## Technical analysis for beginners

Technical analysis is a method for analyzing historical, recurring graphic price patterns in securities such as shares, currencies, futures, and more. The hypothesis is that a market follows certain patterns that make it possible to predict future price movements and developments.

I have worked full-time with trading for 20 years in the US and Europe and have now written guides to make it easier for new traders to get started. For this reason, I have chosen to create a guide, to teach you everything you may need to know about technical analysis! For the beginner and also advanced traders in other words.

An introduction to technical analysis, a method of tracking chart patterns to discern price and volume trends, evaluate investments, futures and identify trading opportunities.

Technical analysis, or using charts to identify trading signals and price patterns, may seem overwhelming or esoteric at first.

Many traders leverage both fundamental and technical analysis when making investment decisions since technical analysis helps fill in the gaps of knowledge. Developing an understanding of technical analysis, swing traders and investors can improve their long-term risk-adjusted returns, but it’s important for understanding and practice these techniques and candlesticks before committing real capital to avoid costly mistakes. You can find commodities and futures trading to beginning traders as well as advanced trader.

Here you can find a full article about what is technical analysis.

## PIVOT POINT We have discussed the concept of Support and Resistance in a different section. As a continuation of that, we introduce the concept of Pivot Point. Let PP be the Pivot Point. It is defined as

PP = (H + L + C) / 3

where H is High, L is Low and C is Close of prices of a stock or of any instrument. With the help of the PP, 3 levels of Resistance (R) and Support (S) are calculated as follows;

R1 = (2*PP) – L

R2 = PP + (H – L)

R3 = PP + 2*(H-L)

S1 = (2*PP) – H

S2 = PP – (H – L)

S3 = PP – 2*(H – L)

In terms of actual numbers, on 25.3.2010 the following numbers for Sensex were observed:

O = 18480

H = 18858

L = 18480

C = 18815

This would imply the following pivot points:

R3 = 19473

R2 = 19095

R1 = 18955

PP = 18717

S1 = 18577

S2 = 18339

S3 = 17961

The above levels provide indicators of taking long and short positions in the market. If the Sensex crosses the first and the second resistance, the market has turned bullish. If it goes below the second support, the market has turned bearish. Pivot points are useful in intra day trading. If the market opens nears the PP and goes up, long the stock and exit once it crosses 2R. Similarly, if it falls below S, short the stock and exit once it crosses 2S. It provides a basis for entry and exit.   However, for volatility trading in options, the use of pivot points is different, and we will discuss it later. Figure 1 shows the various levels using pivot points for Monday, 28.3.2011, using the data for 25.3.2011. Check our Free Trading Strategies.

Figure 1

## Ed Seykota’s Books

Jack Schwager, in his book Market Wizards, says that Ed Seykota was responsible for turning one client’s account from a mere \$5,000 to \$15,000,000. He did this in just 12 years! This is as great an achievement as any trader can hope to have, and it definitely puts Ed Seykota among some of the most legendary traders to ever walk this earth.

While Market Wizards may be the reason why Ed Seykota became a somewhat known figure in the trading world, it was not written by him. Jack Schwager did well to squeeze as much out of Ed as he could, but you also have access to two of Ed’s own books to understand his philosophy.

Ed’s first book, The Trading Tribe, was published in 2005 and focuses on how Ed runs his Trading Tribe. On top of that, the book also delves into the psychology of the trader and the process of aligning your conscious and subconscious to work for the greater good.

Ed’s second book deviates from the norm by getting into modern government. Govopoly in the 39th day was published in 2013 and is a fascinating look into how modern governments are spending money that they do not have. Ed predicts numerous problems arising from the ‘irrational’ behavior of the governments in the near future. He also believes that the public should be much more worried than it is about a situation which is very much ‘appalling’ in nature.

## What Were Ed Seykota’s Trading Strategies?

While it is possible to write an entire essay on Ed’s trading strategies, it is also possible to condense his strategies into a few paragraphs, albeit extremely broadly.

Ed trades trend following strategies that are mostly mechanical. This means that he typically doesn’t spend too much time on the execution part of his trading. Typically his trading is confined to the few minutes it takes to load in the charts and place order for the next day.

### Importance of Money Management

In his interview in the market wizards book, he emphasizes the role his money management rules have played in his success! Ed places stops to make sure he does not lose out massively on every single trade, and try to keep his losses at a maximum of around 5% of his capital. On top of that, he also makes sure to make bets which are small, but big enough that a profit would mean something to him. If the trade is too small for you to care about it, your trading will suffer. However, it’s just as important to not go too big in order to keep emotions in check, something that we further explain later on.

## Two commonly used terms in technical analysis are Support (S) and Resistance (R) It is that level of a stock, below which prices do not fall for the time being. It acts like a floor where the price gets support and rebounds upwards. It assumes importance when prices are falling.

Suppose we look at the price action of a stock. For example, price of ABC Ltd is falling and each time it falls it does not fall beyond Rs 140.65. Buyers understand that may be this stock is strong enough not to fall further and maybe it is worth buying the stock at the support. If we look from seller’s side, we can interpret that sellers are not willing to sell the stock at less than Rs.140.65. So stock price do not fall further. Support is a level where there are more buyers than sellers, who keep the prices from falling further. These buyers always think that the price will rise now and hence either they don’t sell or they keep buying.

For example, from current data on NIFTY, we observe three levels of support as shown in Figure 1. These are 4792, 5172 and 5349. The 5349 level of support was also observed in August 2010 and can be taken as a medium term support. If this is broken, then a short term support can be 5172. If this is also broken, we are looking at a support at 4792 levels. This is how market movements are analysed and trends understood.

Figure 1

Resistance

It is that level of a stock, from where prices of the stock may not go up. It acts as a roof for the time being. Prices are expected to hit this roof and fall. It assumes importance when prices are rising. It gives an estimate as to up to what level prices can rise under the prevailing scenario.

The price of ABC Ltd is rising and each time it rises, suppose it fails to rise further than Rs.210.40. In this case investors think that, whenever the stock reaches this price, it may fall, prompting them to sell the stock. Further, buyers wait for the prices to fall to pick it up cheap later. Thus there is selling pressure and little buying interest leading to fall in prices from this level.

Consider the example of Reliance Industries Ltd. as given in Figure 2.

Figure 2

We observe 3 resistance levels. One at Rs. 1152, the second at Rs. 1091 and the third at Rs. 1055. It can be clearly observed from the diagram that these levels are working as ceilings and the subsequent resistance levels have also fallen. This indicates, that for the time being, a trend reversal will not be observed. Investor expectation of prices to fall further may actually push prices down.

Support and resistance levels helps an investor to understand trend in technical analysis. In an uptrend, resistance levels keep changing and every time a new resistance is created. And similarly with the support level in a downtrend, every time the price of the stock falls, a new support is created. In other words if a breakout happens there can a trend reversal. For example if support level is violated then the trend may reverse from and uptrend to downtrend and vice versa with resistance.

It is also possible that support becomes resistance and resistance becomes support. When resistance becomes support, this indicates an uptrend. Similarly, when price drop below support level, that level becomes a resistance level and indicates a downtrend.  An example is given in Figure 3 where support at Rs.680 in October – December 2010 has become resistance in March 2011.

Figure 3

## TICK Technical analysis of stocks, futures, forex etc. starts from understanding the TICK. It is the basic starting point and one has to clearly understand the implications of it. We will explain this in terms of share prices.

A TICK looks this.

The highest point of the line is the day’s highest price, the lowest point is the day’s lowest price, the left horizontal line is the opening price for the day, and the right horizontal line is the day’s close price. For example, on 22.3.2011, for NIFTY, the High was 5428, the Low was 5376, the Open was 5391, and the Close was 5414. The TICK thus has 4 dimensions, and these keep changing everyday. Some of the shapes that it can take are

In A, the high, open and the close are the same. In B, the low, open and close are the same. In C, the open is near the low and the high is near the high. In D, the open is equal to the low and the close is equal to the high. In E, the open is equal to the high and the close is equal to the low. In F, the open and close are the same.

One can think of infinite number of combinations and each has a different meaning and implication with respect to daily price behavior. One can draw their own lessons from the shape of the TICK at the end of the day and also regarding daily movement in TICKS. For example, D is bullish as it says that the market closed at a high. E is bearish as the market closed at a low from where it opened. There was loss of interest in the market during the day. A shows stagnant interest as the market only went down during the day and recovered ground. F shows consolidation and rethinking as the market closed at the open and tasted high and low. It also can reflect uncertainty.

The length of the TICK shows intraday volatility. If the TICK is long as in K, the market was volatile. If the TICK is short like L, the market was not volatile. It was relatively stagnant. This means that there was not much buying and selling interest during the day.

On two successive days if we have the TICKs like M, then this means that the market has turned bullish. This is because the lengths of the ticks has remained the same, today’s open is higher than yesterday’s open, today’s close is higher than yesterday’s close, today’s low is higher than yesterday’s low and today’s high is higher than yesterday’s high.

Two successive TICKs like N shows declining interest in the market.

For a concrete live example let us look at the chart of Pantaloons Retail Ltd.

From 11.3.2011 to 16.3.2011, the closes were lower than the open indicating that prices would fall further. On the 18th, volatility increased as the range was higher and the high was higher than the previous days high. Some interest can be observed. On the 22nd the trend got reversed and the close became higher than the low. This signaled a reversal, and on the 23rd. the stock saw prices going up. So close observation of ticks can provide some insight into future price movement, for 1 or 2 days.

For Nifty, from the close being higher than the open on 16.3.2011, on the 17th the close became lower than the open. This indicated a reversal and this is what happened. The Nifty fell on the 18th and also on the 21st. On the 22nd, the close became higher than the open indicating again a reversal. The Nifty rose on the 23rd.

## MOVING AVERAGE (MA) While analyzing share price movements, moving average is one way to track market direction. It is mainly a follower of the market and tells us about a particular direction of the market. It is a rolling average where each observation is generated by the sum of all the closing prices over a particular time period divided by the number of days. To get the next observation, the first price needs to be dropped and the last observation needs to be added. For example for 100 days share price of a company, the 10 day moving average would be defined as

MA 1 = (P1 + P2 +………+ P10)/10

MA2 = (P2 + P3 + ………+ P11)/10

and so on, where P is price. Clearly the first MA will be posted on the 11th day.

Moving averages (MA) smooth the data to form a trend following indicator. Result is a smooth line which provides information on the direction of the market and cleans out the noise. It is also a laggard as it tells us what has happened but, this ‘time lag’ can be reduced with shorter moving average like 10 day, 15 day, but it cannot be completely removed. They also form the base for many other technical indicators such as BollingerBands, MACD etc.

The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). SMA is nothing but just average of the prices of certain time period as shown above. SMA has a disadvantage as it gives equal importance to each day and no extra importance is given to recent prices. Hence to overcome this problem, EMA has been defined. It gives much greater importance to recent prices and lower importance to past prices. The weights that are used for different day’s prices fall exponentially.

For ease of understanding, we reproduce below a calculation from www.pandacash.com

Initially, for the EMA, an exponent needs to be calculated. To start, take the number of days’ EMA that you want to calculate and add one to the number of days that you’re considering (for example for a 200 day moving average, add one to get 201 as part of the calculation). We’ll call this Days+1.

Then, to get the Exponent, simply take the number 2 and divide it by Days+1. For example the Exponent for a 200 day moving average would be (2÷201) which equals 0.01

Once we’ve got the exponent, all we need now are two more bits of information to enable us to perform the full calculation. The first is yesterday’s Exponential Moving Average. We’ll assume we already know this as we would have calculated it “yesterday”. However, if you aren’t already aware of yesterday’s EMA, you can start by calculating the SMA for yesterday, and using this in place of the EMA for the first calculation (ie “today’s” calculation) of the EMA. Then tomorrow you can use the EMA you calculated today, and so on.

The second piece of information we need is today’s closing price. Let’s assume that we want to calculate today’s 200 day Exponential Moving Average for a share or stock which has a previous day’s EMA of Rs.120 and a current day’s closing price of Rs.136. The full calculation is as follows:
Today’s Exponential Moving Average = (current day’s closing price x Exponent) + (previous day’s EMA x (1-Exponent))

OR

Previous day’s EMA + (current day’s closing price – previous day’s EMA)*Exponent

So, using our example figures above, today’s 200 day EMA would be

(136 x 0.01) + (120 x (1- 0.01) which equals an EMA for today of Rs.120.16.

Examples of SMAs are given in Figure 1 for Tata Steel. Examples of EMAs are given in Figure 2 for the same company. Figure 3 gives the difference between the two MAs when plotted together.

Interaction between two moving averages provides very interesting insight into future movement of prices. That is, although MAs are based on past data, when we take 2 MAs side by side, it gives an estimate of future movement of prices. A larger period MA moves slowly as compared to a smaller period MA. The reason being that it carries with it greater baggage. The fastest moving MA is the daily data itself. Thus it can be said that a smaller period MA like a 10 day moving average (DMA) pulls the 100 DMA, the latter pulling the 200 DMA. Thus if a 10 DMA intersects the 100 DMA from above, it can be said that prices are set to fall. On the other hand, if the 10 DMA intersects the 100 DMA from below, we can say prices are set to rise. Thus, a shorter period DMA intersecting a longer period DMA from above is a bearish signal, whereas a shorter period DMA intersecting a longer period DMA from below is a bullish signal. This is clearly demonstrated in Figure 4.

Figure 1

200 DSMA (blue), 100 DSMA ( green), 10 DSMA (red)

Figure 2

200 DEMA (blue), 100 DEMA (green), 10 DEMA (red).

In ellipse 1 and 3, the 10 DMA has intersected the 100 DMA from above and hence subsequently the prices of ICICI Bank fell. Whereas in ellipse 2, the 10 DMA intersected the 100 DMA from below and prices of ICICI Bank increased. We can thus use this rule to estimate the future movement in prices. Note, however, an interesting phase given in AAA.  Here the 10 DMA is falling, but the 100 DMA is rising. This is because the longer period DMA moves slower compared to the shorter period DMA. For the 100 DMA to fall, the 10 DMA has to fall for quite some time. That is why the points of intersection of the two carry meaning.

Figure 3

200 DSMA (blue) , 200 DEMA (red)

Figure 4

## APPLICATION OF THE TOOL OF MOVING AVERAGE In a previous post I had explained the concept of moving average as a technical tool to understand share price movement and make predictions. I had showed how when a shorter term moving average intersects a long term moving average from below then it is a bullish signal. When a shorter term moving average intersects a long term moving average from above then it is a bearish signal. Here we will examine some share price movements and their moving averages and see whether we can make reasonable predictions.

Figure 1

Let us take the example of Ajanta Pharma. In Figure 1 200 Day Moving Average (DMA) is the blue line, 100 DMA is the green line, 30 DMA is the purple line and 10 DMA is the red line. The shorter MA follows the data closely as compared to a longer MA. When the 10 DMA flattens out at 1, the 30 DMA shows the dip later at 2, followed by the 100 DMA at 3 and 200 DMA just flattens out. So a shorter term MA pulls a longer term MA, and there is a drag involved.

As the 10 DMA intersected the 30 DMA from below around mid March 2011 (A), as expected the market turned bullish. Further this got strengthened at B when the 100 DMA intersected the 200 DMA from below. However, note that at that time the 10 DMA has started moving downwards, which indicates a reversal in fortune. All these facts have to observed to make predictions regarding future movement in prices. We need to wait to see whether the 10 DMA does intersect the 30 DMA from above. Then we would say that the prices are going to fall shortly.

Consider the example of Federal Bank as given in Figure 2.

Figure 2

The 10 DMA (red) intersecting the 30 DMA from above at 1 led to the downward journey which got strengthened when the former again intersected the 100 DMA (green) from above at 2 and subsequently the 200 DMA (blue) from above at 3. The reverse happened in 4, 5 and 6. In 7, 8, and 9 the 10 DMA is moving above and below the 30 DMA without majorly affecting the 100 DMA and 200 DMA. The share prices of the company, if we observe from the figure, are moving in a range. We can expect the prices of this company to remain range bound, which implies that this is a period of consolidation. If there is no fundamental news from the company, then we may not see a breakaway. Prices may actually fall as shareholder interest wanes.

## USE OF PIVOT POINT We have introduced the concept of Pivot Point earlier. Here we will observe some applications of the concept and test whether we can use this method to enter and exit the same day.

Let us look at Tata Steel intraday real time data on price movement from 9.45 am to 11 am on 11.7.2011 (Figure 1) and we are sitting at 11 am and deciding on a strategy whether to go long or short. The prices are Open (O) Rs.593, High (H) Rs.594.25, Low (L) Rs.591.80 and Close (C) Rs.592.50. We take 11 am price as the close price for the time period. Using the Pivot Calculator yields the following Support and Resistance points.

Figure 1

After 11 am the prices started falling and around 12.30 pm the prices fell below the third support S3 at Rs.587.95. Given that there was still 3 hours to go for market close, going long would have been advisable as we observe that the market had given enough opportunity for exit at 1 pm, 1.45 pm, 2.30 pm etc.

## RURAL ELECTRIFICATION CORPORATION (REC) This write-up is a demonstration of concepts of Support (S) & Resistance (R).  We choose REC as an example. We will examine whether the concepts of S and R are useful in terms of predicting future movement in stock prices.

Figure 1

On 11.8.2009, from a support level of Rs.183, share price of REC faced a resistance at Rs.222 and then fell. It found support at Rs.196 levels thrice in September 2009, but was not broken, It also could not break the resistance of Rs.222 during this period. Then once it broke away from this resistance level, and found this level as support in February 2010, it was time for the stock to move up. And it did!!

From October 2010 the price of this stock started falling in a sequence of Elliot Waves, but again found support at Rs.222 levels. It bounced up and then violated this support in May 2011. It bounced back, but this time, the Rs.222 level had turned into Resistance. It broke the second support at Rs.196, but has found support at the Rs.183 level. If on the bounce back, it breaks the support at Rs.196 level, then it will also test the support of Rs.183.

I would advise investors to hold on for a few days. The turnaround of this stock has not started yet. On the basis of S and R, we should be able to spot a turnaround.

## BOLLINGER BAND In a previous post, I have discussed in detail the concept of moving average. I have also demonstrated the concept with the help of examples. Here we will discuss a technical indicator known as the Bollinger Band (BB). It is an indicator which uses the concept of moving average, but combines it with the concept of confidence interval. A confidence interval is a statistical concept which combines descriptive statistics with probability theory. Generally speaking, we say that if X is a random variable and S is the variance, and if X follows a normal distribution, then if we construct an interval equal to X +/- 2S, we can say with 95% confidence that any value of this random variable will lie within this interval. For example, if ri is the daily returns from a stock over a period of time with mean r* and variance s2 , then we can say that in the next 100 trading days, 95 times the daily returns will lie within r* +/- 2s. The concept of Bollinger Band is built around these concepts.

BB is constructed as an envelope around a 20 day moving average, the upper band being +2s away from the moving average and the lower band being -2s away. Since the spacing between the bands is based on the standard deviation, the bands widen when the security becomes more volatile. They band contracts when the security becomes less volatile. Let us straight go to an example. Readers who are visiting my other web site fin-insight.com must be familiar with BB by now as I use it quite extensively.

Figure 1

Consider Figure 1 where we have drawn Bollinger Band for Baja Auto for the period 24.6.2010 till date. It is a band constructed around a 20 day simple moving average at 2s distance from the moving average. 4 observations are in order which makes BB an useful indicator.

1. When the actual price hugs the upper band, prices fall after that, and when it hugs the lower bound, it is time for prices to rise;
2. When the band narrows along a trend, it is time for a reversal; a narrowing of the band implies consolidation and reversal;
3. When the actual prices move outside the band, it implies that the trend will continue;
4. The middle curve, which is the 20 day moving average, should be interpreted as a support and a resistance as the case may be.