role of technical analysis in predicting volatility of uk stock market

7/30/2019 Role of Technical Analysis in Predicting Volatility of UK Stock Market

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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..................................................................................................................... 72.4 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


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List offigures

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


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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.


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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


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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 thetechnical 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.


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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).


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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).

1 Diagrams are generated and taken from the source website but the technical analysis with lines and trends are

sketched by the researcher himself.


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Figure 3. Six month FTSE 100 closing prices

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 buyingand 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.

4800

5000

5200

5400

5600

5800

6000

6200Six months trading of FTSE 100

Closing Price


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

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.

Double Top

Double Bottom


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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).


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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.


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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


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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.


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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-5-2010/

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 ofFinance, 15.


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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 PACIFICSPREEMINENT 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=

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