Technical Analysis – is a study of any freely traded markets based on the past data, price movement and supported indicators and oscillators. We can fairly say that technical analysis is a complex, ever-evolving discipline. In today’s modern world, technical analysis is rooted in basic economic theory. It has evolved over period of time as a niche super specialty. The basic assumption on which technical analysis is based is:
• Stock prices are determined solely by the interaction of demand and supply.
• Stock prices tend to move in trends.
• Shifts in demand and supply cause reversals in trends.
• Shifts in demand and supply can be detected in charts.
• Chart patterns tend to repeat themselves.
Technical analysis can be defined as an art that is used to identify trend changes at an early stage and to maintain an investment position until the weight of the evidence indicates that the trend has reversed.
Below, we look into important indicators and patterns that an investor can use while buying or selling stocks:
1. MACD (Moving Average Convergence Divergence) : This is an “Oscillator” and Gerald Appel is credited with developing this MACD Oscillator. It is usually plotted below the price at the bottom of the price chart. MACD is calculated as a difference of 26-Day EMA (Exponential Moving Average) and 12-Day EMA of the price. This MACD, once created oscillates above and below a zero line. A 9-Day EMA of this MACD is created which is known as “Signal Line”.
Interpretation and Use: MACD is very useful in “Trending Markets”. Often Buy and Sell Signals are created by “crossovers” of MACD and its signal line. When MACD crosses above its signal line from below, a buy signal is generated. When MACD reports a negative crossover, i.e. when it moves below the signal line, a sell signal is generated. This is a lead indicator.
2. ROC (Rate of Change) : This is one of the simplest of all oscillators. It is a measure of rate at which a stock price has changed over past “N” periods.
Interpretation and Use: This is never used singularly. It is always used and read along with other indicators or oscillators. Its position relative to zero can indicate the underlying trend. It can also act as divergence indicators showing relative momentum to price and can also act as “overbought or oversold” indicator.
3. RSI (Relative Strength Index) : This confirmation oscillator developed in 1978 by J Welles Wilder. This measures the strength of a stock against its own history of price change. It is very important to note that it does not compare a stock with any benchmark but compares the stock’s own strength against its own price history.
Interpretation and Use: RSI value moves between 0 and 100. When it is below 30, it is defined as “oversold” and value above 70 denotes “overbought” formation. It also subjects and offers itself to similar pattern analysis like stock prices. Its main use is to generate buy or sell signals. When it is above 50, the general trend of the stock is considered upwards and vice versa. Being a lead indicator, its pattern analysis help to generate buy and sell signals as well as it helps spotting bullish or bearish divergences as compared to price.
4. Head and Shoulder Pattern: This is one of the major “Reversal Pattern”. The formation of such pattern marks a “TOP” for the markets and likely reverses the trend.
A left shoulder is created by a strong rally always accompanied by high volumes followed by a minor decline with relatively much lesser volumes. Then follows another high volumes advance which moves past the previous high making a “Head” for the formation. However, this too is followed by a decline until the level of the previous decline. The volumes remain lower. There is another advance but it does not reach until the levels of the Head. It usually reaches until the levels of the previous shoulder or lower. Then the decline sets in again. This makes a “Right Shoulder”. Finally , decline of prices take places and it goes down through the line (the “neckline”)drawn across the bottoms of the reactions between the left shoulder and the head and the head and the right shoulder. A drop below 3% of the levels of neckline usually marks the confirmation of a downward breakout.
5. Inverted head and shoulders: This is also a “Reversal Pattern” and marks a BOTTOM after a significant decline.
As evident, it is the total opposite of Head and Shoulder formation. The way Head and Shoulder form a TOP this “Inverted” Head and Shoulder formation marks a Bottom for the stock price. We would see a decline, more or less climaxing a extensive downtrend sees a minor recovery. This recovery is accompanied with lesser-than-average volumes. This marks the creation of “Left” Shoulder. The decline follows which it takes it below the bottom of the left shoulder. Here an increase in volumes are noted and this is followed by another recovery that carries above the bottom level of the left shoulder and on which activity may pick up and volumes increase. This makes the “Head”. There is a third decline on very less volume and this makes a “Right” shoulder. Finally, an advance occurs on which the volume and activity increases notably, which pushes up the neckline and closes above by an amount approximately equivalent to 3 per cent of the stock market price with a burst of activity and increase in volume. This is noted as “Conformation” of a upward Breakout.
(The author is CMT, Consultant Technical Analyst at Gemstone Equity Research & Advisory Services)