Dow theory also gives a lot of importance to volume of transactions. If the main trend is bullish the volume of trading would also rise with rise in prices. In a bearish market the volume of trading would increase along with the fall in prices.
2. ELLIOT WAVE THEORY |
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Ralph Elliot formulated this theory in 1934. According to this theory the market moves in waves. A wave is a movement of the market price caused by demand and supply in the market. |
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A movement in a particular direction can be represented by five distinct waves. Of the five waves three are impulse waves and two are corrective waves. Impulse waves are named 1,3 and 5. They are along the direction of the primary trend. Corrective waves or reaction waves are named 2 and 4. They move against the impulse waves. Once the five waves are completed, there will be a correction against the main trend which consists of three waves usually named as A, B and C. |
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Wave 1 is in the impulse wave in the upward direction and wave 2 corrects the wave 1.If the main trend is bullish wave 2 never goes below the bottom of wave 1. Similarly wave 3 and wave 5 are impulse waves in the upward direction. As can be seen wave 4 corrects wave 3. However the bottom of wave 4 never goes below the bottom of wave 2 in a bull market. Once the five-wave sequence is over the trend changes and a three-wave sequence starts. Waves A and C will be against the main trend and wave B will be in the direction of the main trend. Fall in prices during the three-wave sequence corrects the entire rise during the five-wave sequence 1,2,3,4,5. Hence the lower bottom of C can be anywhere and it can even go below the bottom of wave 1. |
2. ELLIOT WAVE THEORY |
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An impulse wave can again be spilt up in to a five-wave sequence followed by a corrective three-wave sequence. |
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This process can be continued for many times and even five to ten minutes charts are produced and used for day trading.
This wave like movements can take place either in a bullish phase or bearish phase. For example in phase B market is bearish. However B wave becomes an impulse wave when it is taken as a single wave. Once a full cycle of movements (8 waves together) is completed there will be a fresh cycle again. Elliot Theory holds that every action is followed by a reaction. This theory also provides time frames and probable quantum of movement in prices under various waves. This theory is therefore can be used for predicting future price changes and in deciding the time of investment. |
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3. BREADTH OF MARKET ANALYSIS |
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This indicator measures the strength of an advance or decline as shown by market indices such as NSE NIFTY or BSE Sensex. It helps us to understand the extent to which a general price rise or decline as indicated by an index, affects the main body of stocks or the larger population of stocks. For example BSE Sensex of 30 shares may advance further, but the general trend of a vast array of stocks listed on BSE may be moving in the opposite direction. This does not happen in the usual circumstances. However it sometimes happen. For example on 27-09-2004 Monday Sensex fell by 16 points, but there were more advancing shares than declining shares on BSE. In this case the breadth of the market is positive, showing that the trend is changing or going to change soon. In fact on 28-09-2004 markets changed direction.
There are many methods to determine the breadth of the market. A simple method is the advance/decline line (A-D line) |
Computation procedure |
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Here we compare the number of shares whose prices advanced on a particular day to the number of shares whose prices declined on the same day. Each day's net difference between advances and declines is added to next day's difference between advances and declines and so on. In other words, the net difference of advances and declines is cumulated over the period under observation so as to get a continuous cumulative index. This cumulative index is known s the breadth of the market. If the market as a whole is bullish, the net figure on most of the days will be positive. This cumulative index is plotted as a line graph and compared with the stock market index. In a bull market we get ascending charts showing that the market is in the up trend. |
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Day | Advanced-A | Declined-D | A-D | Breadth |
| Monday | 1000 | 400 | 600 | +600 |
| Tuesday | 650 | 800 | -150 | +450 |
| Wednesday | 500 | 1100 | -600 | -150 |
| Thursday | 900 | 700 | 200 | +50 |
| Friday | 1200 | 400 | 800 | 850 |
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Cumulative figures are plotted on a graph. It is called the A-D line.
A stock market index like Sensex is also plotted along with this line |
Normally the A-D line and the index will move in the same direction. But whenever there is a divergence between the two, i.e. whenever they move in different directions it indicates a turning point in the index. It is a key signal of a change in the existing trend shown by the index. Whenever the two diverge, the A-D line will show the true direction of the market. This is so because an index can not move contrary to the market as a whole- at least not for long. Thus whenever an index is rising but A-D line is falling, it indicates that the index is going to fall in the near future. If the index is falling but the A-D line is rising, it means that the index is going to rise in future. |
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| 4. MOVING AVERAGE ANALYSIS |
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A moving average is a summary measure of stock price movements. It is the average of share prices or market values for a specific period. It reduces the distortions in prices to a minimum by evening out the day-to-day fluctuations in prices. The underlying trend is thus clearly identifiable when moving averages are used. For example if the share prices move up for many days, the average price will always be less than the last prices. |
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Hence the moving average will always lie below the closing price chart when the market is moving up for days. Hence moving averages can be used to identify the trend of the general market as well as that of individual stocks. |
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To construct a moving average chart, the time span of the moving average has to be decided first. Usually a period of 15, 50, 100 and 200 is selected. As can be seen a moving average made out of 15 days is a short -term moving average and gives a short-term trend. Similarly 200 day moving average is a long-term moving average and gives the primary trend of the market. |
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It can be seen that moving averages smooth out the fluctuations. The smoothing effect is more in the case of long-term moving averages. There are two commonly used moving averages. |
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| (a) | Simple Moving Average (SMA) |
| (b) | Exponential Moving Average (EMA) |
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SIMPLE MOVING AVERAGE |
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Simple moving averages are commonly used because they are easy to construct. In SMA calculation, a set of averages are calculated for a specified number of days, each average being calculated by excluding an old price and including a new price. For example to construct a 100day simple moving average on an index, the values of the closing values of the index for the first 100 days are summed up. Then the sum is divided by 100. This will be the first point on the SMA. To get the second point, the index value prevailing on the first day is excluded and that of the 101st day is included in the first sum. This represents the next 100-day period. The average of these for 100 days will give the second point. This process of exclusion, inclusion and averaging will be continued to get the third SMA value, fourth SMA value and so on for the time period. It should be noted that the first point is obtained at the 100th day. |
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| Day | SENSEX closing | Sum of last 5 days | 5 day SMA |
| 1 | 5160.85 | 0 | 0 |
| 2 | 5187.73 | 0 | 0 |
| 3 | 5221.90 | 0 | 0 |
| 4 | 5225.90 | 0 | 0 |
| 5 | 5131.72 | 25928.10 | 5185.62 |
| 6 | 5131.54 | 25898.79 | 5179.76 |
| 7 | 5229.34 | 25940.40 | 5188.08 |
| 8 | 5285.54 | 26004.04 | 5200.81 |
| 9 | 5299.96 | 26078.10 | 5215.62 |
| 10 | 5315.81 | 26262.19 | 5252.44 |
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It can be seen that the first SMA value becomes available only on 5th trading day. When simple moving average is plotted for a long period charts similar to one given below will be the out come |
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It can be seen that the first SMA value becomes available only on 5th trading day. When simple moving average is plotted for a long period charts similar to one given below will be the out come |
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In the chart above closing price of a particular share or an in index is plotted on a daily basis. As share prices moves like waves in a sea, it fluctuates with a trend. In the above chart the primary trend is upwards. Moving average values are also plotted on this chart. These charts are called line charts because they are represented in lines.
When the share prices are moving up their averages will always lie below the share price line chart. Therefore when a moving average cross over a share price line chart |
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from the bottom it indicates a change in trend. For example in the chart shown above at point C, moving average moved over the share price chart. It can be seen that the SMA moved over the price chart for some time and all through out these periods the share prices were falling. Therefore the cross over point C gives an indication of a change in trend. Similarly B share price chart crosses the moving average chart. Or SMA crosses the share price chart from the top. It can be seen that share prices moved up for sometime after that. Hence here also cross over point indicates a change in trend. Thus when ever a moving average crosses a share price line chart in indicates a change in trend. If it does from the bottom, the trend changes from bearish to bullish and if it crosses from the top the trend changes from bearish to bullish.
At point A share price chart touches the moving average and SMA did not move over the share price chart. Here also a change in trend occurred. Thus by drawing simultaneously the share price chart and SMA, change in trends can be identified. A trader or investor could sell his shares at point C and enter the share at point B. |
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EXPONENTIAL MOVING AVERAGE (EMA) |
When long-term moving averages are computed, the relevance of the values at the beginning is not much. But the prices near the last day's values have more influence on the share price than the old values. For example when one charts a 200-day moving average, the influence of the first day's value is less important than the Previous day's value. Exponential moving averages rectifies this deficiency. An EMA gives more weight to recent prices and less weight to older prices. It is calculated by the expression Current day's EMA = [(current closing price- Previous day's EMA) exponent + Previous day's EMA. Exponent or multiplying factor = 2/n+1, where n is the number of days for which EMA is calculated. As n increases the factor becomes smaller and smaller and its influence becomes lesser and lesser. |
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| Day | Closing value | 5 day EMA |
| 1 | 482 | 482 |
| 2 | 442 | 468.80 |
| 3 | 440 | 459.30 |
| 4 | 480 | 466.13 |
| 5 | 437 | 456.52 |
| 6 | 434 | 449.09 |
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Notes - Exponent =2/5+1 = 0.33
- EMA for the first day is taken as closing price of the first day itself
- EMA of 2nd day = (442-482)0.33 + 482 = 468.80
If n=200, exponent becomes 2/201 = 0.01. Hence the influence of the first portion becomes negligible while computing the EMA. |
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5.VOLUME OF TRADING |
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Volume of trading is a leading indicator of stock price movement. Volume is the total number of stocks bought or sold a day. Volume changes are a pre requisite to any change in price. Volume is a function of demand and supply of stocks. It can signal turning points for the general market as well as for individual stocks.
During bull markets, volume increases with price advances and decreases with price declines. In bear markets volume will increase with price declines and decrease on price increases.
However, when the markets reach the end of a bull market, volumes will reach a peak with prices dipping at the end. Similarly at the end of a bear market, volumes will increase and price may go up. In the case of a bull market that has reached its peak, all knowledgeable investors sell when prices reach their peak values and there will be more sellers than buyers on
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such a situation. Therefore volumes will go up and prices will dip. During this period shares change hands from knowledgeable investors to ordinary investors who continue to hold on to their investments thinking that prices will go up again. Similarly at the end of the bear markets, ordinary investors sell their holding in panic most probably at the end. But good investors wait for the end and buy these shares in the panic when the shares are obtained much below their intrinsic values. Hence, volumes will go up and prices will go up. Similarly volumes decline in advance of major declines, because there are not many sellers at this rock bottom prices. Volumes may decline when prices escalates too fast because, there are not many buyers at those high prices. Thus the relationship between volume and trend changes is not very straightforward. However watching the change in volumes an astute operator or a trader will be able to smell a change in trend in the future. That is why volume is called a leading indicator. |
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TOOLS FOR INDIVIDUAL STOCK ANALYSIS |
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By a general analysis of indexes the healthiness of a market can be found out. This helps to forecast the probable future performance of the general market. There are many tools for analysis of individual stocks and indexes in Technical analysis.
1. Price charts
The basic tool to study the price movements is a price chart. A share may be traded at different prices on a particular day. However, a share will have an opening price, day's high, day's low and a closing price. Out of this the closing price is the most important because it shows how the share closed on a particular day. For example if the share price closed near the high, there is more probability of it opening next trading day near the high of the Previous day. However, knowing the other values is also very helpful. If the opening price and closing price are known, one can find out whether the share is on down trend or in the up trend. If the low, high, opening and closing prices are known, one could find whether the share recovered from its fall or the share fell from its high at closing. Therefore charts drawn mostly with closing prices or with prices indicating open, high, low and closing. Financial news papers like The Economic Times and Business India provide all these values and the volume of trading. A line chart is the simplest of all price charts. In this chart, the closing prices of a security
Are plotted on the Y-axis and time is plotted on the X-axis. Closing price on a particular day is represented as a point. By connecting points for different days, a line chart is obtained. A typical line chart for Hindustan Lever is shown for a few days below. |
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Type of price charts |
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i. Line chart |
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A line chart is the simplest of all price charts. In this chart, the closing prices of a security
Are plotted on the Y-axis and time is plotted on the X-axis. Closing price on a particular day is represented as a point. By connecting points for different days, a line chart is obtained. A typical line chart for Hindustan Lever is shown for a few days below. |
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| Day | Closing price | Remarks |
| 1 | 120 | |
| 2 | 122 | |
| 3 | 123 | |
| 4 | 123 | |
| 5 | 121 | |
| 6 | 120 | |
| 7 | 119 | |
| 8 | 118 | |
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ii BAR CHART |
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A bar chart gives more information than a closing price line chart. To draw a bar chart four values are needed.Opening |
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To plot stocks price movements on a bar chart on a day the highest price and lowest price are joined by a vertical line. This is called a bar. Thus the higher end will represent the highest value reached by the share on a particular day and lowest point represents the lowest point. Opening price is indicated by a small horizontal tick on the left side of the bar. Similarly the closing price is indicated by a small horizontal tick on the right side of the bar. |
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ii. CANDLE STICK CHART |
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Candlestick chart is a Japanese method of plotting the prices of a commodity and was used by rice traders. It is an enhanced version of bar chart. Here the body of a candle represents the highest and lowest prices of a day. There are whiskers at the top and bottom of the candle. The highest point on the upper whisker represents the highest price and the lowest point on the low whisker represents the lowest price. |
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A candlestick gives the same information given by the bar chart. |
| PRICES |
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IV. POINT AND FIGURE CHART |
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This is not used commonly as the other three charts. A PFC concerns itself with only the measurement of prices. Volume of trading and time dimension are to be ignored. Construction of a PFC involves the use of two symbols 'X' and 'O'. While 'X' indicates increase in price, 'O" indicates a decrease in price. A PFC does not measure every movement in price. It records changes in prices that are larger than a specific amount called points. A PFC can be constructed to measure changes in prices over and above a specified value say Rs2. Then the chart is called a 2-point chart. The decision about the size of the point is based on price range and degree of volatility in the stock. |
| PFCs are plotted on a graph paper. Suppose 5-point PFC is to be plotted for data given below All fractions are approximated. First of all the unit price change to be indicated by each square should be decided. The graph may begin by recording the price at the chosen level. Across the price level marked on the Y-axis, either 'O' or 'X' is marked for the beginning price. Subsequent change in price level is noted. If the price increases, for every increase equal to or over Rs5 an 'X' is marked on the same column, if the chart began with an 'X' mark for the beginning price level. A decrease in price equal to or above Rs5 is treated as a change in direction. So one shift to the next column and a series of 'O's to indicate the magnitude of the fall in prices. No marking is made if the price remains at the same level or if changes are less than Rs5. Prices are marked on the same column irrespective of the time period, as long as the direction of the change remains unaltered. |
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| Note- In case of price increase, begin one cell up and in case of price decrease begin one cell down |
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| DAY | Closing Price |
1 | 700 |
2 | 690 |
3 | 700 |
4 | 690 |
5 | 700 |
6 | 710 |
7 | 710 |
8 | 720 |
9 | 690 |
10 | 725 |
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| 730 | | | | | | | X |
| 725 |
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| X |
| 720 |
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| X |
| X |
| 715 |
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| X | O | X |
| 710 |
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| X | O | X |
| 705 | X |
| X |
| X | O | X |
| 700 |
| O | X | O | X | O | X |
| 695 |
| O |
| O |
| O |
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| 690 |
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| 685 |
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| 680 |
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TREND AND TRENDLINES One of the major assumptions of technical analysis is that share price moves in trends which continue for a considerable length of time, in spite of minor fluctuations. A trend is simply the direction of the movement of share prices in the stock market. A trend is a series of ascending or descending peaks and troughs. When prices move upwards, it is called an up trend. An up trend is defined as a series of successive higher peaks and troughs where successive peaks and troughs are the preceding peaks and troughs. |
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When prices move downwards it is a falling or down trend. It is defined as a series of descending peaks and troughs where successive peaks and troughs are below the preceding peaks and troughs. |
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When prices move within a narrow range it is called a flat or horizontal trend. It is sideways trend with horizontal peaks and troughs.
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A. SUPPORT AND RESISTANCE PATTERNS When share prices move up or move down, they take resistance at certain levels while going up and take support at some levels when they fall. |
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Share prices never move in a smooth straight line as shown above. The main upward or down ward trend would be interrupted by short-term movements in the opposite direction. They are called trend reversals or secondary reactions. The technical analyst tries to identify the trend reversal at an early stage to make wise investment decision. For example when the reversal is from falling trend to rising trend the technical analyst would recommend purchase of fundamentally strong shares. |
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CHART PATTERNS When price charts of several days are drawn together, certain standard patterns could be identified in them. These formations or patterns observed on bar or line charts have predictive value. They give clues as regards to future movements of prices. The chart patterns may be classified into
1. Support and resistance patterns
2. Reversal patterns
3. Continuation patterns |
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A. SUPPORT AND RESISTANCE PATTERNS When share prices move up or move down, they take resistance at certain levels while going up and take support at some levels when they fall. |
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This happens because investors have long memories of Previous tops and bottoms. When share prices falls to a Previous low, supply of shares decreases. There will be more and more buyers at that level because they remember the Previous low.
When share price reaches a Previous top a large number of sellers will be there because they remember the Previous top. Hence supply increases and price falls. However, if there is some favourable news there will be more demand and share prices might move above the resistance line, with huge volumes. This is called a break out. When this happens, all short sellers will be forced to cover up their short positions and therefore there will be more demand. Hence prices might move up further. |
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When there is some unfavourable news, share prices might move down the support level and continue fall with huge volumes, breaking the trend. |
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B. REVERSAL PATTERNS It is just a reversal of the triple top. It is also like reverse head and shoulder pattern where all the bottoms are at the same level. This gives out bullish signals at E and G. |
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1. Head and shoulder patterns |
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This is the reverse of head and shoulder pattern. Here the price hits the bottom thrice. The middle bottom, which is the lowest of the three, is the head and the other two bottoms are the shoulders. Most of the time the price cuts the neckline after the second inverted shoulder, creating an upward break out. This is a signal to buy. |
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This pattern is called a head and shoulder pattern because it resembles a human head with shoulders. A neckline is formed by joining the bottoms of the formation. The price movements after the formation of the second shoulder should be carefully noted. If the price goes below the neckline, then a drop in price s indicated. Hence it is a bearish sign. This usually appears at the end of the fifth cycle. |
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2. Inverse head and shoulder pattern It is just a reversal of the triple top. It is also like reverse head and shoulder pattern where all the bottoms are at the same level. This gives out bullish signals at E and G. |
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This is the reverse of head and shoulder pattern. Here the price hits the bottom thrice. The middle bottom, which is the lowest of the three, is the head and the other two bottoms are the shoulders. Most of the time the price cuts the neckline after the second inverted shoulder, creating an upward break out. This is a signal to buy.
Triple Tops
It is similar to head and shoulder pattern. Here the share shows three peaks, all at the same level. The volume generally declines with each successive peak. The triple top pattern is completed only when the price goes below both the bottoms (B&D) with heavy volumes. A technical analyst usually decides to sell if the price rallies up to E, but fails to cross the Previous peak and starts declining. It also gives a sell signal when price falls below the support level. It also give another sell signal when it starts correcting at point G after some recovery. |
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Triple Bottoms It is just a reversal of the triple top. It is also like reverse head and shoulder pattern where all the bottoms are at the same level. This gives out bullish signals at E and G. |
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A buy is recommended when share price reverses at E and when it recovers from G after the break out. Usually after breaking out H, share price moves up and then falls to its support at G (It is the Previous resistance level). This happens because, all buyers above H might feel mistaken when the share price does not go up much. It is called "buyer's remorse'. However when share price recovers from H it becomes almost a sure bullish signal. |
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Double Top This is a bearish pattern, which is generated at the end of an up trend. The general features of double tops are similar to that of head and shoulder pattern and triple tops. Double top patterns generally look like 'M'. The price hits the peak twice (A&C). The share price after reaching peak at A declines a little to point B. Thereafter it rises sharply again to another peak C. The first sell signal is generated when price violates the upward trend line drawn connecting Previous bottoms. The chart gives a confirmed sell signal when price falls below the level of point B and again when I reaches a new peak at E, which fails to move above B |
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Double Bottom
It is exactly opposite of the double tops. It appears like the English alphabet 'W'. All features of double tops also apply to double bottom. However significant increase in volume is important on the upside break out. This chart pattern gives buy signals three times. First the price line breaks the downward trend line after creating the second bottom C . Next signal is generated when price moves above the peak point B with heavy volumes. Finally at point E, when a new bottom is formed, above point B |
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C. CONTINUATION PATTERNS
These patterns are brief pauses during an up trend or down trend. After the completion of the patterns, the price tends to move along the original trend. They are called continuation patterns because they are continuation of the trend prevailing before the formation of the pattern. The most important continuation pattern patterns are given below. |
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1. Channel
This is a series of uniformly changing tops and bottoms giving rise to a channel formation. This pattern is formed when the rates at which the support and resistance levels change are identical and constant over time. The direction of the slope of the channel indicates the way in which the market will move in future. |
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The direction of the slope of the channel indicates the way in which the market will move in future. A downward sloping channel would indicate declining prices and vice versa. If the price breaks out at the channel boundaries (upper boundaries or lower boundaries), then a definite change in the market sentiment is indicated. |
2. Wedge
A wedge is a channel whose top and bottom are boundaries. Instead of being parallel, they are converging or diverging. The slope of the wedge will indicate the general direction of movement of share price. |
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3. Triangle
Triangle is an extension of a wedge. Where the top and bottom boundaries intersect to form a triangle. A triangle may be formed during bull phase or a bear phase. In either case, it would indicate a continuation of the trend. When price movement occurs outside the triangle is called a break out. A break out upwards or downwards from a triangle is usually accompanied by increasing volumes. |
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4. Flag
A flag formation occurs mid-way between sharp rise or a fall in price. A flag looks like a parallelogram with the trend lines forming two parallel lines. The volume of trading is expected to fall during a flag formation and will again rise up on breaking out from the pattern. A flag formation indicates the following. Some news about the scrip will cause the initial price rise. The rise will be very sharp and will form the pole of the flag.
Prices fluctuate subsequently when there is a great disagreement about the earlier news. A break out indicates a definite direction in the movement of prices. A series of flags in a rising market would indicate that the market might not come down very sharply. |
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5. Pennant
A pennant is a long narrow flag usually triangular in shape. The upper trend line formed by connecting the tops stoops downwards whereas the lower trend lines formed by connecting the bottoms rises upwards. A pennant is formed mid way between a bullish trend or a bearish trend. A break out from the pattern is marked by an increase in volume. |
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6. Gap
A gap is formed when the opening price of a trading day is well above the highest price on the Previous day. |
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Wider the gap, the stronger the signal for a continuation of the observed trend. On a rising market if the opening price is considerably higher than the highest price reached on the Previous day it means that the traders are willing to pay a much higher price to acquire the scrip. Again, on a falling market, if the opening price is very much lower than the Previous day's lowest price, it shows that there is a selling pressure. A gap can be shown in a bar chart or Candlestick chart. |
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When a share moves in a sideways manner for many days, it might break out of the sideways trend with a wide gap on favourable news. There will be big volumes when it happens. This is called a breakaway gap. When the markets are very bullish, a number of gaps might occur continuously. These are called run away gaps. This is a danger signal. It shows that there is a buying frenzy and the markets are going to crash. |
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Break out gaps and run away gaps can occur during the bear phase also. |
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2. Moving Averages
Moving averages can also used to analyse individual securities. One of the most reliable and easily read technical indicators is the 200-day moving average of a security. When the share price lies above the 200 day moving average it is bullish sign. It is found that the share takes support at this chart and recovers. |
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When the chart of a share falls below the 200 day moving average it becomes bearish. This gives a clear sell signal. |
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3. Relative strength Analysis( Relative Strength Comparative)
Stock prices of shares tend to move more or less in tandem with the overall market represented by the market index. When the price chart of an individual stock diverts from the course chartered by an index, the concept of relative strength comparative Relative strength can be used to study such divergence. This can also be used to compare two stocks and find out which appreciates much more than the other. Relative strength refers to the ability of a stock to out perform the market. Relative strength refers to the ability of a stock to out perform the market at turning points. Relative strength arises out of the inherent merit of a stock to recover from a bear market or peak out earlier than most of the stocks trading in the market. Relative strength comparative is obtained from dividing the price of the stock by the market index. When computed in this manner, a rising relative strength comparative indicates that the stock is doing better than the market index. Relative strength also follows trends, the reversal of which signifies change in the relative strength of the stock. When the relative strength comparative of a stock is potted together with the market index, the relative strength comparative generally reverses ahead of the market index. |
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The same concept can be used to compare two scrips. If an investor thinks of selecting one of the two scrips for investment, it is possible to compare the performance of the scrips by drawing the relative strength comparative. In this case the market index is replaced by the second share. If the chart obtained is a rising chart, it means that the first share is moving faster than the second one. |
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4. Oscillators
Oscillators are mathematical indicators which help in identifying over bought and oversold conditions during up trends and down trends. They are called oscillators as they oscillate or move across a reference line. The most common oscillators are |
| 1. | Rate Of Change (ROC) |
| 4. | Relative Strength Index(RSI) |
| 5. | Momentum |
| 6. | MACD(Moving Average Convergence and Divergence) |
| 7. | Stochastic Oscillators |
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i. Rate Of Change.
ROC is very popular oscillator that measures the rate at which prices rise or fall with respect to historical price. It is based on the premise that ROC usually rises and falls sharply well ahead of the peak and before the trough respectively. When used for short-term measurements, a 12 -day ROC is computed. ROC is computed as given below ROC = Current price/Historical price - 1. For example to compute 12 day ROC divide the latest price by the historical closing price (i.e. closing price of the scrip 12 days before) and then deduct 1 from the resultant figure. ROC may be oscillate between positive, zero or negative. A 12-day ROC usually moves between +0.2 and -0.2 in India. When ROC becomes +0.2 or 20% the share becomes over bought. Similarly when ROC becomes --0.2 or -20% it becomes oversold |
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The same concept can be used to compare two scrips. If an investor thinks of selecting one of the two scrips for investment, it is possible to compare the performance of the scrips by drawing the relative strength comparative. In this case the market index is replaced by the second share. If the chart obtained is a rising chart, it means that the first share is moving faster than the second one. |
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Most of the time ROC turns direction before the share price dips. For example at the end of a bull run, ROC reaches over bought conditions and starts falling while share price still goes up. This is known as divergence. A divergence in a bull market or bear market shows that a reversal is eminent. Hence ROC is a leading indicator that gives advance warning of the impending fall in prices. |
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It can be seen that ROC shows over bought position at around 0.80 and over sold position at -0.80 for Nasdaq.
ii. RSI (Relative Strength Index)
RSI is a very important oscillator used for short-term and long-term technical analysis.
RSI computed as given below
RSI = 100- 100/1+RS |
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Where RS =Average of 'n' periods price gain/Average of 'n' periods price loss. Usually 14 day RSI is computed for short-term purposes. The following procedure is followed. |
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Total gains in 14 days=19
Average gain = 19/14
Total loss in 14 days = 13
Average loss = 13/14
RS = Average gain/ Average loss = 19/13 = 1.46
RSI = 100- 100/2.46 = 100 - 40.65 = 59.35
59.50 is a point on the RSI chart. For the 15th day, the first day's value is omitted and 15th day's value is added. It is found that RSI oscillates between 0 and 100. When the share price goes up continuously on all the 14 days RS= infinity and hence RSI =100. When share price falls on all 14 days RS=0 and RSI =0. Under normal circumstances a share becomes over bought when its RSI reaches 70. It becomes over sold when its RSI reaches 30. RSI also is a leading indicator. It was developed by J. Welles Wilder junior in 1978. RSI also obeys the trends line supports and resistances |
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iii. Momentum
Momentum indicator helps to take short-term enter-exit decisions. It is the basic application of oscillator analysis, which measures the rate of change in price. Momentum shows the speed with which the current price moves against the historical price (Say 13 days ago). Momentum is calculated by taking price differences continuously for a fixed time interval. To calculate a 13-day momentum indicator, subtract the closing price 13 days ago from the latest closing price. The difference is plotted on a graph. The X-axis will represent the time (days, Weeks, and Months) and vertical axis will represent the actual difference between the share prices. Momentum can be positive, negative and zero. This indicator moves up and down around zero. It also shows over bought and over sold conditions. Momentum indicator crossing the zero line from bottom is a signal to buy and the indicator moving down the zero line from the top is an indication to sell. Momentum should not be used in isolation. It should be used along with tools like SMA or EMA to reach valid conclusions. |
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iv. Moving average convergence and divergence(MACD)
It is a very important tool for long-term predictions. It is the difference between two moving averages of different lengths. It is constructed by taking the difference between two moving averages of different lengths and plotting that difference against time. For plotting MACD Exponential Moving Averages are generally used. It gives faster signals. Two EMAs, one with short duration and another with long duration are used for this. Usually 26 days EMA and 12 day EMAs are used for this purpose. The EMA value of the long term EMA is deducted from the short term EMA to arrive at the MACD value for any particular day.
Both short-term and long-term averages are used to derive the benefits of both. A short-term EMA generally works better when prices move sideways. A long average is quite useful when the price in up trend or downtrend. Thus it becomes a problem to identify which one to use. MACD is a solution to the above problem which uses both, |
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Technical Analysis
by taking the difference between both averages The difference is then plotted on the chart and this MACD chart oscillates across zero line. A simple moving average line is then superimposed on the MACD line. This line is nothing but the simple moving average of MACD data. Generally a 9-day SMA is used for this purpose.
Interpretation If MACD moves above the zero line from bottom it is a bullish sign. When MACD falls below the zero line from the top it a bearish signal. The simple moving average line super imposed, on the chart gives signals to buy and sell. When MACD line and SMA lines are below the zero line and if MACD line crosses the SMA line from below and moves up it is a buy signal. When MACD and SMA are above zero line and MACD line cuts SMA from top and moves down it is sell signal |
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In the chart above short-term SMA is 12 days and long-term SMA is 26 days. MACD is drawn with broken red lines. Blue colour line denotes the 9-day SMA. Buy signals and sell signals are marked on the chart. |
This indicator gives the short-term state of the market. This indicator is based on the closing, high and low of a share or an index for a short period of time. The period chosen is usually 5 trading days. Some select 10 days also. This oscillator was developed by George Lane and is widely used for short-term trading purposes. It helps to identify the tops and bottoms most of the time. To plot this oscillator four parameters of the price are needed. In addition trading period should also be selected. Usually 5-day stochastic oscillators are plotted. Four parameters required are - Opening value on the first trading day.
- Highest value of among the five past trading days
- Lowest value of the last five trading days
- Closing value on the last day.
Stochastic oscillator value for a particular day determined by the formula
%K = (C-L/H-L) 100 Here C in the numerator is the closing price and L is the lowest price in the last five days. Hence C-L gives the difference between the closing value and the lowest value. The denominator H-L gives the difference between highest price and lowest price. The ratio between C-L and H-L gives position of the closing value with respect to the total movement of the share price during the last five trading days. When c is very near H, %K will be near 100. When C is very near L, %K will be almost zero. Thus this oscillator moves between 0 and 100. As the movement of this oscillator is very fast and erratic, a smoothing line is drawn along with the %K line. This line is called the %D line. It is found that the share becomes over bought when its stochastic oscillator moves over 80%. Similarly when its stochastic oscillator moves down below 20% it becomes over sold. A sell trigger is signaled when D-line cuts the K-line from the top and a buy signal is generated when the D-line cuts the K-line from the bottom. It should be clearly noted that movement of the stochastic to over bought regions itself do not generate a sell signal. There are many instances of the stochastic lying in the over bought region for days together. The same rule applies in the over sold region also. Let the period chosen be 5 days.
| Trading day | High | Low | Close |
| 1 | 201.90 | 190 | 190 |
| 2 | 208.40 | 203.65 | 205 |
| 3 | 211.95 | 208.15 | 210 |
| 4 | 210.05 | 200.7 | 202 |
| 5 | 204 | 197 | 198 |
| 6 | 205.95 | 199.6 | 200 |
| 7 | 199.75 | 194 | 195.5 |
| 8 | 199.75 | 190 | 192 |
| 9 | 188 | 175.1 | 177 |
| 10 | 188.65 | 172.4 | 173 |
| 11 | 180.65 | 174.6 | 176 |
| 12 | 189.77 | 178.25 | 187 |
| 13 | 187.85 | 180.25 | 182 |
| 14 | 195.45 | 186.55 | 194 |
| 15 | 190.3 | 181 | 181 |
| 16 | 183.9 | 176.15 | 178 |
| 17 | 176.55 | 145.65 | 150 |
| 18 | 154.35 | 127.2 | 146 |
| 19 | 156 | 145.5 | 156 |
| 20 | 158.35 | 154.15 | 158 |
| 21 | 150.45 | 141.2 | 144 |
| 22 | 155.8 | 144.6 | 144.6 |
| 23 | 165.8 | 139 | 139 |
| 24 | 165.4 | 154.15 | 157 |
| 25 | 162.85 | 157.8 | 160 |
| 26 | 164 | 157 | 158.85 |
If the first five days are considered the high of the share is 211.95 and the low is 190.The closing price on the fifth day is Rs.198.
The formula for computing the value of the stochastic oscillator is given below.
Value of the stochastic oscillator = 100 * (Close – Low)/(High – Low)
= 100 * (198 – 190)/(211.95 –190)
= 100 * 8/21.95
=36.45
This shows that the closing on the fifth day is at 36.45% of the range of price movement of the share .On the sixth day the value of the stochastic oscillator will be 100 * (200 – 197)/(211.95 – 197)= 20.06
We will get a number of points as shown in table 2.2.If these points are plotted on a graph paper one will get an oscillating chart called % K line. In fact, % K line shows the range of price movement of the share Table 2.2
| Day | Value of Stochastic Oscillator |
| 5 | 36.45 |
| 6 | 20.06 |
| 7 | 8.36 |
| 8 | 9.98 |
| 9 | 6.16 |
| 10 | 1.79 |
| 11 | 13.16 |
| 12 | 53.38 |
| 13 | 55.27 |
| 14 | 93.71 |
| 15 | 30.7 |
| 16 | 13.58 |
| 17 | 8.73 |
| 18 | 27.55 |
| 19 | 45.63 |
| 20 | 54.48 |
| 21 | 34.04 |
| 22 | 55.86 |
| 23 | 0 |
| 24 | 67.16 |
| 25 | 78.36 |
| 26 | 74.0 |
It can be seen that within 26 trading days this indicator has moved down three times below 10. It went above 90 once. It can also be noticed that the chart formed oscillates between 0 and 100. Hence it is called an oscillator. One interesting fact about this oscillator is that it goes down whenever it goes above 80. It may lie above 80 for a few days sometimes when the share is extremely bullish. However, it will surely go down from these levels within a few days after remaining in these levels. If the history of the share is taken for a few years, it will be seen that this behaviour repeats again and again. In fact it is an advance indicator that turns even before the share changes trend. When the share continues its upward move and its stochastic oscillator turns down, it is an advance signal that the share has peaked and its fall is imminent. Similarly, if the stochastic oscillator goes below20 and stays there, it gives the signal that the share will recover from its fall soon. In short, a share can be said to be over bought when its stochastic oscillator goes above 90. It can also be said that it is over sold when its stochastic oscillator reaches below 20.
Thus buying a share or an index when it's stochastic hovers above 90 is not wise. In fact, it is the time one should sell the index or share. With the same reasoning selling a share when its stochastic oscillator is lying below 20 is not wise. On should in fact think of buying it at that point. Determining the values of the stochastic oscillator by the method shown above is cumbersome and is difficult. Computer programs such as Metastock provides an easy way for computing this and showing the results as a chart. Metastock computes the chart by two methods. There is a slow stochastic and a fast stochastic. The method shown above gives the fast stochastic. In this method, the slowing period is to be given as 1. The value of one shows that there is no slowing. If a value more than one is given for slowing say 3, Metastock will take the average of the highest high for three days and the average of the lowest low for the three days before performing division. This stochastic is called a slow stochastic. A moving average of the %K values is then calculated using a specified time, usually 3 for the five day stochastic. Plotting these values along with the stochastic Previously plotted %K-line will provide a smoothing chart known as %D moving average. It can be seen that when the share price is moving up fast %K line stays above the %D line. When the share is falling down fast %D line stays above the %K line. Thus, cross over points will show the buying and selling points in a more reliable manner. It should be noted that the stochastic oscillator did not reach 80% level in the last two occasions. Thus a person who bought the share when the stochastic was below 20% with the intention of selling it when the stochastic will reach above 80% will be getting in trouble because the share stated falling before that. Therefore total dependence on stochastic alone is not 100% trust worthy.
There are some other indicators similar to the stochastic oscillator that gives advance warnings about impending change of trend. Williams' % R, ROC and RSI are three such indicators. WILLIAMS' %R
Williams %R is a momentum indicator The formula used to calculate Williams' %R is similar to the stochastic Oscillator.
This is an indicator, which is plotted upside down on a scale using negative numbers. For interpretation purposes it is the absolute value which counts so disregard the negative sign. The indicator itself measures overbought and oversold levels. The calculation is as follows: [(Highest High in n periods minus today's close) divided by (Highest High in n periods minus Lowest Low in n periods)] * (times) -100. Always wait for a change in the security's price before taking action based on an oversold/overbought indicator like Williams %R. This is because overbought/oversold indicators tend to be leading indicators in that they turn before the security. Oversold readings tend to occur in the 80 to 100 range and overbought readings tend to occur in the 0 to 20 range.As with all over bought and over sold indicators, it is better to wait for the security's price to change direction before placing your trades.
For example, if Williams' % R shows over bought condition it will be wise to wait for the security's price to turn down before selling the security. It is not unusual for over bought/oversold indicators to remain in an over bought/ over sold condition for a long period of time as the security's price continues to climb /fall. Williams'% R indicator has the ability to anticipate a reversal in the under lying security's price. This indicator always forms a peak, turns down a few days before the security's price peaks, and turns down. Like wise, Williams'% R usually creates a trough and turns up a few days before the security's price turns up. |
| RANDOM WALK THEORY |
Fundamental analysis, which studies the intrinsic value of a share, tells us what to buy and sell. Technical Analysis, which studies past price movements through charts, predicts future price movements and advises us when to buy or sell.
Random Walk Theory questions the basic assumptions of technical Analysis that share price movements are quite orderly and systematic. Random Walk Theory tells that share price movements are irregular, random and unsystematic. Favourable or unfavourable information about changes in economy, industry and company alters the share price immediately to a new level, either upward or downward. This rapid shift to new level whenever new information is received amplifies the fact that all information is fully reflected in the price of the stock. Further change in price of the stock will occur only as result of some other new piece of information, which was not available earlier. Thus random walk theory says that successive price changes over short periods are clearly independent of each other. That is, the past prices are in no way connected to future prices; each price change is caused by a new piece of information and is independent of other price changes. The basic premise underlying random walk theory is that information relating to economy, industry, and company performance is immediately and fully transmitted to all types of investors. As a result, current stock price fully reflects all available information on the stock. Therefore the price of the stock on each day is independent; it may be constant, higher or lower than the Previous day's price. Each day's price is dependent only on new piece of information received periodically. For example, the price may be Po day -1. It may change to P1 on day -2. On day -3, it may remain constant at P1, it may revert to Po on day -4 and so on. The real cause of this random or irregular or zig- zag price change is the arrival of new information. Information is unbiased and independent. Price changes will also be independent. Thus price movements are not regular. They are definitely irregular. The random market theory is based on the hypothesis that the markets are efficient and perfect. There is free flow of information, which in turn affect stock prices instantaneously. Therefore this theory is also known as Efficient Market Hypothesis.
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EMH states that the capital market is efficient in processing information. It absorbs all information through demand and supply forces. When someone refers to efficient capital markets, they mean that security prices fully reflect all available information. The EMH is concerned with the speed with which information is incorporated in security prices. In an efficient market, it is impossible to make above-average returns or excessive returns by undertaking fundamental analysis or technical analysis, as prices adjust to new and correct levels, instantaneously, whenever new information arrives.
Forms of Market efficiency
The EMH has been sub-divided into three forms, each dealing with a different type of information.
- Past price information
- Other public information
- Public as well as private information.
Accordingly there are three different forms of Capital Market Efficiency.
1.The weak form
2. Semi-strong form
3.Strong form
Weak form
The weak form states that the current prices of shares already reflect all available information contained in the past prices. The prices move in a random fashion independent of the past and hence there is no benefit in examining past prices for predicting future prices. Therefore this hypothesis rejects Technical Analysis. In fact, if there is no value in studying past prices and past price changes, there is no value in Technical Analysis. Therefore the weak form of EMH is popularly known as Random Walk Theory.
For example, if the closing prices of stock X for a certain period have been Rs43, 44, 45, 46 and 47,it may appear that tomorrow, the closing price is more likely to be Rs48 than Rs46. But this is not so. The price Rs47 fully reflects whatever information is implied by or contained on the price sequence preceding it. In other words, stock prices approximate a random walk, i.e. prices have no memory and yesterday has nothing to do with tomorrow.
Semi-strong form
Semi-strong form of EMH deals with historical prices as well as all public information about a corporation. Examples of publicly available information are
- Information about corporate results
- Dividend policy
- Corporate announcements about stock splits, bonus issues, rights issues
- Mergers, acquisitions etc
The semi-strong form of EMH maintains that as soon as information becomes publicly available it is absorbed and fully reflected in stock prices. Publicly available information can not be used to earn consistently superior investment returns.
Strong form of EMH
Strong form of EMH deals with all information-both public and private (inside information). The strong form of EMH contends that both public information and private information are fully reflected in security prices. Therefore publicly available information and inside information can not be used to earn consistently superior invest returns. Not even security analysts and portfolio managers, who have speedy access to information than general investing public, are able to use this information to earn above average returns.
But do share prices move in tandem with information? It is be noted that information transmitted is objective. It becomes subjective in the minds of the investors. Some will perceive it be good, certain others will perceive to be bad. The market will move with the majority perception. For example Infuses published superior results for the second quarter of 2004 and share price moved up only Rs10 the first day. But on the second day the share price moved up by Rs100. The information available was objective. But its perception changed after two days.
EMH VS FUNDAMENTAL AND TECHNICAL ANALYSIS
The three theories used to explain stock price movements are fundamental analysis, technical analysis and EMH.
Fundamental analysis estimates the intrinsic worth of a security by studying the economy, industry and company fundamentals. They also identify the mis-priced securities (under priced and over priced). Fundamental analyst then advises investors to purchase under priced securities and to sell over priced securities.
The technical Analyst holds that fundamental analysis is unnecessary. Technical Analyst by studying historical price movements, predict future price movements and advises investors when to buy and when to sell.
The EMH exists in three forms. The weak form of EMH is inconsistent with technical analysis. When random walk hypothesis (weak form of EMH) states that successive price changes are independent. Chartists claim that they are dependent-i.e. Past prices and past price changes can be used to forecast future price changes. The semi-strong form of EMH contracts fundamental analysis to some extent by claiming that publicly available information can not be used to consistently to earn above average returns. The strong form of EMH maintains that all information-public as well as private information is useless to the investor in making above average returns.
Although EMH rejects both fundamental and technical analysis, the market is efficient precisely because of the systematic and organised efforts of thousands of analysts undertaking fundamental analysis and technical analysis. Therefore, the paradox of EMH is that both fundamental and technical analysis are required to make the efficient market to work.
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