TECHNICAL ANALYSIS — PART 2

HISTORY OF TECHNICAL ANALYSIS
Before we jump in, it is worth spending time to understand in brief the history of Technical Analysis. The principles of technical analysis was derived from the observation of financial markets over hundreds of years. The oldest known hints of technical analysis appear in “Joseph de la Vega’s” accounts of the Dutch markets in the 17th century.

In Asia, the oldest example of technical analysis is thought to be a method developed by Homma Munehisa during early 18th century which evolved into the use of candlestick techniques, and is today a main charting tool.
In the 1920s and 1930s “Richard W. Schabacker” and “William Peter Hamilton” published many books relating to “Dow Theory and Technical Analysis.” Will discuss this theory at a later stage.
In 1948 “Edwards and John Magee” published “Technical Analysis of Stock Trends” which is widely considered to be one of the seminal works of the discipline. It is exclusively concerned with trend analysis and chart patterns and remains in use to the present. It is now in its 9th edition.
As is obvious, early technical analysis was almost exclusively the analysis of charts, because the processing power of computers was not available for statistical analysis. Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.
INDUSTRY

The industry is globally represented by the “International Federation of Technical Analysts (IFTA)”,which is a Federation of regional and national organizations and the “Market Technicians Association (MTA).”
In the United States,the industry is represented by both the “Market Technicians Association (MTA)” and the “American Association of Professional Technical Analysts (AAPTA).”
In the United Kingdom,the industry is represented by the “Society of Technical Analysts (STA).”
In Canada the industry is represented by the “Canadian Society of Technical Analysts.”

Professional technical analysis societies have worked on creating a body of knowledge that describes the field of Technical Analysis. A body of knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field. The Market Technicians Association (MTA) has published a body of knowledge, which is the structure for the MTA’s Chartered Market Technician (CMT) exam.
TECHNICAL ANALYSIS — SET UP
As we had discussed in the last lecture that analysing or forecasting the direction of prices happen through past market data. This data can be visualised in the form of charts and requires mainly four data points.
Open {O} — When the markets open for trading, the first price at which a trade executes is called the opening Price.
High {H} — This represents the highest price at which the market participants were willing to transact for the given day.
Low {L} — This represents the lowest level at which the market participants were willing to transact for the given day.
Close {C} — The Close price is the most important price because it is the final price at which the market closed for a particular period of time. The close serves as an indicator for the intraday strength. If the close is higher than the open, then it is considered a positive day else negative. Of course we will deal with this in a greater detail as we progress through the series.
The closing price also shows the market sentiment and serves as a reference point for the next day’s trading. For these reasons, closing price is more important than the Open, High or Low prices.
The Indian stock market is open from 9:15 AM to 15:30 PM. During the 6 hour 15 minute market session, we can draw a technical chart for the trading action of a stock for the whole day, mentioning the four data points for each hour/minutes of the day. Similarly, if we want to look at the trading action of a stock for a week,each day will have four data points and hence there will 28 (4 data point x 7 days) data points. Hence you can get understanding how complicated it would be, when we will try to summarize the trading action of a stock for a month, six months or a year.
TYPES OF CHART
In previous chapter, we learnt about what is technical analysis through examples. In this chapter, we will understand how traders use different charts.
Some charts which are used mentioned below:
Line Chart.
Bar Chart.
Candlestick Chart.

The line chart is the most basic chart type and it uses only one data point to form the chart. When it comes to technical analysis, a line chart is formed by plotting the closing prices of a stock or an index. A dot is placed for each closing price and the various dots are then connected by a line.
If we are looking 60 day data then the line chart is formed by connecting the dots of the closing prices for 60 days.
The line charts can be plotted for various time frames namely monthly, weekly, hourly etc. So ,if you wish to draw a weekly line chart, you can use weekly closing prices of securities and likewise for the other time frames as well.
The advantage of the line chart is its simplicity. With one glance, the trader can identify the generic trend of the security. However the disadvantage of the line chart is also its simplicity. Besides giving the analysts a view on the trend, the line chart does not provide any additional detail. Plus the line chart takes into consideration only the closing prices ignoring the open, high and low. For this reason traders prefer not to use the line charts.

The bar chart on the other hand is a bit more versatile. A bar chart displays all the four price variables namely open, high, low, and close. A bar has three components.
The central line — The top of the bar indicates the highest price the security has reached. The bottom end of the bar indicates the lowest price for the same period.
The left mark/tick — indicates the open
The right mark/tick — indicates the close
The length of the central line indicates the range for the day. A range can be defined as the difference between the high and low. Longer the line, bigger the range, shorter the line, smaller is the range.
While the bar chart displays all the four data points it still lacks a visual appeal. This is probably the biggest disadvantage of a bar chart. It becomes really hard to spot potential patterns brewing when one is looking at a bar chart. The complexity increases when a trader has to analyse multiple charts during the day.
Hence for this reason the traders do not use bar charts. However it is worth mentioning that there are traders who prefer to use bar charts.
But if you are starting fresh, I would strongly recommend the use of Candlesticks. Candlesticks are the default option for the majority in the trading community. Will discuss about candlesticks in the next lecture in detail.
TIME SERIES/FRAME
A time frame is defined as the time duration during which one chooses to study a particular chart. Some of the popular time frames that technical analysts use are:
Monthly Charts
Weekly charts
Daily or End of day charts
Intraday charts — 30 Mins, 15 mins and 5 minutes

One can customize the time frame as per their requirement. For example a high frequency trader may want to use a 1 minute chart as opposed to any other time frame.

A technical analyst should always start with monthly and weekly charts. Only after that one should deal with the daily chart. For a more precise fine-tuning you can then investigate intraday charts (top-down procedure).
Daily and weekly charts are suitable for medium to long-term analysis. Intraday charts are optimal for short-term trading (displaying trading activities of only a few days).
ASSUMPTIONS
Fundamentalists believe there is a cause and effect between fundamental factors and price changes. This means, if the fundamental news is positive the price should rise, and if the news is negative the price should fall. However, long-term analyses of price changes in financial markets around the world show that such a correlation is present only in the short-term horizon and only to a limited extent. It is non-existent on a medium- and long-term basis.

In fact, the contrary is true. The stock market itself is the best predictor of the future fundamental trend. Most often, prices start rising in a new bull trend while the economy is still in recession (position B on chart shown above), i.e. while there is no cause for such an uptrend. Vice versa, prices start falling in a new bear trend while the economy is still growing (position A), and not providing fundamental reasons to sell. There is a time-lag of several months by which the fundamental trend follows the stock market trend. Moreover, this is not only true for the stock market and the economy, but also for the price trends of individual equities and company earnings. Stock prices peak ahead of peak earnings while bottoming ahead of peak losses.
The purpose of technical analysis is to identify trend changes that precede the fundamental trend and do not (yet) make sense if compared to the concurrent fundamental trend.
So, to identify this it is important to understand the assumptions that is required for technical analysis. Here are few of them:
1) Markets discount everything — This assumption tells us that, all known and unknown information in the public domain is reflected in the latest stock price. For example there could be an insider in the company buying the company’s stock in large quantity in anticipation of a good quarterly earnings announcement. While he does this secretively, the price reacts to his actions thus revealing to the technical analyst that this could be a good buy.
2) The ‘how’ is more important than ‘why’ — This is an extension to the first assumption. Going with the same example as discussed above — the technical analyst would not be interested in questioning why the insider bought the stock as long he knows how the price reacted to the insider’s action.
3) Price moves in trend — All major moves in the market is an outcome of a trend. The concept of trend is the foundation of technical analysis. For example the recent upward movement in the NIFTY Index to 12000 from 10000 did not happen overnight. This move happened in a phased manner, in over 12 months from October, 18 to November, 19. Another way to look at it is, once the trend is established, the price moves in the direction of the trend.
4) History tends to repeat itself — In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements in a remarkably similar way, each and every time the price moves in a certain direction. For example in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a down trend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.
In the next few lecture, will discuss the Candlesticks, Different Concepts & Overlays of Technical Analysis, Types of Indicators and Patterns. Will take each concept one at time and explain you everything in detail.

