Technical Analysis: Towards valuation

Contents Why analyse equites In the beginning was Technical Analysis Charts and Candlesticks Trends and Moving Averages Other indicators and Terminologies Towards Fundamental Analysis

Approaching Valuation Think about a typical day in equity markets. Prices fluctuate constantly. Information comes in… -- Governments, central banks make pronouncements on the economy… -- Journalists write about industries or sectors… -- Regulators consider rules that affect some subset of firms… -- Financial analysts put out research reports… -- Companies release news about products, markets, management… -- Pundits pontificate on financial television…

Approaching Valuation In response -- Portfolio managers meet to decide on a course of action… -- New investors want to enter (immediately or slowly) … -- Others want to exit (quickly or slowly) … -- Retail investors do homework and act (or wait)… -- Day traders jump in and out (often faster than the eye can see)… Suppose the news is good and you want in. What is a fair price? What to focus on?

What to Focus on to arrive at Fair price? The obvious is to study price movements in the hope that they might reveal something about supply/demand characteristics for that stock. The premise of “technical” analysis is that the adjustment of prices to new information is gradual. What follows is by no means exhaustive (this could be a whole course in itself). It is merely illustrative and provides context. In this early world (before accounting indicators became popular), one views markets as a contest between bulls and bears and looks for patterns in price movements that might indicate which side is more likely to win.

Technical Analysis Charts Some of the earliest were charts such as: Before computers, people actually plotted such things daily on graph paper !!!

Candlestick Then came the Candlestick: open-to-close is rectangle (body), shaded for down days, clear for up days, lines above and below for high and low.

Can we see any trends?

Some Questions to Ponder Q: Why not plot price changes instead of prices? Arithmetic (y-axis divides equally on price change or log (y-axis divides equally on percentage change). One may signal a trend break and the other may not !!! Q: Why stop at prices? Why not volume charts? (signal of commitment) and money-flow charts that track volume of trades at the ask (bullish) or bid (bearish). Q: Can we see a trend in prices? Trends in this world are widely interpreted as reflecting investor expectations. Can we see a change in trend? Q: Why not plot moving averages of prices rather than price itself? For a moving average of “N” days, each day the oldest price is dropped and the newest one added. If the current price is above the moving average => current expectations higher than the past –bullish. By using these, one is more likely to be on the right side of the market but always late !!! The 50-day and the 200-day average are viewed as significant, but definitions depend on your time horizon.

Trend is your friend Look at a weekly chart of the SPX .

Trend is your friend Look at a weekly chart of the BSE

AND the CNX 500

Country ETFs from a while ago! Notice the similarities in many, you see the 20-day move over the 50-day MA (golden cross?) and there is a trend for awhile.

Other trend related patterns Head and shoulders, double tops, broadening tops and bottoms - all signal trend reversal. Triangles: symmetric implies continuation of preceding trend Flags and pennants, also signs of congestion in a major trend

More Indicators…. Q: Are there more indicators than just prices and volume? Think in terms of momentum: price momentum 10-day is the difference between closing price today and closing price 10-days ago (to see which direction prices are moving) Another broad measure of momentum is the (# of advancing stocks - # of declining stocks). Q: Why not stabilize these with moving averages as well? Oscillator: e.g. 10-day moving average of the difference between the # of advancers and the # of decliners. Lots of variations here. Subtract a moving average from price. Take the difference between two moving averages (MACD oscillator = 12-day MA minus 26-day MA. Why not other time frames, because this works, they say. F > 0, recent expectations more bullish than older one.

Some Terms… Support (demand) and resistance (supply) levels – are barriers to changes in expectations Traders remorse—e.g. after resistance (or a trend) is broken, price goes up for a few days, but market participants change their minds. Creates a “bull trap” when price moves back to resistance. When do you believe the break? -- Check volume. IF successful, old resistance becomes new support. Convergence/Divergence => when the oscillator moves with or differently from the current price. (divergence when price reaches lows while oscillator doesn’t). Overbought/oversold: when prices are too high (low) and subject to a decline (increase). Is a short-term expectation of a reversal and is inferred from extreme movements in oscillators

Bollinger Bands For any moving average, the upper and lower bands are 2-standard deviations above and below. Bands widen (narrow) with increasing (decreasing) volatility.

Tried getting one for the NIFTY – weekly, 5-years…

Points to remember You could look at hundreds of charts in a day, technical traders do. There are MANY, MANY more patterns in a trader’s toolkit. Many charts will tell you nothing. Even the ones that tell you something, they tell you about past patterns, tomorrow can be different from yesterday. As Mark Twain said, ”History may not repeat but it often rhymes!” Does this approach make money?. Academic evidence says that it does not do so consistently. Academics test data rigorously over various sets of technical strategies. Technicians argue that they use different tools from the kit for different situations. Malkiel (A Random walk down Wall Street), tells a story of having his students toss coins, plot the patterns on a chart. Upon showing a technical analyst some “selected charts’” the response was, “Which stock is that? I have never seen a clearer buy signal!” How can we make decisions without knowing the fundamentals of a company, how its product, markets, management, and without listening to what they might have to say about the future?