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Role of Technical Analysis in Predicting Volatility of UK Stock Market

Explaining the factors that determine demand and supply of houses in the UK during the above period

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Table of Contents
Abstract ........................................................................................................................................... 3 1. Introduction ................................................................................................................................. 4 1.1 Objective of Study ................................................................................................................ 5 1.2 Structure of Study ................................................................................................................. 5 2. Understanding Different Chart Patterns Using FTSE 100 index ................................................ 5 2.1 Head and Shoulders .............................................................................................................. 5 2.2 Trend Lines (Chart Pattern) .................................................................................................. 6 2.3 Cup and Handle..................................................................................................................... 7 2.4 Double Top and Double Bottom ........................................................................................... 8 2.5 Broadening Top and bottom ................................................................................................. 9 2.6 Triangle Chart Patterns ....................................................................................................... 10 3. Technical Analysis of Tesco Plc (Listed Company of FTSE 100 Index) ................................. 11 4. Conclusion ................................................................................................................................ 15 References ..................................................................................................................................... 15

List of figures

Figure 1. Head and Shoulder Identification ................................................................................... 7 Figure 2. One year daily trading of FTSE 1008 Figure 3. Six month FTSE 100 closing prices.9 Figure 4. Identification of double top and double bottom in FTSE historical data..10 Figure 5. Broadening top and bottom using FTSE 100 index...11 Figure 6. Identification of Triangle pattern using FTSE 100 index..12 Figure 7. Tesco Plc 5 day historical data with 15 minutes reporting13 Figure 8. Two month historical prices of Tesco Plc..13 Figure 9. Tesco plc six month historical data14 Figure 10. One year historical data of Tesco Plc...15

3 Abstract This study is about the technical analysis and its importance in evaluating the stocks future pricing behaviour. The FTSE 100 index is used to understand different chart patterns i.e. head and shoulders, cup and handle, double up and bottom, trend lines, broadening up and down and triangle charts. These chart patterns are used by the investors for decision making purposes. Tesco plc, the world largest food items retailer is taken as sample for technical analysis of 5 days, 2 months, 6 months and 1 year data. Technical analysis has significant impact on stock prices and contemporary stock behavior tends to move according to past behavior because thanks to technical techniques, past trends and movement of stocks are linked with the current investor behavior in the market. Tesco Plc used as the sample from FTSE 100 index. With the help of different chart patterns it shows the increasing trend in market so it is assumed that with the decrease in volatility and increase in price Tesco will have a stable increase in prices.

4 1. Introduction Behaviour of equity prices in the stock market is volatile and unpredictable. It is difficult for the investor to make a decision on the basis of the companys fundamentals. Proper understanding of behaviour of stock market requires previous trends. The technical analysis of stocks or portfolio of stocks on the basis of past trends and data helps investors to evaluate the behaviour of the market and they are able to see that how stock prices are moving in the market. Different patterns of stocks help to provide different investor sentiments, whether there is bullish or bearish trend in the market how much momentum and strength market has and much more. Technical analysis with the help of charts on the basis of the past data not only provide the graphical representation of stocks but also show trends which help in forecasting the movement of stock prices (Kirkpatrick & Dahlquist, 2006). Most of the technical analysts try to evaluate the behaviour of investors. According to Murphy (1999) there is positive impact of past investors behaviour on the investment decision of contemporary investors, which can be reflected in the stock price movement. Most of the stock movements are irrational and different chart patterns such as head and shoulders help the technical analysts to provide the logical reason out of the movements of the stock market. Murphy (1999) also believes that the charts provide the certain level of recognition and prediction in price patterns. Technical analysis goes against the fundamental analysis. Fundamental analysis deals with the company information, facts and performance, whereas technical analysis deals with the quality of market information its impact on price change in security. Both fundamental and technical analyses are important for financial analysts, investors, brokerage and technicians. Marshall, Cahan, & Cahan (2008) indicate that for various market participants there is more importance and reliability of technical analysis than fundamental analysis in short time horizons. The main idea behind technical analysis is to see how historical prices of stock communicate the behaviour and information of the stock. It does not include the impact of outside factors such as fundamentals of the company, economic factors and different events in the economy. The behaviour of stock according to previous data tends to repeat the pattern

5 because investors tend to move according to the pattern shown by the security in the past so the patterns tend to repeat themselves (Elder, 2008). Many chart patterns i.e. head and shoulders, double bottom and top etc. used by the investors to predict the future trends in prices to exploit some profits out of market because these trends tend to repeat in the market. When to invest and when to sale are based on the information which is communicated by the security itself. It is assumed that once the pattern started some sort of a form it is possible to predict the future volatility in stock prices (Reid, 2001). 1.1 Objective of Study The stock market is the unpredictable place to invest in. Investors without any information of the market can sustain heavy losses. The aim the study is to see whether the technical tools can be used to evaluate the future patterns of stock and also how much these technical tools are important to evaluate trends in the market to use these trends to curb the volatility in the market. 1.2 Structure of Study The second section provides the understanding of different chart patterns using FTSE 100 index as an example. The third section deals with the stock evaluation using Tesco Plc as sample and use 5 day, 2 months, 6 months and 1 year historical data for technical analysis. Finally, the last section provides conclusion. 2. Understanding Different Chart Patterns Using FTSE 100 index Prices of stock show different patterns in the market to monitor the movement and with the movement of stock there are certain concepts and indicators of technical analysis which help to understand the contemporary volatility of stocks. Some of these patterns are given below. 2.1 Head and Shoulders Head and shoulders pattern forms when with the support of the neckline the stock has three successive peaks. The middle peak becomes the highest peaks then the almost equally heighted left and right peak.

6 Figure 1. Head and Shoulder Identification

Source: Laidtrades (2010) The above figure is the FTSE 100 stock performance as on July 5 2010 and three peaks definitely show the head and shoulder pattern with the support of the neckline at 4575.50 which helps in determining the price level for the stock. The difference between the neckline and peaks are the indicators for the price determination. 2.2 Trend Lines (Chart Pattern) To evaluate the market movement traders use pivot points to see whether there is bullish or bearish environment in the market. Trend lines are drawn in between two or more prior pivot points. The most common use of trend line is to draw diagonal levels, which help in making decision regarding entering and exiting investment in the stock market (Edwards & Magee, 1948).

7 Figure 2. One year daily trading of FTSE 100

Source: (Yahoo Fianance, 2013)1 The black lines in above figure show the trends of the stock market and provide the sentiment to the investors about the future behaviour of stocks. 2.3 Cup and Handle Cup and handle pattern is formed when stock prices drop at significant level then raise back up to the original price then instantly drop a small value and the raise back up shaping a formation of the cup (Stockchart, 2012).

Diagrams are generated and taken from the source website but the technical analysis with lines and trends are sketched by the researcher himself.

8 Figure 3. Six month FTSE 100 closing prices

6200 6000 5800 5600 5400 5200 5000 4800

Six months trading of FTSE 100

Closing Price

The above generated figure shows the cup and handle pattern of the FTSE 100 index which is clearly shown on the diagram. There is cup and handle pattern in the last two month. 2.4 Double Top and Double Bottom Another technical analysis tool which investor uses to evaluate market trends with the help of historical data. The basic idea behind this chart is to analyse the momentum of buying and selling in the market. The double top is the form of two high peaks and these consecutive peaks are at almost at the same level then there peaks are separated by one valley. Valley indicates the decrease in the price level after first peak and then at point there is another increase in price toward the second peak.

9 Figure 4. Identification of double top and double bottom in FTSE historical data

Double Top

Double Bottom

Source: (Yahoo Finance, 2013) The above figure shows the historical data for FTSE 100 index for the past year and from the figure the technician can identify some of the double tops and bottom in the data to see the supply and demand of the stocks. This figure shows the example of FTSE 100 index to see the double top and bottom in the trends shown. 2.5 Broadening Top and bottom These patterns are considered reversal patterns. These patterns are based on the up and down swing in price level each swing is larger than the previous swing which means each swing contains more variation. Broadening tops and bottoms are formed by the slightly angles trends lines (The Traders Journal, 2009). Figure 5 shows the identification of broadening lines in the FTSE 100 index. As the trend lines got broadened it is clear that the market is unpredictable and the prices are more volatile than before so it is imperative for the investors to get out of the market. The figure shows that July to August there is the broadening top trend and there is broadening down from March 2012 to May 2012 and September 2012 to November 2012.

10 Figure 5. Broadening top and bottom using FTSE 100 index

Source: (Yahoo Finance, 2013) 2.6 Triangle Chart Patterns Triangle chart patterns are commonly used in the stock market. They show the price range contraction overtime which gives the triangle shape overtime. There are two types of triangle chart patterns; one is ascending triangle which shows the trend of the triangle to be finished at some high point and descending triangle where the trend of triangle furnished at some lower price level.

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Figure 6. Identification of Triangle pattern using FTSE 100 index

Source: (LiveCharts, 2013) The above figure shows the ascending chart pattern using the FTSE 100 indexs daily data for the past two month it shows the decrease in volatility in price level and also the stability in prices from January 2013 to February 2013, which is a good sign for the investors because the prices are more predictable and there is an increasing trend in the market. 3. Technical Analysis of Tesco Plc (Listed Company of FTSE 100 Index) I have selected Tesco as the case from FTSE 100 index companies to evaluate the trends in stock prices from previous data. Deferent tenor is used on the basis of the need of the study and to see a more comprehensive picture while analyzing the results. Tesco founded by Jack Cohan in 1919 from the market stall in London. Now Tesco Plc is considered as the world largest retailer and has its branches in more than 14 countries. Tescos 60% of the food retail business comes from the UK market and therefore it has a developed market in the UK. It has 3000 stores all over UK market (Tesco Plc, 2013).

12 Tesco current price level is 373.95 as closed on February 25, 2013. I will use 5 days historical data, 2 months, 6 months and 1 year historical data of Tesco to see trends and volatility in prices of stock and then evaluate whether the communicated trends or patterns can help us to predict the future prices of Tesco plc. Figure 7. Tesco Plc 5 day historical data with 15 minutes reporting

Source: (LiveCharts, 2013) The figure shows the 5 day historical prices of Tesco Plc in FTSE 100 index. With red lines it is clearly shown that it maintains the ascending triangle which shows that there is decrease in stock price volatility. This estimates the investors that stock prices can be predictable and will be stable next day then there is double bottom indicated by a blue curve line show the decrease in price then increase at some level and then again decrease to almost equal level than before there is cup and handle trend from February 21st to February 25, 2013.

13 Figure 8. Two month historical prices of Tesco Plc

The trend lines in Figure 8 shows the upward movement of prices. This gives the positive sentiment to investors who are willing to invest in Tesco Plc. The trend lines show the resistant line which indicates the highest level where prices can go and the supportive trend which show the lowest price level in the study. An investor can use these trend lines to make his investment decisions. Figure 9. Tesco plc six month historical data

14 Source: (Yahoo Fianance, 2013) Figure 9 shows six month pricing behaviour of Tesco stock in the UK market. With the analysis it is shown that the security from last four months has shown very good progress as shown by the yellow trend lines shown in the figure. But it has recovered from the broadening bottom trend shown in September 2012. There is also a double bottom pattern shown by the green dotted line in the diagram. Figure 10. One year historical data of Tesco Plc

Source: (Yahoo Fianance, 2013) The above figure shows an interesting structure of Tesco performance in the market for past one year the stock trading started and went low as shown by the trend lines from Mar 2012 to May 2012. Then setting the neck line at approximately 309 we get the head and shoulder pattern, where price go up to 325 then went to then raise to 350 level and then went down to 310 and then again give the little raise to 327 to complete the head and shoulder pattern. After head and shoulder the upward trend is shown by the image and the volatility tends to decrease which show the stable increase in stock. An investor can trust this stock which investing in it at this point.

15 4. Conclusion This study elaborates the importance of Technical analysis in evaluating the market performance and its future behaviour. The study highlighted selected diverse technical patterns which provide the justification for movement in stocks prices. The study uses FTSE 100 index and its listed company i.e. Tesco Plc. It is shown that the technical patterns are very important in predicting the price volatilities and future behaviour of prices. Fundamentals and economic indicators also post some impact of stock prices but the previous trends of stock and their patterns help to investor to evaluate the stock behavior in the market. The technical analysis has significant impact on the performance of equity stocks and it serve as the sentiment for the investors in the market to make decisions regarding entering or exiting the stock market.

References Reid. (2001). International Encyclopedia of Technical Analysis. Reference Reviews, 15(1), 21 22. Edwards, R. D., & Magee, J. (1948). Technical Analysis of Stock Trends. Springfield, MA (p. 505). Elder, I. (2008). Chapter 1. Trend vs Counter-Trending Trading. Kirkpatrick, & Dahlquist. (2006). Technical Analysis: The Complete Resource for Financial Market Technicians. Financial Times Press, 3. Laidtrades. (2010). FTSE 100 head and shoulders breakdown. Retrieved from http://www.laidtrades.com/2010/07/05/ftse-100-head-and-shoulders-breakdown-july-52010/ LiveCharts. (2013). FTSE 100 Share Price Chart. Retrieved from http://www.livecharts.co.uk/share_prices/UKX-stock-chart-technical-analysis Marshall, B. R., Cahan, R. H., & Cahan, J. M. (2008). Does intraday technical analysis in the U.S. equity market have value? Journal of Empirical Finance, 15(2), 199210. doi:10.1016/j.jempfin.2006.05.003 Murphy, J. J. (1999). Technical Analysis of the Financial Markets. New York Institute of Finance, 15.

16 Stockchart. (2012). Cup with handles pattern. Retrieved from http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:cup_ with_handle_con Tesco Plc. (2013). No Title. Retrieved from http://www.tescoplc.com The Traders Journal. (2009). Trading Broadening Top/ Bottom Patterns. ASIA PACIFICS PREEMINENT TRADING MAGAZINE. Yahoo Fianance. (2013). FTSE 100 Technical Analysis. Retrieved from http://finance.yahoo.com/q/ta?s=^FTSE&t=1y&l=on&z=l&q=l&p=&a=r14&c=