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Applying Technical Analysis In Nonliquid Markets

08/29/05 02:10:49 PM PST
by Alexander Nikolov

Can technical analysis be used in low volume markets? Of course it can.

One important prerequisite for the application of technical analysis is that the commodities or stocks to be analyzed must be liquid; they must attract significant public interest so the price charts reflect popular sentiment. That is why most investors of emerging markets, which characteristically have low volume levels, avoid using technical analysis tools. The general belief is that the only successful approach in such markets is to study the fundamentals (macroeconomic data and companies' financials), and that any attempt to analyze these markets using technical analysis will be fruitless.


My experience in the emerging markets has shown the contrary; that despite general belief, technical analysis can be used successfully and, in some cases, is the only possible tool with which to identify early entry and exit points. For example, the average daily volumes on the Bulgarian Stock Exchange (BSE) are less than $1 million, yet you can observe almost textbook chart patterns in the following examples. The other market from which I offer an example is the Russian stock market. With an average daily turnover of about $300 million, it is much more liquid than the BSE, but compared to the western European and US stock markets, it is still a low volume market.

One of the most striking examples of how investor psychology changes before the fundamentals do can be found in Figure 1, which shows a chart of the Bulgarian chemical company Orgachim (ORGH). It is one of the blue-chip companies listed on the BSE. In 2004, SOFIX — the major Bulgarian Stock Exchange index — gained 40%, while ORGH shares lost 7%. At that time, the market did not find the stock to be that appealing, as the company had huge debts and only generated minor profits. From a charting point of view, however, we could see a textbook bull flag pattern had been developing for most of that year.

In late December 2004, the price broke above the upper line of the channel drawn on Figure 1. Fundamental investors continued to dismiss the stock, but from a technical perspective, the stock was a buy because:

1) It broke above the upper line of the channel restricting the prices in 2004;
2) It broke above the previous minor peak, and
3) It broke above both the 21- and 100-day exponential moving averages (EMAs).

As illustrated in Figure 1, the price oscillated around BGN 25 for almost a month (from mid-December 2004 to mid-January 2005) before it shot up. Then in late January 2005, an unexpectedly positive financial report came out showing significant improvement in the company's earnings. In the skyrocketing Bulgarian market, this stock became one of the cheapest (measured by the widely used price/earnings ratio, where it stood at 5 at that time), and investors started to buy it aggressively. As a result, within a month, the price soared to BGN 70 before pulling back in March and April.

Figure 1: Daily chart of Orgachim (ORGH). The breakout of the bull flag preceded the release of the unexpectedly strong earnings a month later.

Note how the prices stayed firmly above the 21- and 100-day EMAs during this spectacular bull run. The subsequent breach of the 21-day EMA provided a short-term exit signal. That the price is above the 100-day EMA (at BGN 45) indicates that the larger trend is still defined as "up," and so the present weakness may turn out to be another good buying opportunity. A fall below BGN 45 would confirm that a major top had been reached.

Investor psychology turned positive a month before the fundamentals showed improvement. By using simple technical analysis tools, market participants could have spotted this shift and taken advantage of it.

The second example comes from Russian automaker Avtovaz. Despite the extremely attractive valuations (P/E ratio of 7, P/BV = 0.3!) the stock was in a sideways consolidation in 2002 and the first half of 2003. Note the textbook triangle in Figure 2. The price was oscillating in a symmetrical triangle for almost 18 months. Once the triangle was broken on the upside, a strong rally commenced and brought about a 100% rise for just six months.

Figure 2: Weekly chart of Avtovaz. The year-and-half sideways consolidation of a textbook symmetrical triangle was followed by a 100% rally.

In addition, observe how the triangle consolidation was confirmed by the moving average convergence/divergence (MACD) indicator's pattern, which also developed into a symmetrical triangle. At the same time the price triangle was broken on the upside, the MACD oscillator penetrated the zero line and moved above its previous peak — an opportunity you could not afford to miss. In a situation like this, you should immediately enter a long position and never go against it!

One of the simplest — yet most powerful — tools in technical analysis is the EMA. In my work, I use two EMAs: a fast 21-period and a slow 100-period. The fast moving average keeps the short-term trends intact as long as the market is in a trending mode. Once the short-term trend ends and a pullback starts, if the larger trend is to remain intact, I look for the 100-period EMA to hold. This simple technique is illustrated best with the example in Figure 3. There you see a daily chart of Industrial Holding Bulgaria (IHLBL), a holding company that attracts lots of public attention, but still has an average daily turnover of less than US$50,000.

Figure 3: Daily chart of Industrial Holding Bulgaria (IHLBL). Once the price broke above the 100-day EMA and previous chart resistance at 0.4, the uptrend accelerated.

As you can see from this chart, once the price broke above the 100-day EMA and moved above BGN 0.4, the stock was supposed to be in a trending mode (and the trend was up). Note how the prices stayed above the 21-day EMA during this entire spectacular bull run. So if you were to use the 21-day EMA as a trailing stop, you would be able to participate in this market euphoria. It is interesting to note that in 2003 and 2004, the company's fundamentals were exactly the same as those in early 2005, but the trend was mostly sideways in 2003 and 2004.

It was the general market euphoria and the break above the key technical resistance levels (above BGN 0.4 and BGN 0.7) that led to the 10-fold rise in late 2004/early 2005. Once again, those using technical analysis would have been ahead of the market, despite the general belief that illiquid markets like the Bulgarian one are mostly driven by fundamental factors and insider information.

I have a close-up view of the Industrial Holding Bulgaria daily chart that shows an almost perfect textbook (yes, textbook again!) head-and-shoulders reversal pattern (see Figure 4). With the break below BGN 3.3, the reversal pattern was confirmed. You can see how the price returned to test the neckline from beneath, but in this rally attempt, it failed to move above the 100-day EMA (the blue line), and so the short-term trend remained downward. Once the price breaks below 3.0, we can expect downside acceleration toward BGN 2.5/2.4 (previous minor resistance and also the head and shoulders typical target). Thus, we are currently bearish on this stock.

Figure 4: Daily chart of Industrial Holding Bulgaria (IHLBL). A possible head & shoulders reversal pattern points to lower prices in the near future.

These examples demonstrate how the standard techniques of technical analysis that are widely used in liquid markets can be applied the same way in illiquid ones. From my experience, the less complicated that technical analysis tools are, the more accurate the analysis of individual stocks is. That's why I tend to use simple indicators like moving averages, the MACD oscillator, and basic charting techniques (trendlines, channels, chart support and resistance levels, chart patterns: triangles, flags, and head and shoulders, to name only a few).

Further, I have found that limited public attention (due to the lack of significant volume) is an obstacle in profitably applying more complex techniques like Fibonacci retracement and projection levels, or the Elliott wave principle. On the other hand, when I try to analyze a market index, such as the market indexes in Bulgaria (SOFIX) and Russia (Micex 10), the chart patterns are sometimes clearer. Thus, using the wave principle together with the Fibonacci retracement and projection levels can significantly improve accuracy.

Alexander Nikolov is the chief technical analyst and head of the international capital markets department at Karoll Finance House (, a leading Bulgarian brokerage firm. His experience includes coverage of the US stock market, eastern European markets, and major currencies.

Charts by Karoll Finance House, Bulgaria

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Alexander Nikolov

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Title: Chief Technical Analyst
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