Technical Analysis 105: Important Tools - II

Earlier posts of Technical Analysis:

• Technical Analysis 101
• Technical Analysis 102
• Technical Analysis 103: Trends and Channels
• Technical Analysis 104: Important Tools – I

There are numerous other tools which are used in Technical Analysis – (a) Oscillators, (b) Stochastics, (c) RSI, (d) Moving Average Convergence Divergence, and (e) Bollinger Bands, just to name a few. However, I do not think I would be able to follow so many of the tools, and have identified two additional tools which I believe I could track:

1. Relative Strength Indicator (RSI): Very simply put, it measures the relative strength of the overall market, and has readings between 0 and 100. Usually, it is computed as

RSI = 100 - {100 / (1 + RS)},
where RS = Average of N period’s up moves / Average of N period’s down moves

RSI would be more than 50 if the average up moves are greater than the down moves, and would reach 100 (theoretically) when all days are up-days. Usually N is taken as 13 or 14. An RSI value above 70 is considered signs of an over-bought market, and RSI value below 30 indicates oversold markets. However, one should also look at the price charts in addition. If the prices are forming a double top, whereas the RSI isn’t, then it may be a bearish signal. Similarly, in situation when RSI is making a double top, and prices aren’t,we might see an up-move in prices.

2. Bollinger Bands: These are bands placed 1.5 to 2 standard deviations up and below a simple moving average line. For example, if we are looking at a 20 DMA line, then its Bollinger band would be 2 sigma up and below the 20 DMA line. Usually, the prices would remain within the band, however, the breakout is a strong bullish/bearish signal. If a breakout happens on the upside, its a bullish sign. And only when it returns back to the band, its a sign of reversal.

Technical Analysis 104: Important Tools - I

Earlier posts of Technical Analysis:

• Technical Analysis 101
• Technical Analysis 102
• Technical Analysis 103: Trends and Channels

In this post, and the next one, I would discuss about some of most commonly used tools (indicators) in Technical Analysis:

1. Moving Averages: Perhaps the most important points on any price charts are the moving averages – and they can used both for short term as well as long term analysis. Usually, there are multiple ways of calculating the MA, but most commonly used is the Simple Moving Average, and hence I would be using this one.
The important moving averages which should always be kept in mind for the important securities are:

1. 5 DMA
2. 10 DMA
3. 20 DMA
4. 50 DMA
5. 100 DMA
6. 200 DMA

These are important levels on the charts, and act as strong support and resistance levels. In addition to the home markets, they should also be followed for the regional as well global markets. I would be following the levels on Nifty, Sensex (home markets), Hang Seng, Shanghai composite, Kospi, Nikkei (regional markets), S&P, Dow, DAX, and FTSE (global markets) – on a daily basis.

2. Relative Strength: In a trend, there are sectors which perform well, and there are sectors which are laggards. Its always profitable to identify the sectors (and within the sector, the stocks) which have the strongest relative strength, as well as those with the weakest relative strength. This coupled with the general market trend could result into good stock picking early in the cycles.
I would be following the sectors of the home market, and track their performance vis-a-vis Nifty on a weekly basis, and report on Friday.

3. Volume and Open Interest: There is great information hidden in the market volume, as well as open interest data. Very few people in the market are able to make sense of these, and due to added complexity due to options data, it becomes quite complicated to make any sense. However, would try to capture the data and their sense on a weekly basis – how have markets moved, volume during the week, and how has open interest changed. Would start with Nifty on this, and as I become more comfortable, might add a couple of other indices or stocks.

Technical Analysis 103: Trends and Channels

Earlier Posts on Technical Analysis:

• Technical Analysis 101
• Technical Analysis 102

One of the principles on which technical analysis is based is that prices move in trends, and continue to do so for some time.

Trendlines: A trendline is simply a straight line connecting two or more points on a price graph. An uptrend line connects a series of bottoms, and a downtrend line connects a series of tops.

• The more the number of points that form the line, the more important it is.
• The longer the trendline holds (time period), the more significant it becomes.
• The angle of the trendline is also very crucial, the lower the angle, the stronger is the trend (a very steep trend is very unlikely to persist).

Trendlines are broken when three criteria are met:

• Extent of penetration: The trendline must be broken by atleast 2%-3% to be sure of a clear break, more valid for longer term lines. For short term trends, the extent of break would be lower to confirm the break-out.
• Time Filter: The prices shouldn’t go back to trendline immediately after penetration, and should confirm the penetration by staying in the range for 2-3 days. Usually, intra-day breaks are discounted to confirm a break-out.
• Volumes: If the penetration is followed by heavy volumes, then the breakout is much more credible, as against one with low volumes. 

Channels: Like trendlines, prices also tend to move in channels, with parallel support and resistance lines. There are traders who trade for price actions within the channel, buying near the support line, and selling near the resistance line, with stop-loss on other side of the lines. Some signals from channels:

• If prices after being in a channel, fail to reach the top line or bottom line, then it might signal a break on the other side. For example, if prices fail to reach the top line repeatedly, then it might signal that prices would break the lower support line.

Support and Resistance: Support and Resistance are very important levels, and prices often bounce back from these levels. A support is the level where there is good demand for the stocks, and resistance are levels where there is a good supply of the stock.

• If the prices touch a level repeatedly, then the level becomes more and more important – a long term support/resistance is much more important level, then short term levels.
• After the level is broken, support becomes resistance and vice versa. And more the time stock has spent near the level (consolidation), more important is the level.

Retracements: Another important tool is retracements levels – after a trend reversal, the prices tend to retrace by a certain proportion before continuing the earlier trend. Often, prices will retrace from a minimum of 33% to a maximum of 67% of its previous move, before continuing in its earlier trend direction. 50% retracement is also a very important level, and is observed quite frequently. However, if the prices retrace by more than 67%, then the trend may be broken for good.

Technical Analysis 102

There are broadly two types of trading opportunities:

1. Event-based Trading
   • View on rates
   • View on FX
   • FII Flows
2. Short Term Trading
   • Chart Patterns
   • Fundamentals – Industrial Production, Inflation, GDP, RBI announcements
   • Derivatives Markets Information – PCR, SF Basis, SF OI, Nifty OI, Nifty Basis, Volatility, Options OI, Strike Distribution, Skew
   • Institutional Activity – FII, DII
   • Regional Markets, Global Markets
   • Commodities
   • Currencies

On Chart patterns, some specific averages are followed by a vast majority of technical analysts:

• 10 Min MA
• 10 HMA
• 10 DMA
• 10 WMA
• 30 MA
• 50 MA
• 200 MA
• 500 MA

Some specific points to keep in mind:

1. If the market opens gap-up, and immediately gets weak (selling starts), the day’s high may be made in the opening few minutes. In addition, markets usually close at day’s low.
2. If after opening gap-up, markets continue to trend up, then it might keep on going up over the day.
3. Gaps get filled 80-90% of the times, and hence there is a decent chance of market coming back to the gap levels.
4. If the stock futures basis is strong, it implies more speculators in the market. Any negative news would lead to large moves in the market.
5. If Index futures trading at a premium, then hedging activity with Nifty futures is very low. Again, any negative news could lead to large moves in the market.
6. If the stock futures OI increasing and premium is rising, then retail speculative interest is building up.
7. If one can’t roll the positions, the same is unwound in the cash market in the last 30 minutes on the expiry day. Stocks which have been trading at a discount (and hence have short stock, long SSF positions) would rise in the last 30 minutes.

Technical Analysis 101

I have started reading a bit about Technical Analysis once again, and here I would note down all the important points so that I do not have to get back at the bulky books again and again for future reference.

Introduction

Technical Analysis is the study of patterns – price, volume or any other variable. And it is based on a few fundamental principals:

1. Everything is discounted and reflected in the market prices: All the knowledge about the specifics of the company and sector has been captured by the prices, and any movement is purely based on supply and demand of its stocks. Here, it implicitly differentiates between the underlying company (real world) and its stock. The stock price moves purely as a function of its demand and supply. In other words, Price is King.
2. Prices move in trends and trends persist: It means here that there is a trend in motion due to interplay between demand and supply. And once the trend is set, it continues for some time unless there is a clear reversal. It assumes here that not all people react at the same time, and hence once there is buying in a stock, it would go on for some time. As they say, ‘Trend is your Friend’.
3. Market Action is Repetitive: Certain patterns appear time and again on the charts, and it means that people behave in the same way as they have in the past. People react similarly in similar situations, and this can lead to identify major tops and bottoms.

Basics of Charting

The most important indicators are related to price, volume and open interest. While tracking prices, one should keep in mind that there are usually 4 prices which are important – Open, Close, High and Low (for each period). In terms of volume and open interest, they are usually read in conjunction with the price action, and independently do not signify anything.

Important Chart Patterns

1. Reversal Patterns
   • Head and Shoulders Pattern
   • Ascending and Descending Triangles
   • Rectangles
   • Double and Triple Tops/Bottoms
   • Rising and Falling Wedges
2. Consolidation Patterns
   • Flags
   • Pennants (Triangles)
   • Symmetric Triangles
   • Head and Shoulders Continuation Patterns
3. Gaps
   • Breakaway Gap
   • Runaway Gap
   • Exhaustion Gap
   • Island Reversal

Put Call Ratio

I was looking over the internet to find some interesting articles on the Put/Call Ratio based strategies. As of now, have just found out one:

1. Put/Call ratio in themselves are not very helpful in predicting the market direction. However, extreme values (compared with say 50DMA) may indicate a rise/fall in market volatility.

Addendum (March 28, 2009):

a. Usually Volume PCR is a more useful indicator during the day as it accurately reflects the ‘current’ market activity. OI PCR, on the  other hand, is slightly out-dated, and may be skewed by long-tenor options as well as past trades (which may be deeply OTM/illiquid now).

b. PCR works as a contrarian indicator in the bear markets (when majority of the people are wrong). When the ratio reaches high levels, it indicates that there is already a lot of ‘protection bought’ by the market, and hence the chances of a crash are relatively lower. On the other hand, when the ratio becomes abnormally low, then it reflects the ‘euphoria’ and ‘complacency’ in the market.

It works exactly the reverse during the bull market (when majority is right). A low PCR indicates people expecting markets to go up, and it indicates that.

Tape Reading

Tape reading is a technique of reading the price action of the stocks, and infer something about the market activity in that name. In earlier days, expert traders used this to track strong buy or sell orders in a particular stock.

These days, the technique has become a little complicated, with millions of people having access to the trading terminals, and different software programs generating automated responses to certain events. However, as always, any astute trader can still devise his ways and means of reading the tape - which now may include in addition to price information on volume, open interest, put-call ratio and futures' basis.

I like this concept, and will try to get my hands on some literature on the subject.