Nov 27, 2014,13.29 IST

All you wanted to know about Technical Analysis

1. What is technical analysis?

Technical analysis is a process of analyzing the future price movement of an asset by using charts, and can be used to identify buying and selling opportunities.

It must be understood that technical studies are based entirely on prices and do not include balance sheets, P&L accounts (fundamental analysis), the assumption being that the markets are efficient and all possible price sensitive information is built into the price graph of a security / index.

Therefore, technical analysis supports the efficient market theory as against the "random walk theory" which supports the belief that stocks can be bought / sold on random events like flipping a coin. Technical analysis is more dynamic as compared to fundamental analysis based on one simple argument - fundamental analysts depend on corporate events like quarterly results and special announcements like earnings guidance and policy changes in operations to generate a buy / sell recommendation.

If fundamental analysis was the single most reliable indicator of trends, prices would predominantly fluctuate only 4 - 5 times a year - around quarterly results and special announcements like mergers and acquisitions etc!! Why would prices fluctuate almost daily? If the prices fluctuate ever so often, is there a way to forecast them? Yes according to technical analysis.

2. What are Continuation and reversal patterns?

The continuation pattern in technical analysis indicates that the price trend will continue in the same direction. The continuation pattern can be seen on the tick chart, daily chart or weekly chart. Reversal pattern is seen when the continuation pattern fails. Reversal pattern indicates that the trend is ending and new market trend is about to begin.

Continuation patterns are channels, flags and pennants, and trendlines. Reversal patterns are island reversal, moving average crossover, and head and shoulder formation.

3. How to use Relative Strength Comparative?

Technical analysis offers a few wonderful tools with the help of which we can check out the Relative Strength Comparative (RSC). As the name suggests, it is a comparative measure of strength vis-à-vis a benchmark or a share or a sector. The best way you can put the RSC to use before initiating a trade is to check out how your scrip has performed historically -- it can be against the indices, its peers in the same sector and/or a separate asset class like say, commodities. To that effect, RSC helps in determining which scrip would be the most profitable investment.

Highly volatile scrips rise or fall faster than the indices, but may not make large net moves in any single direction. On the other hand, high RSC scrips will rise faster than the indices but fall slower than the indices in a downturn. To that extent, they are solid market outperformers and have unidirectional upward movement. Needless to say, buying scrips with the highest RSC reading among the available choice of stocks will ensure a greater probability of capital appreciation.

4. Which are the different types of candlestick patterns?

The candlestick is a way of presenting price movement of stocks in graphical pattern. There are two type candlesticks:  
Bullish candlestick: It is formed when closing price of stock is more than the opening price.

Bearish candlestick: It is formed when the closing price of stock is less than the opening price.

The candlestick patterns include various bullish/bearish reversal and continuation patterns like Abandoned Baby Bottom and top, Bearish Belt Hold, Bullish Belt Hold, Bullish Engulfing, Bearish Engulfing, Bearish Harami and Bullish Harami.

5.     Which are three types of indicators?

There are basically three types of indicators.
a. Leading Indicators: These are indicators that lead the price move. In other words, the indicators move first and the price move follows. They usually help identify the overbought and the oversold position.
b. Lagging Indicators: The price of the stock moves first and the indicators follow. They help in identifying trend continuation or trend reversal.
c. Coincident Indicators: The coincident indicators occur almost simultaneously with the event that they signify. Such indicators are not of much use for predicting future trends for stocks.

6.     What is Moving Average? What are the types of Moving Averages?

Moving averages: Although it is the simplest of all indicators, analysts across the world swear by the efficacy of this tool in predicting the future movement of a stock or the markets. Moving averages help in calculating the average price of a security over a given time period.
a. Simple Moving Average (SMA) : Moving averages are lagging indicators. It is simply an average of the closing prices of a stock for a given number of days, that is, the sum of the closing price for each day divided by the number of days.

b. Weighted Moving Average: Here, weights are attached to the closing price. The common weights used are 1 for day one, 2 for day two, 3 for day three, and so on. To calculate the weighted average, first the closing price for each day needs to be multiplied by its weight.
Over a medium to long-term time period, Simple Moving Averages have proved to be much more effective than Weighted Moving Averages, when it comes to predicting upward or downward trend. And, hence, you would find most analysts using SMA more than anything else.

7.     What is Trend?

There are two types of trend. If a stock price is trading above the moving average level, it signals ‘bullishness’ and if the price is trading below the moving average level, it suggests ‘bearishness’.

8.   What is Support and Resistance?

The moving average also gives us support and resistance. Hence, if a stock is trading above the moving average, it will find support at the moving average level and resume its uptrend. Whereas, if a stock is trading below the moving average, it will find resistance at the moving average level and continue to fall.

9.     What is RSI?

The RSI is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine the overbought and oversold conditions of an asset. It was developed by Wells Wilder. It basically helps to determine the technical strength and weakness in a particular stock by comparing the days a stock closes up versus the days it closes down. Most people use 5-day, 7-day, 9-day, or 14-day period for calculating the RSI. RSI is a leading indicator.

Interpretation: If the RSI range is from 1 to 100, RSI above 70 is considered overbought and RSI below 30 is considered oversold. If a stock is moving down but the RSI is rising or if a stock is moving up but the RSI is falling, it signals divergence and it means that a trend reversal is on the cards.

10. What is a Pivot Point?

A technical indicator used to determine the overall trend of the market for the next trading day based on today’s price action. On the subsequent day, trading above the pivot point is thought to indicate a bullish sentiment, while trading below the pivot point indicates a bearish sentiment. It also helps to calculate support and resistance levels for the next trading day. Once you master this indicator you too can give support and resistance levels for a stock or an index. Basically you need three things to calculate the Pivot Point (P) and the support and resistance of a stock: Previous day’s High, Low, and Closing Price.

If the stock opens above the pivot point on the next trading day, then the trading bias is upwards. If the stock opens below the pivot point, then the trading bias is downwards. R1 and S1 is the first Resistance and Support level, from where the price can reverse. If the market is near R2 or S2, it suggests that it is in the overbought or oversold zone respectively and a reversal is likely.

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