Page 1 of 12
Journal for Studies in Management and Planning
Available at
http://internationaljournalofresearch.org/index.php/JSMaP
e-ISSN: 2395-0463
Volume 01 Issue 02
March 2015
Available online: http://internationaljournalofresearch.org/ P a g e | 103
Study of Predictive power of Moving Averages
as a tool of Technical Analysis
Jyotika Bahl
Research Scholar
University of Delhi, India
Email: jyotikadsedu@gmail.com
I. Introduction:
Technical analysis uses past prices in order
to predict future prices. It tries to detect
some predefined "patterns" in price series,
and claims it is capable of exploiting the
trends that it discovers.1 The methodology
of technical analysis rests upon the
assumption that history tends to repeat
itself in the stock exchange. If a certain
pattern of activity has in the past produced
certain results nine times out of ten, one
can assume a strong likelihood of the same
outcome whenever this pattern appears in
the future. It should be emphasised,
however, that a large part of the
methodology of technical analysis lacks a
strictly logical explanation. Technicians
using charts search for archetypal price
chart patterns, such as the well-known
head and shoulders or double top/bottom
reversal patterns, study technical
indicators, moving averages, and look for
1
Anderson John’s study.
forms such as lines of support, resistance,
channels, and more obscure formations
such as flags, pennants, balance days and
cup and handle patterns. Technical
analysis is widely used among traders and
financial professionals and is very often
used by active day traders, market makers
and pit traders. In the 1960s and 1970s it
was widely dismissed by academics. In a
recent review, Irwin and Park reported that
56 of 95 modern studies found that it
produces positive results but noted that
many of the positive results were rendered
dubious by issues such as data snooping,
so that the evidence in support of technical
analysis was inconclusive; it is still
considered by many academics to be
pseudoscience. Academics such as Eugene
Fama say the evidence for technical
analysis is sparse and is inconsistent with
the weak form of the efficient-market
hypothesis. Users hold that even if
technical analysis cannot predict the
future, it helps to identify trading
Page 2 of 12
Journal for Studies in Management and Planning
Available at
http://internationaljournalofresearch.org/index.php/JSMaP
e-ISSN: 2395-0463
Volume 01 Issue 02
March 2015
Available online: http://internationaljournalofresearch.org/ P a g e | 104
opportunities. A fundamental principle of
technical analysis is that a market's price
reflects all relevant information, so their
analysis looks at the history of a security's
trading pattern rather than external drivers
such as economic, fundamental and news
events. Therefore, price action tends to
repeat itself due to investors collectively
tending toward patterned behavior – hence
technical analysis focuses on identifiable
trends and conditions.
Techniques of Technical Analysis
1. Dows theory
Dow developed his theory to explain the
movement of the indices of Dow Jones
Average. He developed the theory on the
basis of three hypotheses, first being, that
no single individual or buyer can influence
the major trend in the market. However an
individual investor can affect the daily
price movement by selling or buying huge
quantum of particular scrip. His second
hypothesis is that market discounts
everything, even a natural calamity such as
earthquake, plague, fire gets discounted in
the market.
According to the theory the trend is
divided into primary, intermediate and
short term trend. The primary trend may be
a broad upward or downward movement
that may last for a year or two, whereas the
intermediate trends are corrective trends
which may last for three weeks to three
months. When the market exhibits the
increasing trend it is a bull market. The
bull market is operational when a new high
is higher than previous high and new low
is higher than previous low. The short term
trends refer to the day to day price
movements.
2. Point and Figure Charting
Point and Figure charting is a technical
analysis technique in which time is not
represented on the x-axis, but merely price
changes (independent of time) are
recorded via a series of X’s for increasing
price movements and O’s for decreasing
price movements.
Figure 1: Example of a Point and Figure
Chart
53 X
52 X
51 X
50 X X X
49 X X O X O X
48 X O X O X O X
47 X O X O O
46 O
Page 3 of 12
Journal for Studies in Management and Planning
Available at
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e-ISSN: 2395-0463
Volume 01 Issue 02
March 2015
Available online: http://internationaljournalofresearch.org/ P a g e | 105
Evidence suggests that the technique is
over 100 years old and is now a standard
feature on many widely-used professional
market analysis software systems such as
Bloomberg, Reuters, Trade Station and
Meta Stock. The trading rules adopted
here were applied in Davis (1965) and are
reproduced below labelled as buy signals
and as sell signals.
Figure 2: Double Top (Buy Signal)
Figure 3: Double Bottom (Sell)
X
X X Buy
X O X
X O X
O
The Double Top (Double Bottom)
formation is, by definition, the most
widely observed trading pattern in Point
and Figure as all of the more sophisticated
patterns discussed below must contain this
basic pattern. The formation occurs by
prices rising above (below) the previously
established highest price. It implies that
prices trading above (below) a previous
high (low) suggest that the market is
subject to an increase in demand (supply)
beyond the local maxima (minima) and
that the stronger demand (supply) will
persist. Consequently the continued buying
(selling) should cause prices to increase
(decrease) so producing a profitable
trading opportunity.
3. Moving Average
The underlying trend of the movement of
prices can be studied by smoothening the
data. To smooth the data moving average
technique is used. Buy and sell signals are
provided by the moving average. The
stock price may intersect the moving
average at a particular point. Downward
penetration of the rising average indicates
the possibility of a further fall. Hence a
sell signal is generated. Upward
penetration of a falling average would
indicate the possibility of further rise and
give a buy signal.
When long term and short term moving
averages are drawn, the intersection of two
moving averages generates buy or sell
signals. When the scrip price is falling and
if short term average intersects the long
term moving average from above and falls
X
O X O
O X O
O O Sell
O
