If you are interested in technical analysis, the analysis tool (InteractiveCharts) in OP eServices offers great assistance when you make your investment decisions and time your transactions.
You can choose from 35 different indicators for technical analysis. You can include several indicators in one chart at the same time and also make use of the drawing tools. These instructions describe the most common and well-known indicators for technical analysis.
Background information for technical analysis
The primary function of technical equity analysis is to give long-term investors appropriate information for timing buy and sell decisions. Technical analysis is the primary tool in short-term investing but can also be utilised when investing in the long term.
Fundamental analysis examines the value of the company and its share. The objective is to determine whether the share is overvalued, undervalued or correctly valued in the markets. However, share prices depend on demand and supply, and technical analysis was designed for the purpose of analysing demand and supply in the markets. This means that technical analysis and fundamental analysis are not opposites but complement each other. Since technical analysis is not science but empirical research, there are deviations from the basic rules. Besides shares, technical analysis can be applied to indices, currencies, commodities, interest rates as well as options and futures.
Technical analysis is based on three assumptions:
- All information is discounted in prices all the time
- Market movements follow trends
- History tends to repeat itself.
A technical analyst can use two basic parameters: (1) price and (2) volume. With the help of these parameters the analyst can draw graphs and by interpreting them deduct the probable future direction of the underlying asset.
The times series of technical analysis, including price and volume as variables, are presented as graphs. There are diverse charts available, such as column chart, line chart and candlestick chart. The candlestick chart, developed by the Japanese in the 1600s, presents the price data for a specific time period in the form of a candlestick. The candlestick consists of opening and closing prices as well as the highest and lowest quotation. Candlestick charts are highly illustrative. For instance, rises and falls show clearly thanks to the different colours.
Technical analysis deals with three trends: up, down and the trading range. One of the key functions of technical analysis is to define an existing trend. When successive highs and lows are above the previous highs and lows, it is considered an uptrend. When successive highs and lows and below the previous highs and lows, it is considered a downtrend. The term 'trading range' is used when successive highs and lows are at the same level; in other words, the market has remained between its support and resistance levels.
In addition to price, volume is the most important parameter in technical analysis. Technical analysis should only be used for shares with a sufficiently high trading volume to ensure efficient price formation. As a rule, trend and volume have a high positive correlation, and hence volumes reinforce share price movements to both directions. When the price and volume move into opposite directions, the volume predicts a change in the trend.
Support and resistance levels
Support level means a price level where demand for a share exceeds supply. This means that the support level lends support to the share price. The logic of support level is based on the assumption that when the share price falls and approaches the support level, more buyers want to buy the share 'low' than sellers sell the share' low'. In a falling market the level from which prices have previously turned upwards is the support level. If the support level is crossed, the crossed support level becomes the resistance level. A crossed level is normally tested from the other side (return move).
Resistance level refers to a price level where supply exceeds demand. In other words, the resistance level is opposite to the support level, and resists a share price rise. The logic of resistance level is based on the assumption that when the share price rises and approaches the resistance level, more sellers want to sell the share 'high' than buyers want to buy it 'high'. In a rising market the level from which the price has previously turned downwards is the resistance level. When the resistance level is crossed, it becomes the support level. Similarly to the support level, a crossed resistance level is normally tested from the other side (return move). Support and resistance levels can also be psychological, as is often seen with indices.
Moving averages are the most commonly used indicators in technical analysis. They are accurate mathematical indicators that generate explicit signals. There are diverse moving averages, such as SMA (simple), EMA (exponential) and WMA (weighted). In these indicators aggregated prices have been weighted in different ways.
You get a simple moving average (SMA) by adding up number 'n' of the most recent share prices and dividing the sum by 'n'
SMA = (Sum of prices)/n
n = Number of time periods
You get an exponential moving average (EMA) by multiplying the latest closing price by the desired value (x) and adding it to the previous day's moving average multiplied by 1-x. For example, your get a 30% moving average with the following formula:
EMA= (0.30*closing price)+((1-0.30)*previous EMA)
You get a weighted moving average (WMA) by adding more weight to more recent observations than to old observations. WMA is calculated by multiplying the closing price of each day by the desired weighting coefficient.
Day Coefficient Price Weighted average
1 1 * 12.00 = 12.00
2 2 * 11.00 = 22.00
3 3 * 13.00 = 39.00
4 4 * 10.00 = 40.00
5 5 * 11.00 = 55.00
Total 15 168/15=11.20
You apply moving averages by comparing them with the price curve. Signals arise when the price curve of the share and the curve of the moving average cross each other:
- when the price curve crosses the moving average from below, you get a buy signal
- when the price curve crosses the moving average from above, you get a sell signal
The advantage of a signal system of this kind is that the investor remains constantly on the right side of the markets; in other words, the investor's portfolio only includes rising shares. The weakness of moving averages is that the signals arrive with a delay, which means that the investor does not gain from the price rise when prices are at their lowest and sale transactions take place when the price has already started to fall. The sensitivity of the signals depends on the length of the selected average. The shorter the average, the faster it reacts to a rise. On the other hand, the problem with moving averages is that false signals are common, and the problem with long moving averages is the scarcity of signals. Furthermore, most of the rise/fall has already been realised before you get a signal. It is sensible to optimise the length of the applied average for each share by visual estimation or by using historical data.
Some of the false signals can be eliminated if you use two moving averages of different lengths.
- It is a buy signal when the shorter moving average crosses above the longer moving average
- It is a sell signal when the short moving average crosses below the longer moving average
Moving averages work well in uptrends and downtrends but poorly in a trading range. The most commonly used lengths for moving averages are 25, 50, 100 and 200 days.
Moving Average Convergence Divergence (MACD)
The MACD indicator shows the relationship between two exponential moving averages (EMA) of different lengths (usually 12 and 26 days). MACD is calculated by subtracting the longer EMA from the shorter EMA. The signal line (trigger line) is usually the 9-day EMA. When the MACD crosses above the signal line, it is a buy signal, and an opposite situation generates a sell signal. Alternatively, the MACD indicates an uptrend when it is above zero, and a downtrend when it is below zero. When the MACD reaches the zero line while the share price goes to new extreme points, it may indicate a weakening or reversing trend. The MACD is a highly useful indicator and works best in a trending market.
With Bollinger bands you can measure whether the present prices are high or low relative to previous prices. Bollinger bands are plotted above and below a moving average (usually 20 days) usually two standard deviations away from the moving average. The use of two standard deviations ensures that statistically 95% of the price data is between the upper and lower band. If only one standard deviation is used, 67% of the observations would be between the Bollinger bands. Since standard deviation (volatility) is used, Bollinger bands widen and contract when volatility increases and decreases.
When the share price reaches the upper Bollinger band or crosses above it, the share is considered to be overbought (sell signal). When the share price reaches the lower Bollinger band or crosses below it, the share is considered to be oversold (buy signal). However, it is not sensible to generate buy or sell signals solely on the basis of Bollinger bands; instead, they should be examined together with other technical analysis methods. Bollinger bands work best in a trading range.
Envelope bands (support and resistance levels) resemble Bollinger bands. Envelopes refer to specified price levels (often a certain percentage of the moving average) placed a certain distance above and below the moving average. When the price touches or crosses the levels, it can be considered to indicate the following trend or a signal of an opposite trend, depending on the distance of the levels from the moving average.
RSI (Relative Strength Index) is one of the most popular technical analysis tools. The RSI measures the relative speed and magnitude of a share price rise and fall. The index oscillates between 0 and 100. Oscillating indicators are useful in timing buy and sell orders when the share is in a trading range, but not worth using in a highly trending market.
The RSI is calculated by dividing the average gain of up periods by the average loss of down periods over a specified time period, which is usually 14 days. The RSI indicates whether the share is overbought (values above 70) or oversold (values below 30). Consequently, the RSI generates a buy signal when the index starts to rise and the share is oversold (values below 30) and the signal is confirmed when the index rises above 30. The RSI generates a sell signal when the index starts to fall and the share is overbought (values above 70) and the signal is confirmed when the index falls below 70.
Williams %R compares the difference of the highest price in a specified time period and the present price with the corresponding difference in a longer time period. Williams %R gives a negative signal when it comes down from overbought conditions (> -20) and a positive signal when it goes up from oversold conditions (<-80). This indicator works best in markets with no clear direction.
Technical analysis is a basic tool for investors and most efficient when combined with fundamental analysis. Indicators that work well in an uptrend or downtrend include various moving averages and MACD. Oscillating indicators as well as support and resistance levels are useful in timing buy and sell transactions when the share is in a trading range. You should not rely on one indicator or method alone when making your buy or sell decision but use two or more indicators or methods to receive a confirmation for a buy or sell signal. With technical analysis you should also bear in mind that false signals may occur.