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Concepts & Tutorials

LearnTA: Introduction to Technical Analysis

Technical Analysis is how you analyse stocks based on their price movements. Prices are an indication of fear, greed and all those emotions that are inevitably part of stock markets, apart from  a belief in the underlying fundamentals of the business.

At Capital Mind Premium we bring you a multi-part demystification of the concept of technical analysis. This is how to use price patterns. In part 1 today, we cover:

  • Why Is Price Important?
  • The concepts of Support and Resistance
  • Stock charts: Lines, OHLC and Candlesticks
  • It’s all about the Probabilities

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Why Technicals? Is Price Everything?

To many, it’s a bit of a dilemma. If a good company is available at a lower price, isn’t it a great buy? Shouldn’t we buy good companies when they are beaten down?

The answer is that the words “good” and “bad” are always applied in hindsight. You might love a stock named Reliance Industries. It is now effectively debt free, has massive petrochemicals and oil refining businesses that generate steady cash. It is investing in exploration, telecom, in organized retail and in healthcare. And still, that stock languishes way below the highs of Rs. 1,500 it made way back in 2008. It’s a good company, but not good for buyers-and-holders.

The problem with looking at fundamentals – profits, cash flow, business growth, “moats” and all that jazz – is that they aren’t everything. A great company can continue to be available at prices that are really low, and eventually that “moat” you thought was permanent suddenly ceases to exist. You just bought a great business that became a not-so-great business, and the market never recognized it.

The business itself can be falsifying sales and profit reports by overstating income or underreporting costs. The management could be dishonest and siphon out money that should have accrued to shareholders. Regulations can suddenly change. Competitors can suddenly emerge. You just don’t know.

The asymmetry of information ensures that some people will always know more about a business than you. The promoters will. Their friends will. Some analysts will, because they happen to wine and dine with executives. The regulators don’t like that, but it simply cannot be avoided.

Prices, on the other hand, are actual trades at which people buy and sell. This is real money changing hands. And real money means that the price of the stock is quite literally the value of the stock today. The movements in prices tell us a lot.

Prices form strong patterns. A stock that refuses to go up further despite all sorts of good news is telling you something – that there are strong sellers at this price. A market that refuses to go down despite bad news (like India in the last part of 2013) is also telling you that there strong buyers. You should not ignore this as an investor.

There is a Gujarati saying, “Bhaav bhagwan che”. Which means prices are like six Gods. (Sorry).

No, I’m confusing Hindi and Gujarati. But it really means the Price is God. You can complain that the price isn’t behaving according to your thinking, but the price right now is what you will get if you sell. In effect, it reigns supreme. And the price changes, they can tell you where the stock is heading.

Are prices random?

A number of people, including very smart ones, have made the case that prices are random and there are really no such patterns. That whatever price patterns are out there are just figments of someone’s imagination. We’ve read the books, we’ve studied prices, and we’ve realized that they are plain wrong. Price patterns are typically based on human reactions.

For instance when a stock peaks at a point and then reverses, a lot of investors think that “If it goes back up to that level, I’ll sell and break even”. This is loss aversion at play, a behavioural pattern that makes us hate the concept of booking a loss. In larger numbers it means when the stock goes back up it automatically hits a wall at that last high, because past investors are trying to sell at their “break even” points. The price tells you that – just the level at which the stock peaked last becomes a price level to watch out for, and you don’t even have to know why.

Derived Price Indicators

The embedded emotions are sometimes subtle. Volume may wane off, because there are no more buyers after the stock’s made a big up move, and sellers are hoping that prices go higher. Then, as sellers despair, the stock turns downward. This might not immediately be visible if you’re looking only at the price.

Imagine a car that accelerates fast from zero to 100. Then it starts to taper off at 120, struggling to move any faster, with the maximum speed at 180. To a person tracking only the speedometer, he thinks that the car’s still maintaining 120, so what’s the problem? But if you were to track theacceleration, the change in speed over time, you might find the problem way earlier, because the acceleration would have tapered off much earlier.

Translated into stock prices, you can use derived price indicators to figure out if a stock continues to have momentum or is tapering off.

Using Moving Averages smoothens out the squiggles in stock prices. For any day, take the average of the past 20 days, and you have a 20-day moving average. Over time, we can plot the 20 day moving average of the stock itself, and it tells you a little bit about “velocity” of price changes. When the stock crosses over from below to above a moving average, it’s a sign of strength; the other way is a sign of weakness.

The Relative Strength Index (RSI) is the stock’s current price in relation with it’s past few days. The RSI (14) is the price of the stock as a percentage of the stocks range in the last 14 days. So an RSI(14) of 80 means the stock’s at 80% of it’s 14 day price range. A sudden up-move takes the RSI to above 80, but when the stock tapers off, it might fall to 50. The move from 80 to 50 is a sign of weakness. When the stock moves from below 20 to the 50 level, it’s likely the stock has finished a move down.

We can actually combine these indicators and see how the stock has done when they move in tandem:

LearnTA: Introduction to Technical Analysis

There many other indicators which we’ll discuss in some detail in later chapters. But first, what are those things that show the price?

Stock Charts: The Different Ways to Plot Them

You can plot price charts in multiple ways. First, if you care only about the closing prices of the day, you can have a line chart:

LearnTA: Introduction to Technical Analysis

This helps, but misses a lot of the action. Did the stock move a lot in the day and then close at this point, or did it open around here, not move much at all, and then close? What was the day’s range? Is there a way to easily depict them without overcomplicating the chart?

One mechanism is the OHLC chart. The Open, High, Low and Close are determined as little points on a vertical line that is the range of the day.

LearnTA: Introduction to Technical Analysis

Here, the Open is a horizontal tick on the left of the vertical range line. The Close is the tick to the right of it.

Note: The “Close” in India is the volume weighted average price (VWAP) of the last half hour of the day. To understand what a VWAP is, here’s a video that explains:https://www.capitalmind.in/2011/04/what-is-vwap-video/.

The close is really the only trustworthy price of the day, since you can have a “freak” high or low, especially in low-volume stocks.

And finally, there’s a candlestick chart:

LearnTA: Introduction to Technical Analysis

Japanese candlesticks involve plotting the open and close as a rectangular box with “wicks” jutting out that highlight the high and low of the day. As you can see, the box is filled on a down day, and unfilled on an up day.

There are other ways to chart stocks – a profile view, P&F charts, relative moves etc. We’ll discuss those in later chapters.

We will use the candlestick chart the most, because it gives us the maximum information.

Understanding Time Periods

Stock charts are about the close prices on a daily basis, but should we restrict ourselves to the dailies? The reason we plot daily prices is because the market actually opens and closes every day. You can’t trade after the closing time, until the next trading day.

However, it is also useful to look at stocks on different time frames. We might look at stocks on aweekly basis instead. The closing price of each week is just the closing price of the last day of the week. The open is the open of the first day. The High and Low of the week are the highest high of each of the five days, and the lowest low of the last five days. In effect we can “compress” the daily chart into a weekly chart.

LearnTA: Introduction to Technical Analysis

Similarly, we might get more granular data, and look at hourly, 15-minute and 1-minute data as well. For the shorter term data you might need to buy data from a data provider, or you can visit the NSE charts, Yahoo Finance or Google Finance to see only the current day minute-by-minute charts.

Supports and Resistances

Think of loss aversion behaviour. We don’t like to lose money. When a stock goes up, and everyone loves that stock, you don’t go rushing to buy. You watch the stock. Then it goes up again, and again. By this time you’re reasonably sure the price move is overdone. So you wait, saying that if the stock falls you will buy more. And then it falls to the same level when you first started watching it, or to the last “low” price where it had moved from. What happens next?

Most of us would say, it’s a good time to buy this stock now. As buyers increase, the stock price holds steady, and the sellers dwindle, and the stock begins to move back up.

The concept of a “support” is simply a point where the price tells us that buyers are likely to come in and buy. A resistance is simply the opposite – it’s where sellers will come in and sell shares and thus depress prices.

We can see different reasons why a certain price is a support and a certain price is a resistance. For Bharti, the Rs. 275 level has acted as a support in recent times, while the 50 day moving average has been a key resistance.

LearnTA: Introduction to Technical Analysis

If you’ve understood this till now, your questions might be:

  • The Rs. 340  and Rs. 318 are also resistances, because that is where stocks moved down from? Will sellers not come and try to break-even then? (
  • What about the 300 level? Wasn’t it a good resistance in Jan + Feb until it eventually broke down below?

These are excellent questions. Firstly, there can be multiple supports and resistances. The strength of a support is in how many times the stock respected the support line – the more times it did, the stronger the support. That also means that if the stock “breaks” the support, it can mean a longer term down move.

(Note: You’ll see in the graph above how Rs. 320 acted as a support in the months of Sep, Nov and Dec. And in Jan, the stock crashed through, and the same 320 level became a resistance!)

This confuses people sometimes. “You said it would get support but it crashed!” How do this work?

It’s about Probabilities

Remember that technicals are just about probabilities. We believe that something “should” happen because it has happened in the past, but that does not mean it won’t happen in the future. It’s just a calculated risk, and it’s better than just investing blindly, but it’s not a silver bullet. (If it was, no one would reveal it)

Past performance is not an indicator of future behaviour. However the outliers are marked by Supports and Resistances. A stock operates firmly between known support and resistance lines. When it breaks either of them, there is a potential trade – that the stock might continue to trend away towards the next support or resistance.

More importantly, it provides the basis for a stop loss. (If the stock falls below its support, I will exit”) We’ll cover stop losses in detail in a later chapter.

Like Keynes has once said:

“When the facts change, I change. What do you do, sir?”

Embracing the knowledge of Technicals involves, for a large part, the appreciation of probabilities. And the ability to admit we’re going to be wrong.

We hope this has helped you understand some of the charts Capital Mind Premium talks about. If you have any questions, please reply to this email or mail premium@capitalmind.in and we will address them.

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LearnTA: Introduction to Technical Analysis

Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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