Technical Analysis

• Identification of the current trend i.e. the direction of price movement and spotting any trend reversal as early as possible.
• Historical price and volume data analysed with the help of charts.
• For currencies, shares and commodities traded on exchanges, such data is usually available but in the case of interbank currency market, volume data is not available and the analyst makes use of different indicators, which are derived from the price data. Many of these indicators have become so popular that they are used extensively even for financial assets and instruments traded on exchanges.
• Applicable only when prices fluctuate freely in response to market forces of demand and supply for the underlying assets. Obviously not applicable for say a pegged exchange rate like USD/HKD. Our focus hereafter will be on floating exchange rates though the principles of technical analysis apply to other assets such as commodities, stock market indices, certain heavily traded stocks, etc.
• More reliable in case of broad and very liquid markets than thin and shallow markets.
• Helps to judge the emotional state of the market. The market has its own collective consciousness distinct from the individual consciousness of the participants.

Contrast with Fundamental analysis

• Fundamental analysis is concerned with all the fundamental factors. In the case of an exchange rate, the concerned factors are the present and expected interest rates, inflation rates, GDP growth rates, international trade and current account balance, exchange rate policies of the two countries in question, state of capital markets, etc. After analysis of all these factors, the fundamental analyst attempts to ascertain whether a currency is undervalued or overvalued and consequently whether it is likely to appreciate or depreciate.
• Technical analysis, on the other hand, assumes that the price at any given time is the result of not only the fundamental factors but also the market’s collective response to all the factors. At the extreme, technical analysts don’t even want to read newspapers lest the popular news bias their chart analysis! For the same reasons. some even don’t want to know the identity of the underlying asset!!
• Often, economists focus on certain fundamentals and ‘prescribe’ how the market ought to behave when the market behaviour is linked to some other factors. A classic example is the euro’s persistent decline since its launch. The market is labelled as crazy when it doesn’t behave in the prescribed manner. However, those who are exposed to risk can’t afford to go against the market even if they think it is crazy. Hence, the importance of technical analysis or proper understanding of market psychology.

Assumptions in technical analysis

• The market discounts everything – All known information about a market is reflected in the price. In other words, all the present political, economic, psychological and any other type of information pertinent to the market price, is already discounted or priced in. In electronic age, information travels at the speed of light and any new information gets disseminated and discounted quickly whereafter it ceases to be of further relevance to the process of forecasting.
• Prices move in trends — When a price moves in a particular direction, be it up or down, it will continue to trend in that direction till some news changes market perception of future direction and reverses the trend itself. To sum up the markets move in the path of least resistance.
• History repeats itself — This assumption arises from the fact that mass psychology does not change. Markets overextend because of the herd instinct leading to panic and euphoria time and again.

Data & Charts

Price classification

• Any floating currency pair i.e. whose rate is not fixed by the country’s central bank against any another currency, can and does trade at different prices on the same day.
• The four most important prices are the open, high, low and close. These prices represent the opening price, highest price, lowest price and closing price on any trading day.
• Now the interbank currency market opens in Far East and closes in New York by which time the next trading day starts in the Far East. Hence, for any trading day, the opening price of the day is taken to be the rate at which the market opens in the Far East while the closing price is taken to be the rate at which the market closes in New York. The day’s high and low are the highest and closing prices between the Far East open and New York close.

Types of charts

• Line chart or the closing price chart constructed by plotting the closing prices on hourly, daily, weekly or monthly basis and connecting the same.
• Bar chart comprises of a series of vertical lines. Each vertical line represents the price movement during that unit of time. The high and low are connected and then horizontal hashes are drawn on the left and right to represent the opening and closing prices respectively.
• Japanese candlestick chart differs from bar chart in that the range between the open and the close is shown as a white or black rectangle called the real body. The ranges on either side of the real body are called upper shadow and lower shadow.

Trend & Trendlines

Trend

• Direction of movement. Prices can be rising, falling or moving sideways and give rise to three types of trend — uptrend, downtrend and flat or neutral trend.
• Prices move in a zig-zag fashion with any rise or fall interrupted by a countermove known as a reaction. In an uptrend, the reaction is downwards while in a downtrend, the reaction is upwards.
• Zig-zag movement gives rise to a series of tops and bottoms or highs and lows. The relative position of successive highs and lows determine the trend at any given point of time.
• Uptrend. series of higher highs and higher lows.
• Downtrend. series of lower highs and lower lows.
• Flat trend. no clear cut sequence of higher highs and higher lows or lower highs and lower lows.
• Currency trends. Unlike stocks, commodities, debt instruments, if one currency say the euro is in a downtrend against the US dollar, the latter is automatically in an uptrend against the euro. Since most currencies, except sterling, aussie, kiwi, ecu and irish punt are quoted against one dollar, it can be confusing to talk about the trend of the dollar without specifying the other currency. For example, the dollar has always been in a multiyear uptrend against the Indian rupee but has moved both up and down against the Japanese yen, British pound and Swiss franc.

Trend Reversal

• Nothing lasts for ever and a trend no matter how powerful, is vulnerable to change.
• This change in the direction of the trend from up to down or from down to up is called trend reversal.
• Often, after a large rise or fall, prices move sideways and this is also known as consolidation. Usually, after such consolidation, the previous trend resumes.
• Uptrend is characterised by higher highs and higher lows. If this were to reverse into a downtrend, one would notice the formation of lower highs and lower lows.

Trendlines

• Trendlines are straight lines drawn by connecting either the highs or the lows.
• In an uptrend, 2 or more rising lows are connected to denote an uptrend line.
• In a downtrend, 2 or more falling highs are connected to denote a downtrend line.
• A horizontal or flat trendline is drawn by connecting either the highs or the lows.
• The importance of a trendline lies in its ability to indicate the possibility of a trend reversal.
• Reversal of uptrend signalled by the price falling below the uptrend line.
• Reversal of downtrend indicated by the price rising above the downtrend line.

Finer points of trendlines

• Penetration of a trendline does not necessarily imply a trend reversal but may indicate just a temporary pause in the trend.
• No fixed rule to judge whether such penetration signals a pause or a reversal. However, important clues are often available.
• Steeper a trendline, greater is the possibility of its penetration signalling just a pause and not a reversal.
• As to duration, the longer a trend has been in force, the more powerful is the violation of the trendline.
• Similarly, the more the number of times a trendline is touched by the price, the stronger the trendline and more powerful is its penetration.
• Finally, trendline penetration accompanied by rising volumes or breakout from a reversal pattern very often signals a trend reversal.

Support & Resistance

• The concept of support and resistance is quite basic and still powerful enough for anticipating turning points during any rally or decline.
• Support is the price level where enough buying pressure builds up to stop a decline at least temporarily and prompt a recovery.
• Resistance indicates a price level at which selling pressure mounts to halt an ongoing rally and start a decline.
• As discussed earlier, zigzag price movement gives rise to highs and lows or tops and bottoms.
• Tops offer resistance and bottoms offer support.
• Market psychology about bottoms and tops: A bottom is a price level where the buying pressure exceeded selling pressure and the price moved upwards. Consequently, players who bought at or near the bottom will be encouraged to buy again if the price approaches the previous bottom or low on any reaction. Similarly, those who missed the earlier rally are also likely to buy near the low from where it started. It is this actual and potential buying that creates the support level. In the same manner, tops acts as resistance because players who sold earlier or who missed the last decline come in to sell when the price rallies and reaches the previous top.
• This phenomenon of tops and bottoms often gives rise to the formation of double tops and double bottoms or triple tops and triple bottoms.
• The more number of times a support or resistance level has held, the stronger it is.
• If a price falls below a support level with sellers overwhelming buyers, this level will usually become resistance level. Similarly, a resistance once broken acts as a support level. Strong supports and resistances when broken act as strong resistances and supports.

Fibonocci Retracement Analysis

• Number sequence — 1,1,2,3,5,8,13,21
• Sum of any two consecutive numbers equals the next highest.
• The ratio of any number to its next higher number approaches 0.618 after the first 4.
• The ratio of any number to its next lower number is 1.618 or the reciprocal of 0.618.
• The ratio of alternate numbers approaches 2.618 or its reciprocal 0.382.
• The most common numbers in retracement analysis are 0.382,0.500 and 0.618

Reversal Patterns

• Chart formations indicating trend reversal. Bar charts are the ones most commonly used and could be on a daily, weekly or monthly basis.
• There must be a prior trend to reverse.
• Breaking of an important trend line is the first signal.
• Greater the height and width of the pattern, the more powerful the resultant move from the breakout.
• Topping patterns are usually shorter in duration and the price movement is swift and volatile when fear overtakes greed. Bottoming patterns take more time to form and price range is smaller.
• Volume is important in price patterns. Higher the volume accompanying the breakout, the more reliable the pattern.

Head and Shoulders Reversal Pattern

• Most powerful reversal pattern and resembles a head and two shoulders.
• In an uptrend, price declines from a peak to form the left shoulder.
• Price then rallies to a new high, called the head before falling again to or near the previous low.
• Now the price rises once more but tops out lower than the head and near the level of the left shoulder. This third top is called the right shoulder.
• The price then begins to fall and the pattern is confirmed when the price breaks and closes below the extended neckline joining the previous two lows — first low between the left shoulder and the head and the second low between the head and the right shoulder.
• Volume plays an important role in the formation of this pattern. Volume is rising when prices are approaching the top of the left shoulder and dips on the first reaction. When price crosses over the peak of left shoulder, increase in volume is not prominent. After the head is formed, price falls below the top of the left shoulder indicating possibility of trend change. Price usually finds support near the previous low and rallies again but forming a lower top with lower volume. Finally, when price begins to fall again and breaks the neckline it is on higher volume.
• The head and shoulders breakout is followed by a sharp downmove with heavy volume before price rallies towards the neckline on lower volume. After this return move, the downtrend usually resumes.
• Price target. Vertical distance from the head to the neckline is measured and this is deducted from the level at which the neckline is broken. This is the minimum price target and as such, there is possibility that the price will move below the target but not below the origin of the preceding uptrend.

Double Top Reversal Pattern

• Also referred to as the M type reversal pattern.
• Price rises to form a top with an increase in volume.
• This is followed by a price drop on lower volume.
• Next rally fails to cross the previous peak and ends thereabout forming a second top.
• Double top reversal is confirmed when the price falls and closes below the intervening low.
• From this breakout point, the price target equals the vertical distance between the double top and the intervening low.
• Important point to note is that volume should be rising at the breakout point else the pattern is suspect.

Rectangle

• This pattern after a sharp up move or a down move.
• Market consolidates in a narrow sideways band between two parallel lines, much similar to a rectangle.
• A break over the upper or the lower channel line would result in a big move.
• The target of such a move would be the height of the rectangle (difference between the lower and upper channel lines.

Moving Averages

• Zigzag movement of prices often makes it difficult to judge the underlying trend. Trendlines do help as we have already seen.
• Another popular way is to smooth the price data with the help of moving averages.
• Technical analysts use three different types of moving averages — simple moving average, exponential moving average and weighted moving average.
• We will discuss only the simple moving average because it is the easiest to compute and interpret.
• The moving average system of trading is also known as the trend following system because the trader waits for the trend to be established before initiating a trade.

Calculation

• Closing price is the price that is most commonly used.
• The term moving average signifies that the average is computed for a moving body of data. For instance, a 5-day average is calculated by adding the closing prices for the first five days and dividing the total by 5. At the end of 6th day, the average is taken for the closing prices for day 2 thru’day 6. The average for the first 5 days is compared against the closing price on the 5th day and so on.
• Since the moving average represents the underlying trend, the number of days to average is the most important criterion. This is the period of the average, which also denotes the period of the trend. In other words, a 5-day average will show a 5-day trend and a 20-day average will show a 20-day trend.
• Computer software such as Lotus, Excel etc. provide readymade formula for calculation of the moving average and manual calculation is usually not necessary.
• Charting facilities available on Reuter, Bloomberg, Bridge, etc provide moving averages and various other studies in a very user-friendly form.

Interpretation

• A moving average smoothens the underlying price data and represents the trend for the period used to calculate the average.
• More importantly, it acts as a curved trendline providing support in an uptrend and resistance in a downtrend.
• Since the moving average reflects the trend, intersection of the price with the moving average signals at least a pause in the trend by way of a correction and possibly a trend reversal.
• In an uptrend, both the price and the moving average are rising and price is above the moving average. If the price were now to move below the moving average while the moving average is still rising, it would probably signal just a correction.
• After a while renewed buying usually pushes the price again over the moving average. If the moving average is still rising, such a crossover of the price over the moving average indicates resumption of the uptrend.
• However, caution is indicated if the moving average has begun to move sideways. A trend reversal is now more likely and is signalled when the price again crosses below the moving average.
• Penetration of a very short term average such as the 5-day average occurs often in long lasting trends and often signals temporary pauses in the trend by way of correction or consolidation. This happens after a sharp upmove or a downmove when profit-taking sets in a countertrend move in the opposite direction. However, when prices retrace 50 to 60% of the previous move, players who missed the earlier move usually enter leading to resumption of the underlying trend.
• On the other hand, penetration of say 20-day average accompanied by a change in the direction of the moving average itself, would usually confirm trend reversal or prolonged and deep correction.

Bollinger Bands

• Empirical evidence shows that exchange rates fluctuate around a moving average.
• Ordinary bands such as moving average envelopes are specified as a fixed percentage channel around a moving average.
• An alternate and popular method of constructing bands is based on a moving standard deviation. Such bands are known as Bollinger bands.
• Construction
• Take a n-period moving average of the price data.
• For each period, calculate the standard deviation of the price around the moving average.
• Choose a multiple of the standard deviation and create a band around the moving average.
• A typical set up is a 20-day moving average with bands placed 2 standard deviations from the moving average.

Interpretation

• The width of the band obviously varies with the volatility i.e. the standard deviation of the prices.
• In uptrends, the price usually moves between the 20-day moving average and the upper bollinger band while in a downtrend, the price usually moves between the moving average and the lower bollinger band.
• Penetration of the upper bollinger band in an uptrend or the lower bollinger band in a downtrend usually suggests an acceleration in the trend.
• However, if the price quickly moves back into the band, a trend reversal or at least a deep correction is likely.
• Sharp price movements accompanied by range expansion are often preceded by a contraction of the band due to a period of reduced volatility.

Oscillators

• A system based on a single moving average or a combination of 2 moving averages are called trend following systems.
• The advantage of a trend following system based on say a 20-day moving average is that you can almost always catch large favourable moves or guard against large adverse moves. However, as the earlier charts, show there could be a considerable loss of profits or savings if one waits till a trend change is indicated by the same system.
• Oscillators are price derivatives. Extreme oscillator readings indicate that the market is overextended, that is, overbought or oversold; give advance warnings of an impending trend reversal and alert the trader or hedger to book some profits or to be on the lookout for other signs of a reversal. Caution. Such warnings are not a signal to take countertrend positions but only to trim existing profitable positions or protect them with tight stops.

Momentum

• Momentum denotes the speed at which prices are rising or falling.
• Momentum has to be related to some period. For example, 10-day momentum measures the size and direction of the price change over the last 10 days.

Calculation

• Simplest way to calculate n-day momentum at time is by the following equation:
• M(t) = P(t) — P(t-n) where M(t) is the momentum at time ‘t’, P(t) is the price at time ‘t’ and P(t-n) is the price at time ‘t-n’.
• The momentum line so plotted oscillates around the zero line.

Interpretation

• Just as a car moving at high speed slows down before coming to a halt or making a U-turn, the momentum peaks out and reverses before reversal of the trend itself.
• However, even after reversal of momentum it is prudent to wait for reversal of the price trend because quite often powerful trends overextend before finally reversing. In such cases, we often see prices making new highs or lows on lower momentum indicating a weak technical position susceptible to reversal. Such a phenomenon of a new high or low in price without being confirmed by a new high or low in momentum, is called divergence.
• Such a divergence is a red alert and a signal for booking profits on existing positions rather than a signal for taking positions in the opposite directions.
• On a stand alone basis, the best available confirmation of a trend reversal or trend resumption after a correction is the crossing of the momentum line above or below the zero line.
• Overbought and oversold signals are given when the momentum oscillator reaches extremely high or low values. Extremely high values point to an overbought condition i.e. the price has risen too far too fast and signal a correction while extremely low values suggest an oversold market and warns of a possible rally.
• A disadvantage of the momentum oscillator is that it is difficult to pinpoint extreme values without comparative historical data. Let’s therefore examine 2 other oscillators that are normalized and whose values always move between 0 and 100.

Relative Strength Index (RSI)

• The RSI is an oscillator that always moves between 0 and 100.
• Necessary to specify a period for calculation. Original designer proposed a 14-day period but 9-day RSI has also become popular.

Construction

• Choose a period for the RSI. Say we take it as 14 days.
• Tabulate the up closes and the down closes in the price over the 14-day period up to the given date.
• Divide the sum of the up closes by 14 to arrive at the average rise.
• Divide the sum of the down closes by 14 to arrive at the average fall.
• Calculate the relative strength (RS) as the ratio of the average rise to the average fall.
• Finally, calculate the RSI using the formula: RSI = 100 — [ 100/(1+ RS)]

RSI overbought/oversold levels

• From the formula, one can see that if RS = 0, RSI = 0; if RS = 1, RSI = 50 and if RS = ¥. RSI = 100.
• Normalisation enables easier identification of overbought and oversold values.
• Typically, a market is said to be overbought, if RSI is above 70 and oversold if RSI is below 30.

• Various ways of interpreting RSI movements.
• For instance, reversal of the RSI from the oversold region can be taken as a buy signal and reversal from the overbought region as a sell signal.
• However, in trending markets, RSI reversals opposite to the trend may only signal a correction and these signals could at the most be used for booking profits or trimming positions. On the other hand, RSI reversal in the direction of the trend usually signals resumption of the trend.
• For indicating impending trend reversal, RSI divergence in the overbought or oversold zone is considered as a more reliable signal. Bearish RSI divergence occurs when the price makes a new high but the RSI though overbought makes a lower high. Bullish RSI divergence occurs when the price makes a new low but the RSI makes a higher low in the oversold zone.
• Even after getting RSI divergence, it is prudent to wait for some reversal indication in the price charts because it is not uncommon for RSI divergences to get repeated in powerful trends.

Stochastics

• This oscillator is based on the empirical evidence that the price usually closes near the high of the day or the last few days in an uptrend and near the low of the day or the last few days in a downtrend.
• The psychological reason is probably that as a trend persists longer and longer, market players tend to become less and less cautious and carry larger overnight risks.
• This is a complex indicator and involves calculation of 3 statistical variables. %K, fast %D and slow %D.

Construction

• Choose a period for %K. Typical period is 5 days.
• Identify the highest intraday high (H) and the lowest intraday low (L) in the chosen period.
• Calculate %K as follows: %K = 100 * (C — L)/ (H — L)
• Calculate fast %D as a moving average, in this case, 3-day moving average of %K values.
• Also calculate slow %D as a 3-day moving average of fast %D values.
• Plot %K and fast %D to form the fast stochastic indicator or the fast stochastics. Similarly, plot fast %D and slow %D to form the slow stochastics.
• Evidently, %K oscillates between 0 and 100 and so also do fast %D and slow %D.

Stochastic signals

• As with the RSI, there are overbought and oversold zones. These are usually set as 80 and 20 or 70 and 30.
• With fast stochastics, a buy signal is given if %K crosses over fast %D in the oversold zone and is confirmed when fast %D moves up into the neutral region. A sell signal is given if %K crosses below fast %D in the overbought zone and is confirmed when fast %D moves down into the neutral region. This may be suitable for short-term traders.
• With slow stochastics, the signals are similar except that these are generated with the crossover of fast %D over or below slow %D. This seems preferable for medium-term traders and hedgers.

Summing Up

• For the major currency pairs, it is adequate to use candlestick charts, a trend following system with a 20-day moving average, 2 standard deviation bollinger bands and oscillators such as 5,3,3 or 9,5,5 stochastics, 14-day RSI and 10-day momentum.
• Countertrend oscillator signals are used only to trim or liquidate positions. New/additional positions are initiated only in the direction of the trend when backed by oscillator signals especially stochastic signals.
• Technical analysis tries to reduce uncertainty by arriving at reasonable expectations of future market behaviour based on the present and past behaviour.
• There is no foolproof or failsafe forecasting method. Hence, use of risk limits and good-till cancelled stoploss orders is of paramount importance.
• As some one said, optimism is merely hoping for the best while confidence is additionally being prepared for the worst.
• Judicious blend of technical and fundamental analysis, that is, techno-fundamental analysis is probably the best approach