Assignment

a Technical analysis is based on the assumption that markets are driven more by psychological factors than fundamental values. Substantiate. Ans. Technical analysis is based on the assumption that marke t s a r e d r i v e n m o r e b y psychological factors than fundamental

values. Its proponents believe that asset prices reflect not only the underlying value of the assets but also the hopes and fears of those in the market. They assume that the emotional makeup of investors does not change, that in a certain set of circumstances, investors will react in a similar manner to how they did in the past and that the resultant price moves are likely to be the same. Technical analysts use chart patterns to analyze market movements and to predict security prices. Although many of these charts have been used for more than 100 years, technical analysis believe them to be relevant even now, as they illustrate patterns in price movements that often repeat themselves. Technical analysis can be applied to any security which has historical trading data. This includes stocks, bonds, futures, foreign exchange etc. In this unit, we will give examples of stocks but remember that the technical analysis can be used for any type of security. Tools of Technical Analysis There are many different types of technical traders: some rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two.

Charting: Technical analysts are sometimes called chartists because they study records or charts of past stock prices and trading volume, hoping to find patterns they can exploit to make a profit. Technical Indicators: Technical analysts also use technical indicators besides charts to assess prospects for market declines or advances. A technical indicator is a series of data points that are derived by applying a formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Technical indicators can be classified in a number of ways. One classification divides them into three types: sentiment indicators, flow of funds indicators, and market structure indicators. Sentiment indicators are intended to measure the expectations o f v a r i o u s g r o u p s o f investors, for example, mutual fund investors, and corporate insiders. Flow of funds indicators are intended to measure the potential for various investor groups to buy or sell stocks in order to predict the price pressure for those actions. Market structure indicators monitor price trends and cycles

b. What are technical indicators and how it is useful to a technical analyst? Ans. A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security. Price data can be any combination of the open, h i g h , l o w o r c l o s i n g p r i c e o v e r a p e r i o d o f t i m e . S o m e i n d i c a t o r s m a y u s e o n l y t h e closing prices, while others incorporate volume and open interest into their formulae. The price data is entered into the formula and a data point is produced. For

example, say the closing prices of a stock for 3 days are Rs. 41, Rs.43 and Rs43. If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing is o n e data point

(41+43+43)/3=42.33). However, one data point does not offer m u c h information. A series of data points over a period of time is required to enable analysis. Thus we can have a period moving average as a technical indicator where we drop the earliest closing price and use the next closing price for calculations. By, creating a time series of data points, a comparison can then be made between present and past levels. Technical indicators are usually shown in a graphical form above or below a security price chart for facilitating analysis. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Some times indicators are plotted on top of the price plot for a more direct comparison. Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. A technical indicator offers a different perspective from w h i c h t o a n a l y z e t h e p r i c e action. Some, such as moving averages, are derived from simple formulae and they are relatively easy to understand. Others, like stochastic have complex formulae and require more effort to fully understand and appreciate. Technical indicators can provide unique perspective on the strength and direction of the underlying price action. Indicators filter price action with formulae. Therefore they are derivative measures and

not direct reflections of theprice action. T h i s s h o u l d b e t a k e n i n t o a c c o u n t w h e n analyzing the indicators. Any analysis of an indicator should be taken with the price action in

mind. There are two main types of indicators: leading and lagging. A leading indicator precedes price movements; therefore they are used for predication. A lagging indicator follows price movement and therefore is a confirmation. The main benefit of leading indicators is that they provide early signaling for entry and exit. Early signals can forewarn against a potential strength or weakness. Leading indicators can be used in trending markets. In a market that is trending up, the leading indicator helps identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities. include Some of the more strength

popular leading indicators

Relative

Index (RSI) and Stochastic Oscillator Lagging indicators follow theprice action and are commonly ref e r r e d t o a s trend-following i n d i c a t o r s . Lagging indicators work best when the markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend in intact. As such, these indicators are not effective in trading or sideways markets. Some popular trend-following indicators include moving averages and Moving Average Convergence Divergence (MACD).Technical indicators are constructed in two ways: those that fall in a bounded range andt h o s e t h a t d o n o t . T e c h n i c a l i n d i c a t o r s t h a t a r e b o u n d w i t h i n a r a n g e a r e c a l l e d oscillators. Oscillators are used as an overbought/oversold indicator. A market is said to be overbought when prices have been trending higher in a relatively steep fashion for some time, significantly outweighs those on the

sidelines or holding short positions. T h i s m e a n s t h a t t h e r e a r e fewer participants to jump onto the back of the trend. The oversold condition is just the opposite. The market has been trending lower for sometime and is running out of fuel for further price declines. Oscillator indicators move within have a range, say between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Oscillators are the most common type of technical indicators. The technical indicators that are not bound within a range also form buy and sell signals and display strength or weakness in the market, but they can vary in the way they do this. T h e t w o m a i n w a y s t h a t technical indicators are used to form buy and sell signals isthrough crossovers and divergence. Crossovers occur when eit h e r t h e p r i c e m o v e s through the moving average, or when two

different moving averages cross over each other. Divergence happens when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This indicates that the direction of the price trend is weakening. Technical indictors provide an extremely useful source of additional information.

Thesei n d i c a t o r s h e l p i d e n t i f y m o m e n t u m , t r e n d s , v o l a t i l i t y a n d v a r i o u s o t h e r a s p e c t s i n a security to aid in the technical analysis of trends. While some traders just use a single indicator for buy and sell signals, it is best to use them along with price movement, chart patterns and other indicators.A n u m b e r o f t e c h n i c a l i n d i c a t o r s a r e i n u s e . S o m e o f t h e t e c h n i c a l i n d i c a t o r s a r e discussed below for the purpose of illustration of the concept. Moving average

The moving average is a lagging indicator which is easy to construct and is one of the most widely used. A moving average, as the name suggests, represents an average of a certain series of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (days 11) is added to the total and the oldest close (day 1) is subtracted. The n e w t o t a l i s t h e n d i v i d e d b y t h e t o t a l n u m b e r o f d a y s ( 1 0 ) a n d t h e r e s u l t a n t a v e r a g e computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action. Moving Average Convergence Divergence (MACD) MACD is a momentum indicator and it is made up of two exponential moving averages. The MACD plots the difference between a 26-day exponential moving average and a 12-day exponential moving average. A 9-day moving average is generally used as a trigger line. When the MACD crosses this trigger and goes down it is a bearish signal and wheni t c r o s s e s i t t o g o a b o v e i t , i t s b u l l i s h s i g n a l . T h i s i n d i c a t o r m e a s u r e s s h o r t - t e r m momentum as compared to longer term

momentum and signals the current direction of momentum. Traders use the MACD for indicting trend reversals. Relative Strength Index The relative strength index (RSI) is another of the well known momentum indicators. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval. RSI helps to

signal overbought and oversold conditions in a security. RSI is plotted in a range of 0-100. A reading above 70 suggests that a security is overbought, while a reading below 30 suggests that it is oversold. This ind icator help traders to identify whether a securitys price has been unreasonably pushed to its current levels and whether a reversal may be on the way. Stochastic Oscillator The stochastic Oscillator is one of the most recognized moment u m i n d i c a t o r s . T h i s indicator provides information about the location of a current closing price in relation to the periods high and low prices. The closer the closing price is to the periods high, the higher is the buying pressure, and the closer the closing price is to the periods low, the move is the selling pressure. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing n ear the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below20