TECHNICAL ANALYSIS

PRICE PATTERNS

A typical price cycle has three trends: up, sideways, and down. The sideways trend is essentially a horizontal or transitional one which separates the two major market movements. Sometimes a highly emotional market can change without warning but this rarely happens.

The Rectangle The transitional or horizontal phase separating rising and falling price trends is a pattern known as a rectangle. The rectangle marking the turning point between the bull and bear phases is termed as a reversal pattern. Reversal patterns at market tops are known as distribution patterns and those at market bottoms are called accumulation patterns.

Resistance and Support levels Line AA is technically termed as a resistance area because at this point the index shows opposition to a further price rise. When the demand/supply relationship comes into balance at AA, the market quickly turns in favour of the sellers because prices react. This temporary reversal may occur because buyers refuse to pay more for a security or because the higher price attracts more sellers or for both these reasons.

Resistance and Support levels Following the unsuccessful assault on AA, the prices turn down until line BB, known as support level. At line BB, prices become attractive for buyers who missed the boat on the way up, while sellers who feel that the price will again reach AA hold off.

WHIPSAWS So far, it has been assumed that any move, however small, out of a rectangle constitutes a valid signal of a trend reversal or resumption. Sometimes, the moves out of rectangle may be misleading. These misleading moves are known as whipsaws. It is helpful to establish certain criteria to minimise the possibility of misinterpretation. Conventional wisdom holds that you should wait for a 3 percent penetration of the boundaries before concluding that the breakout is valid.

VOLUME During bull markets, volume increases with price rise and declines with price declines and vice-versa in bear markets. Also, volume generally falls in advance of major declines in the market index and rises sharply during market bottoms.

HEAD & SHOULDERS PATTERNS H&S is probably the most reliable of all chart patterns. It occurs at both market tops and market bottoms. It consists of two shoulders, a head and a neckline. Volume characteristics are of critical importance in assessing the validity of these patterns. Activity is normally heaviest during the formation of left shoulder and also tends to be quite heavy as prices approach the peak. The formation of right shoulder is accompanied by lower volume.

Inverse H&S H&S pattern at the market bottom is known as inverse H&S or reverse H&S or H&S bottom. Normally, volume is high at the bottom of left shoulder and during the formation of the head. The activity contracts substantially on the right shoulder and expands substantially on the breakout. Like the H&S patterns, inverse H&S pattern can have a number of variations in trend line slope and no. of shoulders.

Double tops and bottoms A double top consists of two peaks separated by a reaction or valley in prices. Its main characteristic is that the second top is formed with distinctly less volume than the first. A double bottom is accompanied by high volume on the first bottom, very light volume on the second and very heavy volume on the breakout.

MOVING AVERAGE (MA) MA is constructed by totaling a set of data and dividing the sum by the number of observations. In order to get the average to move, a new item of data is added and the first item on the list subtracted. The new total is then divided by the number of observations and the process is repeated. Generally speaking, a rising MA indicates market strength and a declining one denotes weakness.

A change from a rising to a declining market is signaled when the price moves below its MA. A bullish signal is triggered when the price rallies above the average. Changes in price trend are identified by the price crossing its MA, not by a reversal in direction of the MA. The more times a MA is touched i.e. it acts as a support or resistance area, the greater the significance when it is violated.

What constitutes a valid crossover in MA? A crossover is any penetration of a MA. However, there may be a number of whipsaws or false signals in a MA chart. It is possible to avoid some whipsaws by using filtering techniques. The type of filter to be used depends on the time span in question and is very much a matter of individual experimentation. For example, an analyst may decide to take action on MA crossovers for which a 3 percent penetration takes place and to ignore all others.

The 3 percent penetration filter might be fine with a 9 month moving average where average price movement is of 15 to 20 percent. However, a 3 percent filter would probably encompass the whole move of a 2 week moving average and this kind of filter would be of no use in that case.

Choice of time span for MA The time span for MA depends on the type of market trend that is to be identified: short, intermediate or primary. If it is assumed that a bull and bear cycle lasts for 4 years, a 24 month average would give very slow confirmation of a change in trend. On the other hand, a 4 week average would be so sensitive that it would continually give misleading or whipsaw signals.

RELATIVE STRENGTH RS is a technical concept that measures the relationship between two assets. A RS line is obtained by dividing the price of one item by another. The most common and important use of RS is to compare a stock to a market average like sensex. When RS line is rising, it means that the stock is outperforming the market.

A RS indicator is just what its name implies – relative. A rising line does not mean that a stock is advancing in price, but merely that it is outperforming the market. For example, the market as measured by sensex may have fallen by 20%, and a stock may have fallen by 10%. Both have lost value but the RS line would be rising because the stock retreated less than the market.

When the stock-bond approach is used, the analyst opts for a higher proportion of stocks in the portfolio in a bull market and a higher proportion of bonds in the portfolio in a bear market. In other words, he selects the security type with the most relative strength in the prevailing market. According to Robert Levy, this switching between bonds and stocks could give higher returns as compared to a “buy and hold strategy”.