TECHNICAL ANALYSIS

Technical analysis defined

• It is an art of identifying a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.

• The evidence in this case is represented by a number of indicators like peak and trough analysis, price patterns and moving averages.

• Technical approach is based on the theory that the price is a reflection of mass psychology that moves between panic, fear and pessimism on one hand and confidence, excessive optimism and greed on the other.

• The price level is never what the stocks are worth, but what people think they are worth.

Technical vs. Fundamental analysis

• Technical analysis predicts short term price movements whereas fundamental analysis establishes long term values.

• Technical analysis focuses on internal market data i.e. price and volumes whereas fundamental analysis focuses on E-I-C analysis.

Dow Theory

• It is the oldest and by far the most publicized method of identifying major trends in the stock market.

• It is concerned with the direction of a trend and has no forecasting value as to its ultimate duration.

• This theory is only one piece of evidence in technical analysis.

Dow theory cont…

• The theory assumes that majority of stocks follow the underlying trend of the market most of the time.

• In order to measure the market, Dow constructed two indexes which are now called Dow Jones Industrial Average and the Dow Jones Transportation Average.

Dow theory cont…

• The market has three movements: primary movement, secondary reactions and minor movements.

• Primary or major trend is also known as bull or bear market. Such movements last from less than a year to several years.

Dow theory cont…

• Secondary or intermediate reaction is defined as an important decline in a bull market or advance in a bear market.

• They last for three weeks to few months.• During this interval, the movement generally

retraces from 33% to 66%of the primary price change since the termination of the last preceding secondary reaction.

Dow theory cont…

• Minor movements last from a week or two up to as long as 6 weeks.

• It has no forecasting value for longer term investors since short term movements can be manipulated to some extent unlike secondary and primary trends.

Price action determines the trend

Can point x be considered as an indication of a bear market?

• At point x, the series of rising troughs has been broken but not the series of rising peaks.

• So, only half a signal has been generated at point x.

• The complete signal of a reversal arises at point y.

• But waiting for point y would mean giving up a substantial amount of the profits earned during the bull market.

• Therefore, at point x, the weight of the evidence from other technical indicators such as moving averages, volume and breadth should be considered before forming an opinion.

The averages must confirm

• One of the most important principles of Dow theory is that the movement of the Industrial Average and the Transportation Average should always be considered together.

The averages must confirm