Introduction To Technical Analysis

“ Price action is the most insightful data available on the stock market because it is judgement backed by money.”

Introduction To Technical Analysis Seminar Outline: General Introduction Dow Theory Charting: Line Charts Bar Charts Candlestick Charts Support Resistance Trend Lines Price Channels

Seminar Outline (Continued): Charting Patterns: Falling Wedge Rising Wedge Flag/Pennant Double Top/Bottom Head & Shoulder Top/Bottom Ascending/Descending Triangle Technical Indicators: Moving Averages The À/D Line Indicators: MACD Indicators: Stochasics Oscillator Indicators: Bollinger Bands Indicators: Relative Strength Index

Seminar Outline (Continued): Technical Analysis Application: Current Market Insight: Dow Theory Trade Examples Questions

General Introduction Technical Analysis Is A Tool To Gain Insight Into Market Price Behaviour And So Enable You To More Profitably Judge Investment Entry And Exit Points. In Essence Technical Analysis, Correctly Used, Will Motivate Investment Action That Brings A Higher Probability Of Success Than Through The Use Of Pure Random Choice. Dow Theory When Fully Comprehended, Demonstrates That The Market Is Not Random. Dow Theory Has Proved Itself Over 100 Years. The Hypothesis Works Because Price Action Is A Result Of Human Decisions. Historical Observation Indicates That Price Conditions Change But Human Nature Does Not. Thus Technical Analysis Is Basically A Type Of Behavioural or Social Science. Such Study Cannot Predict The Future, Else There Would Be No Market, (For The Market Is A “Zero Sum Game”) But It Can Be A Guide. In My Experience Use Of Too Many Technicals Leads To” Paralysis By Analysis”. Thus I Advise The Use Of Some Indicators But Not Too Many. My Favourite Analysis Indicators Are: Moving Averages, MACD, Stochastics, Price (Candlestick Format) And The A/D Line.

You will not excel at investment doing actions by rote. Ideally you must understand what you are doing and why you are doing it. You must begin to think for yourself.

Thus we must ask are the markets understandable and logical or are they random and chaotic.

It is our contention that the markets are logical and to support this thesis we will review Dow Theory.

Dow Theory was developed by Charles Dow and William Hamilton in the early 1900’s. They both sought a system that would assist successful investment. As part of the process Charles Dow pioneered the use of the Dow Transport index and the Dow Industrial index.

Why these indices? They wanted to gain a unique insight into how the economy was operating because they realised that the market was merely a perception of economic conditions.

Case in point let us use General Motors as an example. If orders for cars were previously flat but then began to increase demand for steel would rise. This steel would need to be shipped. Thus from a base pattern shipping activity would spike up and load factors on railway lines would rise, increasing turnover.

Thus Dow perceived rail or transport activity as an early or LEADING INDICATOR. As the cars that were produced from the steel were sold the sales figures would show up in the profits of GM.

The Dow industrials would improve in performance. Thus the industrials were a CONFIRMING indicator.

Dow and Hamilton in their writings were among the first to coin the terms Bull and Bear markets. B U LL = B U Y. B E AR = S E LL.

With the system Charles Dow developed certain rules: There can be three trends at play in the market at any time.

Trends: Primary Trend. Secondary or Reactionary or Corrective Trend. Minor or Speculative Trend.

Primary Trend This main trend can last for 2-3 years or for many decades. Once it is identified it is assumed to be in place until otherwise disproved. Superior investment success involves knowing this trend and knowing how to work with it.

Secondary Trend: This movement is a reaction against the main trend and is often tricky to distinguish. Very often such movements turn out to be “sucker” rallies or pullbacks. This trend can last for a few days to many months.

Minor Trend: This movement is mainly speculative and can be ignored from an investor point of view. It can last for a few days or weeks.

Each major trend has 3 phases: Bull Trend: Accumulation Public Participation Distribution Bear Trend: Distribution Public Participation Accumulation

Dow Theory Assumptions The Averages Discount Everything: This means that all available knowledge and news is discounted in the market price at any time. Thus if you know how to read the market you will comprehend all that there is to know.

Dow Theory Assumptions Manipulation Of The Market Is Impossible: Because the main market is so big and broad no one group can control it alone, thus price movement is based on the perception of economic factors.

Dow Theory Assumptions To Have A Valid Dow Signal Both The Dow Transport Index And The Dow Industrial Index Must Confirm: This is perhaps the most important of the Dow Theory rules. History has shown that there can be many false movements of either index but confirmation by both greatly improves the reliability and use of the theory.

Dow Theory Assumptions Trend must be confirmed by volume.

Dow Theory Application A BULL TREND IS SIGNALED BY HIGHER HIGHS AND HIGHER LOWS.

Dow Theory Application A BEAR TREND IS SIGNALED BY LOWER HIGHS And LOWER LOWS.

Dow Theory Application There is always a main or primary trend in operation and the successful investor needs to know how to recognise the signatures of these trends.

Dow Theory Application Dow and Hamilton believed that the “trend was your friend”. That the probability of investment success was greatly improved if you knew what the trend was and invested with it. They understood that the SENTIMENT of investors moved the market and that it was unwise to fight this sentiment.

Dow Theory Application Never invest if the trend cannot be identified. Until the trend is apparent and congruent it is best to stay out of the market on the sidelines in cash because in such cases there is above average risk. Dow and Hamilton only advised investment for the big moves.

Dow Theory Application The theory accepts that the stock market values equities through subjective sentiment. In a bull market stocks thus may become overvalued. In a bear market equities may become undervalued. Therefore the seasoned investor works with such sentiment.

Dow Theory Application We will now quickly review examples of the theory in action: Example 1. 1998-2000 Tech Crash Example 2. 2003 Post Iraq War Rally Example 3. 2007 Sub-Prime Bust

2000 Tech Crash Dow 20 & Dow 30

2000 Tech crash observations: Even though the Dow 30 moved to higher highs in the 1 st Qtr. Of 1999 the confirmation failed with the Dow 20 in the second Qtr. Of 1999. This failure was a warning to seasoned investors. Both averages collapsed in the 3 rd . Qtr. Of 2001.

2003 Iraq War Rally Dow 20 & Dow 30

2003 Iraq War Rally Observations The Dow 30 moved to higher highs In the 2 nd Qtr. Of 2003. This price action was confirmed by the Dow 20 towards the end of the 2 nd Qtr. Also. Both indices exploded hard in the 3 rd . Qtr 2003.

2007 Sub-Prime Bust Dow 20 & Dow 30

2007 Sub-Prime Bust Observations Lower highs and lower lows were indicated by the Dow 30 towards the last Qtr. Of 2007. This was confirmed by the Dow 20. An attempted rally by the Dow 20 in the second Qtr. Of 2008 was not confirmed by the Dow 30. Both indices collapsed in the 3 rd . Quarter of 2008.

A technical analysis chart is basically a graph with price annotated on the left and time on the bottom. Its purpose is to analyse past price changes to try to predict future price movement with a higher degree of probability than random guess.

There are three types of chart: Line Chart Bar Chart Candlestick Chart

Line Chart: A Line chart simply graphs the Closing price of an instrument.

Bar Chart: This chart gives you the high, low, open (left tick) and closing (right tick) prices.

Candlestick Chart: Japanese Candlestick charts are one of the oldest type of charts used for price prediction. They date back to the 1700s, when they were used for predicting rice prices.

Candlestick Chart: The Candlestick format shows the full range of price movement i.e. high, low, open and close in a more graphic manner than on the Bar chart . Thus we more easily get a sense of market sentiment behind price changes.

You do not eed to know the name of each candlestick type but you should get to understand the “market sentiment” behind each form.

Price: Candlestick Format Examples

Price Support & Resistance: Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance. Resistance is the price level at which sellin

Trend Lines: Technical analysis is built on the assumption that prices trend. Trend Lines are an important tool in technical analysis for both trend identification and confirmation. A trend line is a straight line that connects two or more price points and then extends into the future to act as a line of support or resistance. Many of the principles applicable to support and resistance levels can be applied to trend lines as well.

Price Channel: A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower trend line. The upper trend line marks resistance and the lower trend line marks support. Price channels with negative slopes (down) are considered bearish and those with positive slopes (up) bullish.

Price Channels: Main Trend Line: It takes at least two points to draw the main trend line. This line sets the tone for the trend and the slope. For a bullish price channel, the main trend line extends up and at least two reaction lows are required to draw it. For a bearish price channel, the main trend line extends down and at least two reaction highs are required to draw it. Channel Line: The line drawn parallel to the main trend line is called the channel line. Ideally, the channel line will be based off of two reaction highs or lows. However, after the main trend line has been established, some analysts draw the parallel channel line using only one reaction high or low. The channel line marks support in a bearish price channel and resistance in a bullish price channel.

Falling Wedge: The falling wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This price action forms a cone that slopes down as the reaction highs and reaction lows converge. In contrast to symmetrical triangles, which have no definitive slope and no bias, falling wedges definitely slope down and have a bullish bias. However, this bullish bias cannot be realized until a resistance breakout.

Rising Wedge: The rising wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. In contrast to symmetrical triangles, which have no definitive slope and no bullish or bearish bias, rising wedges definitely slope up and have a bearish bias.

Flag/Pennant: Flags and Pennants are short-term continuation patterns that mark a small consolidation before the previous move resumes. These patterns are usually preceded by a sharp advance or decline with heavy volume, and mark a mid-point of the move.

Double Top: The Double Top Reversal is a bearish reversal pattern typically found on bar charts, line charts and candlestick charts. As its name implies, the pattern is made up of two consecutive peaks that are roughly equal, with a moderate trough in-between.

Double Bottom: The Double Bottom Reversal is a bullish reversal pattern and is the inverse of the double top formation.

Head & Shoulders Top: A Head and Shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neck line .Once the neckline is broken price normally collapses radically.

Head & Shoulders Bottom: As a major reversal pattern, the Head and Shoulders Bottom forms after a downtrend, and its completion marks a change in trend. Again its structure is the inverse of the Head & Shoulder Top and price normally rises rapidly once the neck line is breached.

Ascending Triangle: The ascending triangle is a bullish formation that usually forms during an uptrend as a continuation pattern. There are instances when ascending triangles form as reversal patterns at the end of a downtrend, but they are typically continuation patterns. Regardless of where they form, ascending triangles are bullish patterns that indicate accumulation.

Descending Triangle: The descending triangle is a bearish formation that usually forms during a downtrend as a continuation pattern.

Moving Averages: Moving averages smooth the price data to form a trend following indicator. They do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices. Despite this lag, moving averages help smooth price action and filter out the noise. They also form the building blocks for many other technical indicators and overlays, such as Bollinger Bands and MACD. The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA) . These moving averages can be used to identify the direction of the trend or define potential support and resistance levels.

Moving Averages: The longer the average timeline used the slower the response time to trend change, thus there is a trade-off. Simple moving average weights all time data points equally. Exponential moving average givers higher weight to the latest data points, thus it is slightly more sensitive.

Moving averages: Most popular averages used are: 10 DMA, 20 DMA, 50 DMA, 100 DMA and 200 DMA. It is a lagging indicator. MA’s are Bad for range bound markets. The are good for markets with momentum. Trade signals usually involve price crossover or significant MA crossover.

Bull: DMA = Support Bear: DMA = Resistance

Advance/Decline Line (A/D Line): The Advance Decline Line (AD Line) is a breadth indicator based on Net Advances, which is the number of advancing stocks less the number of declining stocks. Net Advances is positive when advances exceed declines and negative when declines exceed advances. The AD Line is a cumulative measure of Net Advances. It rises when Net Advances is positive and falls when Net Advances is negative.

A/D Line Daily MA’s can be incorporated into the /D line. This can work as a wonderful trend confirmation indicator.

A/D Line behaviour in action: 1. 2000 Tech Crash. 2. 2003 Iraq War Rally. 3. 2007 Sub-Prime Bust.

Indicators: MACD Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence (MACD) is one of the simplest and most effective momentum indicators available. MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, MACD offers the best of both worlds: trend following and momentum. MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels. Settings: 12 – 26 – 9 Format: Histogram

MACD: Gives verification of TREND and MOMENTUM. MOMENTUM indicates strength of price movement.

MACD Divergence: Divergences form when MACD trend diverges from the price action of the underlying security. A bullish divergence forms when a security records a lower low and MACD forms a higher low. A bearish divergence is the inverse.

Indicators: Stochastics Oscillator: Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator "doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price." As such, bullish and bearish divergences in the Stochastic Oscillator can be used to foreshadow reversals. This was the first, and most important, signal that Lane identified. Lane also used this oscillator to identify bull and bear set-ups to anticipate a future reversal. Because the Stochastic Oscillator is range bound, is also useful for identifying overbought and oversold levels. Settings: 14-3-3 and 28-7-7

The major insight that Lane had with stochastics was that in a bull move prices tend to close to the top of the range and in bear moves prices tend to close near the bottom of the price range. He also observed that momentum tends to change before price. Trade Triggers would be Crossovers, Divergence and Over Bought and Over Sold Conditions.

Indicators: Stochastics: Divergence: Divergences form when a new high or low in price is not confirmed by the Stochastic Oscillator. A bullish divergence forms when price records a lower low, but the Stochastic Oscillator forms a higher low. This shows less downside momentum that could foreshadow a bullish reversal. A bearish divergence forms when price records a higher high, but the Stochastic Oscillator forms a lower high. This shows less upside momentum that could foreshadow a bearish reversal.

Indicators: Bollinger Bands: Developed by John Bollinger, Bollinger Bands are volatility bands placed above and below a moving average. Volatility is based on the standard deviation, which changes as volatility increase and decreases. The bands automatically widen when volatility increases and narrow when volatility decreases. This dynamic nature of Bollinger Bands also means they can be used on different securities with the standard settings. For signals, Bollinger Bands can be used to identify M-Tops and W-Bottoms or to determine the strength of the trend. Setting: Normally use the 20 DMA as the centre line.

Bollinger Bands consist of a middle band with two outer bands. The middle band is a simple moving average that is usually set at 20 periods. A simple moving average is used because a simple moving average is also used in the standard deviation formula. The look-back period for the standard deviation is the same as for the simple moving average. The outer bands are usually set 2 standard deviations above and below the middle band.

Wide Bollinger Bands indicate markets with high volatility and strong trend. Narrow contracted Bollinger Bands indicate low volatility and range bound markets. Bollinger Bands work well in conjunction with momentum indicators like Wilder’s Stochastics and MACD. Trading Triggers would be multi tops, multi bottoms and line breakouts.

Indicators: ADX Line The Average Directional Index (ADX), Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI) represent a group of directional movement indicators that form a trading system developed by Welles Wilder. Wilder designed ADX with commodities and daily prices in mind, but these indicators can also be applied to stocks. The Average Directional Index (ADX) measures trend strength without regard to trend direction. The other two indicators, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), complement ADX by defining trend direction. Used together, chartists can determine both the direction and strength of the trend. Settings: 9-30

ADX Line Trend Strength: At its most basic the Average Directional Index (ADX) can be used to determine if a security is trending or not. This determination helps traders choose between a trend following system or a non-trend following system. Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below 20. There appears to be a gray zone between 20 and 25. As noted above, chartists may need to adjust the settings to increase sensitivity and signals. ADX also has a fair amount of lag because of all the smoothing techniques. Many technical analysts use 20 as the key level for ADX.

Current Market Insight: Dow Theory (3 day and 1 day) A/D Line (20/50 DMA) MACD (Standard Settings) Stochastics (14 Day and 28 Day settings) Bollinger Bands (Standard Settings) RSI Charts

Trade Examples: Value Strategy

Trade Examples: Momentum Swing Trades:

Trade Examples Momentum Breakout

General Trade Examples: GOOG (04/2011), AMZN (03/2011), BIDU(06/2011), BP(07/2010), C(06/2011), MSFT(06/2011), DLTR(03/2011), DB(06/2011), ARO( 06/2011), TEF(05/2011), ALGT(06/2011).

Introduction To Technical Analysis

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Introduction To Technical Analysis