Topic 6; Technical analysis

Technical analysis is a method of analyzing financial markets and making investment decisions based on
historical price and volume data. It focuses on studying past market trends, patterns, and indicators to
forecast future price movements. Technical analysts believe that historical price data can provide
valuable insights into market psychology and can be used to predict future price behavior.
PRINCIPLES UNDERLYING TECHNICAL ANALYSIS
1. Demand and supply forces are under the influence of both fundamental factors as well as
phycological factors.
2. Combined effect of fundamental factors and technical factors is reflected in the price movement
of securities.
3. Market prices of securities are determined by the forces of demand and supply operating in the
market
ASSUMPTIONS OF TECHNICAL ANALYSIS
✓ Price moves in trends
✓ History repeats itself
✓ The market discounts everything
The Dow Theory
Is a method of analyzing and interpreting stock market trends. It was developed by Charles H. Dow, the
co-founder of Dow Jones & Company and creator of the Dow Jones Industrial Average (DJIA), one of the
most widely followed stock market indices.
The Dow Theory is based on the idea that the stock market moves in trends and that these trends can be
analyzed to make predictions about future price movements.
Principles of Dow theory
1. The market discounts everything: According to this principle, the stock market reflects all
available information and factors in the prices of stocks. It implies that the market price already
incorporates all known information and expectations.
2. The market has three trends: The Dow Theory suggests that the stock market moves in three
primary trends. The primary trend, which can last from several months to several years, is the
main direction of the market. The secondary trend is a corrective movement against the primary
trend and can last from a few weeks to a few months. The minor trend is the shortest and most
volatile, lasting for a few days to a few weeks.
3. The market averages must confirm each other: Dow emphasized the importance of the Dow
Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) moving in the
same direction to confirm the strength of a trend. If both averages are moving upward or
downward, it suggests a healthy market trend. Divergence between the two averages can
indicate a potential reversal.
4. Trends are confirmed by volume: According to the Dow Theory, volume is an important
indicator to confirm the validity of a trend. Rising prices should be accompanied by increasing
volume, indicating strong buying interest. Conversely, declining prices should be accompanied by
decreasing volume, suggesting selling pressure.
5. Trends exist until definitive signals prove otherwise: The Dow Theory assumes that trends
persist until there is a clear reversal signal. It suggests that traders should not assume a trend
has ended until there is sufficient evidence to support a trend reversal.
6. The averages must confirm each other: For a trend to be considered valid, the DJIA and DJTA
should both confirm the direction of the market. If one average is making new highs or lows
while the other is not, it could indicate a weakening trend.
ELLIOT WAVE THEORY
The Elliott Wave Theory is a technical analysis approach that attempts to forecast financial market trends
by identifying repetitive wave patterns in price charts. It was developed by Ralph Nelson Elliott in the
1930s and is based on the premise that market prices follow predictable wave patterns due to investor
psychology.
Key principles of the Elliott Wave Theory include:
1. Wave Structure: According to Elliott, price movements in financial markets unfold in a series of
repetitive patterns called waves. There are two main types of waves: impulse waves and
corrective waves. Impulse waves move in the direction of the overall trend and consist of five
smaller waves, labeled as 1, 2, 3, 4, and 5. Corrective waves move against the overall trend and
consist of three smaller waves, labeled as A, B, and C.
2. Wave Degrees: Elliott classified waves into different degrees based on their size and time
duration. The largest and longest-term waves are called Grand Supercycles, followed by
Supercycles, Cycles, Primary, Intermediate, Minor, Minute, and finally, the smallest and shortestterm waves, Sub-Minute waves.
3. Wave Counting: The Elliott Wave Theory requires practitioners to identify and count waves to
determine the current position within a wave pattern. This process involves analyzing price
charts and labeling waves based on their structure and Fibonacci relationships. The wave count
helps to identify potential turning points and forecast future price movements.
4. Alternation Principle: Elliott observed that in a wave pattern, if one wave is simple and
straightforward, the following wave tends to be more complex or time-consuming. For example,
if Wave 2 is a simple correction, Wave 4 is likely to be more complex in its structure.
5. Wave Validity: To confirm the validity of an Elliott Wave pattern, certain rules must be followed.
These rules include guidelines on wave relationships, wave lengths, and wave retracements. By
adhering to these rules, analysts can determine the probability of a wave pattern being accurate.
The Elliott Wave Theory aims to identify potential price reversals and forecast future market movements.
However, it is worth noting that wave interpretation can be subjective, and there can be multiple valid
wave counts within a given price chart. Traders and analysts often combine Elliott Wave analysis with
other technical tools and indicators to increase the accuracy of their predictions. It requires practice,
experience, and a deep understanding of the theory to effectively apply Elliott Wave analysis in realworld trading scenarios