on principle that prices fluctuate around a given trend in cyclical movements

Envelops consist of points of maximum and minimum divergence from some moving average

Bollinger Bands¶

• Middle line: \(\text{MA(close, \(w\))}\)
• Upper band: \(\text{MA} + z_{\alpha/2} * \sigma (\text{close}, w)\)
• Lower band: \(\text{MA} - z_{\alpha/2} * \sigma (\text{close}, w)\)

Whenever bands narrow, a change in trend occurs: Whenever bands narrow, they have been stable for a while and it is followed by movement which is more volatile and in opposite direction

Patterns¶

Psychological barriers¶

Support & resistance levels

• Bargain hunters “support” the lower level upwards

• Profit takers “resist” the upper level downwards

• Breakout: prices go outside the support/resistance level

• Pullback: prices return within support/resistance level

Patterns¶

Pattern	Trend	Signal
Head & Shoulders	Uptrend	Bearish (reversal)
Inverted head & shoulders	Downtrend	Bullish (reversal)
Symmetric triangle	Uptrend	Bullish
Symmetric triangle	Downtrend	Bearish
Ascending triangle	Uptrend	Bullish
Rectangle	Uptrend	Bullish
Rectangle	Downtrend	Bearish
Flag	Uptrend	Bullish
Flag	Downtrend	Bearish
Pennant	Uptrend	Bullish
Pennant	Downtrend	Bearish
Cup & Handle		Bullish
Inverted Cup & Handle		Bearish

Momentum/Oscillator¶

Measures the velocity of price move

	Indicates	Formula
MACD Moving Averages Convergence Divergence	Trend-Deviation	\(\dfrac{\text{Faster EMA}}{\text{Slower EMA}}\) or \(\text{Faster EMA} - \text{Slower EMA}\)
Signal	EMA of MACD
RSI Relative Strength Index	Buying/selling ratio \(\text{RSI} > 0.70 \implies\) Overbought \(\text{RSI} < 0.30 \implies\) Oversold	\(\dfrac{\text{RS}}{1+\text{RS}}\) \(\text{RS} = \dfrac{\text{Avg(gains)}_w}{\text{Avg(losses)}_w}\) where \(w=\) window size

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