Wednesday, February 13, 2013

Trend is your best friend

This article was first published in the Hindu Businessline, Investment World, February 10, 2013; Co-Author: Archana Mishra, NMIMS Hyderabad.
If prices follow a random walk, past prices cannot be used to predict the future prices. And prices do follow a random walk- this was and still is believed by most academicians and many professionals in the field of finance. This belief gives rise to the belief about the ineffectiveness of Technical Analysis as a tool for aiding trading decisions.

But the question is, do the prices really follow a random walk? The Efficient Market Hypothesis (EMH) has propagated that Technical Analysis is useless if the markets are even "weak form efficient". Lo and Hasanhodzic in their book, 'The Heretics of Finance' (Bloomberg Press, 2009) point out that, research shows, patterns do repeat themselves and identifying these patterns can result in forming profitable trading strategies.

Let us clarify at the outset, that we find the notion of EMH itself is questionable. Having said that, research in developed nations point towards at least weak-form efficiency of the markets. Which might be the reason why many fund houses reduced the number of chartists on their teams in the last two decades. For example, in 2005, Citigroup's Smith Barney unit let go of its entire team of technicians. "The clients no longer wanted technical analysis", reported Wall Street Journal.

In India, technical analysis is still very popular and investors are still fascinated by what the complicated looking lines have to say. Even the "Big Bull" of Dalal Street, Mr. Rakesh Jhunjhunwala said in an interview with the Economic Times, "I use a lot of technical analysis for trading at times".

While more and more analysts and investors are preferring to use fundamental analysis, technical analysis has its own share of loyal chartists in India. Research on the Indian bourses give mixed results, with some of them indicating that price movements in India may not be even weak form efficient, making Technical analysis relevant in the Indian context.

Typically, long term investors like to use fundamental analysis, while traders use technical analysis along with fundamental analysis. However, loyal chartists believe that the charts reflect long term trends too as fundamentals are reflected in price movements.

It is advisable for any trader to look for the following indications before taking any position:

a)      Look for the Trend: first check whether the stock has an upward trend or downward trend. If the trend is upward then take a long position. If the trend is downward, then take a short position.

b)      Look for the indicators: After analyzing the trend, look for indicators accordingly. If the stock has an upward trend, then look for buying indicators such as hammer, morning star, morning star doji, bullish engulfing etc. If the stock has a downward trend, then look for sell signals such as hanging man, bearish engulfing, evening star, shooting star, shooting star doji etc.

c)       Look for Confirmation Candle: If the candlestick chart is used, then after the indicator look for confirmation candle to occur. For the buy indicator, the confirmation candle should close higher than the high of the indicator. While for the sell indicators, the confirmation candle should close lower than the low of the indicator candle.

d)      Look for Volume: The confirmation should always be followed by large volume either at the indicator candle or the confirmation candle.

e)      Verify by using various trading tools: MA, MACD, DMI, Fastk, RSI, Pivot are few of them.

After getting positive indication of the trend from the aforementioned steps, take the position (buy or sell) with stop loss below the low of confirmation candle for buy positions and above the high of confirmation for sell positions.

There are various patterns which may be formed by the prices. A few popular one's are the head and shoulder, triangle, rectangle, flag. Patterns are difficult to find. But once you find them, it's worth the effort.

There is no tailor made ideal way to invest. It really depends on the individual’s comfort level in using the technical analysis tools, or analyzing the fundamentals to take positions. However, one should ensure that at least 3-4 indicators are in sync with each other before taking a decision.
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