2. What is Technical Analysis
Technical Analysis is the forecasting of
future financial price movements based on
an examination of past price movements.
Like weather forecasting, technical analysis
does not result in absolute predictions about
the future. Instead, technical analysis can
help investors anticipate what is “likely” to
happen to prices over time. Technical
analysis uses a wide variety of charts that
show price over time.
3. Three Rules to be Considered
While Using Technical Analysis
According to Dow Theory there are three
rules
◦ Price Discounts Everything
◦ Price Movements are not totally random
◦ “What” is more important than “Why”
4. Price Discounts Everything
This theorem is similar to the strong and semi-
strong forms of market efficiency. Technical
analysts believe that the current price fully reflects
all information. Because all information is already
reflected in the price, it represents the fair value,
and should form the basis for analysis. After all,
the market price reflects the sum knowledge of all
participants, including traders, investors, portfolio
managers, buy-side analysts, sell-side analysts,
market strategist, technical analysts, fundamental
analysts and many others. It would be folly to
disagree with the price set by such an impressive
array of people with impeccable credentials
5. Price Movements are not Totally
Random
Most technicians agree that prices trend.
However, most technicians also acknowledge that
there are periods when prices do not trend. If
prices were always random, it would be extremely
difficult to make money using technical analysis.
Jack Schwager states: “One way of viewing it is
that markets may witness extended periods of
random fluctuation, interspersed with shorter
periods of nonrandom behavior. The goal of the
chartist is to identify those periods (i.e. major
trends).”
6.
7. “WHAT” is more important
than “WHY”
Tony Plummer paraphrases Oscar Wilde
by stating, “A technical analyst knows the
price of everything, but the value of
nothing”.
Technical Analyst mainly focuses on two
aspects
◦ What is the current price?
◦ What is the history of price movement.
9. Introduction
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.
There are two types of moving averages
◦ Simple Moving Average
◦ Exponential Moving Average
10. Simple Moving Average
A simple moving average is formed by computing the
average price of a security over a specific number of
periods. Most moving averages are based on closing
prices. A 5-day simple moving average is the five day sum
of closing prices divided by five. As its name implies, a
moving average is an average that moves. Old data is
dropped as new data comes available. This causes the
average to move along the time scale.
Daily Closing Prices: 11,12,13,14,15,16,17
First day of 5-day SMA: (11 + 12 + 13 + 14 + 15) / 5 = 13
Second day of 5-day SMA: (12 + 13 + 14 + 15 + 16) / 5 =
14
Third day of 5-day SMA: (13 + 14 + 15 + 16 + 17) / 5 = 15
11.
12. Exponential Moving Average
Exponential moving averages reduce the lag by
applying more weight to recent prices. The weighting
applied to the most recent price depends on the
number of periods in the moving average. There are
three steps to calculating an exponential moving
average. First, calculate the simple moving average.
An exponential moving average (EMA) has to start
somewhere so a simple moving average is used as the
previous period's EMA in the first calculation.
Second, calculate the weighting multiplier. Third,
calculate the exponential moving average. The
formula below is for a 10-day EMA.
SMA: 10 period sum / 10 Multiplier: (2 / (Time
periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)
EMA: {Close - EMA(previous day)} x multiplier +
EMA(previousday).
13. Simple v/s Weighted MA
Even though there are clear differences between
simple moving averages and exponential moving
averages, one is not necessarily better than the
other. Exponential moving averages have less lag
and are therefore more sensitive to recent prices -
and recent price changes. Exponential moving
averages will turn before simple moving averages.
Simple moving averages, on the other hand,
represent a true average of prices for the entire
time period. As such, simple moving averages
may be better suited to identify support or
resistance levels
14. The Lag Factor
The longer the moving average, the more the
lag. A 10-day exponential moving average
will hug prices quite closely and turn shortly
after prices turn. Short moving averages are
like speed boats - nimble and quick to
change. In contrast, a 100-day moving
average contains lots of past data that slows
it down. Longer moving averages are like
ocean tankers - lethargic and slow to change.
It takes a larger and longer price movement
for a 100-day moving average to change
course.
16. Introduction
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.
17. Directional Movement
Plus Directional Movement (+DM) and Minus Directional
Movement (-DM) form the backbone of the Average
Directional Index (ADX). Wilder determined directional
movement by comparing the difference between two
consecutive lows with the difference between the highs.
Directional movement is positive (plus) when the current
high minus the prior high is greater than the prior low minus
the current low. This so-called Plus Directional Movement
(+DM) then equals the current high minus the prior high,
provided it is positive. A negative value would simply be
entered as zero.
Directional movement is negative (minus) when the prior
low minus the current low is greater than the current high
minus the prior high. This so-called Minus Directional
Movement (-DM) equals the prior low minus the current low,
provided it is positive. A negative value would simply be
entered as zero.
18. Calculation
The example below is based on a 14-day ADX calculation.
1. Calculate the True Range (TR), Plus Directional Movement
(+DM) and Minus Directional Movement (-DM) for each period.
2. Smooth these periodic values using the Wilder's smoothing
techniques.
3. Divide the 14-day smoothed Plus Directional Movement (+DM)
by the 14-day smoothed True Range to find the 14-day Plus
Directional Indicator (+DI14). Multiply by 100 to move the decimal
point two places. This +DI14 is the Plus Directional Indicator
(green line) that is plotted along with ADX.
4. Divide the 14-day smoothed Minus Directional Movement (-DM)
by the 14-day smoothed True Range to find the 14-day Minus
Directional Indicator (-DI14). Multiply by 100 to move the decimal
point two places. This -DI14 is the Minus Directional Indicator (red
line) that is plotted along with ADX.
5. The Directional Movement Index (DX) equals the absolute value
of +DI14 less - DI14 divided by the sum of +DI14 and - DI14.
6. After all these steps, it is time to calculate the Average Directional
Index (ADX). The first ADX value is simply a 14-day average of
DX. Subsequent ADX values are smoothed by multiplying the
previous 14-day ADX value by 13, adding the most recent DX
value and dividing this total by 14.
19. Wilder’s Smoothing
First TR14 = Sum of first 14 periods of
TR1
Second TR14 = First TR14 - (First
TR14/14) + Current TR1
Subsequent Values = Prior TR14 - (Prior
TR14/14) + Current TR1
20.
21. Interpretation
The Average Directional Index (ADX) is
used to measure the strength or weakness
of a trend, not the actual direction.
Directional movement is defined by +DI
and -DI. In general, the bulls have the
edge when +DI is greater than - DI, while
the bears have the edge when - DI is
greater. Crosses of these directional
indicators can be combined with ADX for
a complete trading system.
24. Introduction
A derivative is a security with a price that is
dependent upon or derived from one or more
underlying assets. The derivative itself is a contract
between two or more parties based upon the asset or
assets. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, intere
st rates and market indexes.
Derivatives either be traded over-the-counter
(OTC) or on an exchange. OTC derivatives constitute
the greater proportion of derivatives in existence and
are unregulated, whereas derivatives traded on
exchanges are standardized. OTC derivatives
generally have greater risk for the counterparty than
do standardized derivatives.
25. Derivatives are further divided into three parts
◦ Forward Contract
◦ Future Contract
◦ Option Contract
A forward contract is a customized contract between two
parties to buy or sell an asset at a specified price on a future
date. A forward contract can be used for hedging or
speculation, although its non-standardized nature makes it
particularly apt for hedging.
A futures contract is a legal agreement, generally made on
the trading floor of a futures exchange, to buy or sell a
particular commodity or financial instrument at a
predetermined price at a specified time in the future. Futures
contracts are standardized to facilitate trading on a futures
exchange and, depending on the underlying asset being
traded, detail the quality and quantity of the commodity.
26. An options contract is an agreement between two parties to
facilitate a potential transaction on the underlying security at a
preset price, referred to as the strike price, prior to the expiration
date. The two types of contracts are put and call options, which can
be purchased to speculate on the direction of stocks or stock indices,
or sold to generate income.
Call Option - A call option is an agreement that gives an investor
the right, but not the obligation, to buy a stock, bond, commodity or
other instrument at a specified price within a specific time period.
Put option - A put option is an option contract giving the owner the
right, but not the obligation, to sell a specified amount of
an underlying security at a specified price within a specified time.
This is the opposite of a call option, which gives the holder the right
to buy shares.
27. Basic Terminology
Strike Price – The price at which the derivative contract is
exercised is known as strike price.
Spot Price – The current price at which the security can be bought
or sold is known as spot price.
In the money - A call option is said to be in the money when the
current market price of the stock is above the strike price of the call.
It is "in the money" because the holder of the call has the right to
buy the stock below its current market price.
At the money - At the money is a situation where an option's strike
price is identical to the price of the underlying security.
Out the money - Out of the money (OTM) is term used to describe
a call option with a strike price that is higher than the market
price of the underlying asset, or a put option with a strike price that
is lower than the market price of the underlying asset.
Intrinsic Value - The intrinsic value is the difference between the
underling's price and the strike price.
Premium - An option premium is the income received by an
investor who sells or "writes" an option contract to another party.
An option premium may also refer to the current price of any
specific option contract that has yet to expire.