M.V.

Sandeep GCW Kolar

Chapter 4

Technical analysis

Technical analysis is a method of evaluating the potential future performance of a stock

by examining past market data, primarily price and volume. This method aims to identify patterns,
trends and signals within the data to assist traders in forecasting future price movement.
Technical analysis uses a range of charting techniques and technical indicators to analyze price
trends and identify entry and exit points for trades.

Technical analysis is a method of evaluating securities and attempting to predict price

movements and future market trends by studying historical market data, primarily price and
volume.

Uses of Technical Analysis

 Entry and exit points: technical analysis helps to identify favourable entry and exit points
for trades. Traders use pattern and indicators to determine when to buy or sell
 Risk management: By analyzing support and resistance level, traders can set stop loss
orders to limit potential losses.
 Market sentiment: Technical analysis also reflects market sentiment. A sudden surge in
trading volume or break out from a trend line can indicate a shift in sentiment.

Pros of Technical Analysis Cons of Technical Analysis

It helps identify trends in the market, i.e. whether It can be subjective and may give conflicting
they are bullish, bearish, etc. signals.

It provides entry and exit signals, which lets an Since technical analysis is based only on price
investor identify when to enter and exit trades. and volume data, it may not consider
fundamental factors.

It helps in managing risk, which ultimately limits It may not work in all types of market conditions
the losses. and may give false signals.

Since technical analysis is based on objective For using technical analysis, it may require
data and mathematical calculations, it provides a some skill and experience. New traders may
clear approach. find it difficult to use.

Technical analysis methods

 Trend analysis: This method involves identifying and analyzing the prevailing trends in a
stock’s price movements. Trends can be categorized as uptrend, down trends, side way
trends.

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 Support and resistance level: Traders look for price levels where a stock tends to find
support (stops declining) or resistance (struggles to rise). These levels help determine
entry and exit points.
 Bollinger bands: This consists of a moving average (typically 20 periods) with upper and
lower bands representing standard deviation from the average. They help to identify
volatility (fluctuations) and potential reversal points.
 Candle stick pattern: Candle stick pattern display price movements in a visually
informative way. Traders look for patterns like doji, hammer and engulfing patterns to
predict price reversals.
 Volume analysis: Volume reflects the number of shares or contracts traded during
specific period. Changes in trading volume can signal potential price movements, such as
breakouts or reversal.
 Chart pattern: Chart pattern are visual formations in price charts that indicate potential
future price movements. Common patterns include head and shoulders, double
top/bottom, flags, and triangles

Components of Technical Analysis

 Charts: Technical analysts use various types of charts, such as line charts and candlestick
charts, to visualize price movements over time.
 Indicators: These are mathematical calculations applied to price and volume data to
provide insights into market trends, momentum, volatility, and other aspects. Examples
include moving averages, Relative Strength Index (RSI), Moving Average Convergence
Divergence (MACD), and Bollinger Bands.
 Patterns: Analysts look for recurring patterns in price movements, such as triangles, head
and shoulders, flags, and pennants, which may indicate potential future price movements.
 Support and resistance levels: These are price levels at which a security tends to find
buying support (support level) or selling pressure (resistance level). They are often
identified through historical price data and are considered important in determining entry
and exit points for trades.
 Volume: Volume in technical stock analysis refers to the number of shares of a stock that
are traded on a certain day or period of time. Volume is critical since it validates previously
determined trend directions. Volume is an important input. While studying stock charts,
consider both price and volume.
 Trends: Technical analysts study trends in price movements, which can be categorized
as uptrends, downtrends, or sideways trends. Identifying trends helps traders make
decisions on whether to buy, sell, or hold a security.

Dow Theory

The Dow Theory is a fundamental principle of technical analysis that is widely used to
identify the overall trend of the stock market. It was developed by Charles H. Dow in the late 19th
century.

Traders and investors have widely used Dow Theory since then to identify market trends
and base investment decisions on them

Dow Theory is a fundamental approach to understanding and analyzing stock market

movements. It suggests markets follow trends that are identifiable and predictable. Based on
Charles Dow’s writings, it breaks down market trends into primary, secondary, and minor
movements, guiding investors in making informed decisions.
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The Paradigms of Dow Theory

To explain the theory, understanding the several rules devised by Dow is vital. These
paradigms are generally known as the tenets or principles of Dow theory.

 Three significant market trends: They are primary, secondary, and minor trends defined
by their duration. Primary trends can be uptrend or downtrend lasting months to years,
while secondary one moving opposite to the primary will last weeks or a few months. Minor
trends are treated as insignificant variations lasting from a few hours to weeks, and they
are not as important as the others.

 Primary trends have three distinct phases: The different phases in bear markets are
distribution, public participation, and panic. Bull markets, on the other, have accumulation,
public participation, and excess phase.

 Stock market discount everything: The market indexes react quickly to all forms of
information. It can be related to the entity or economy as a whole. For instance, any
economic shock or issues in the company management will affect stocks and move the
indices upward or downward.

 Volume confirms the trend: Trading volume increases during an uptrend and decrease
during depressions.

 Indices confirm each other: Multiple indices moving in an identical pattern reveal a trend
since they give the same signal. Whereas if two indices move in the opposite direction, it
is difficult to deduct a trend.

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 Trends continue until solid clues imply the reversal: Traders should be aware of trend
reversals. It’s easy to confuse them with secondary trends, so Dow cautions the investor
to be careful and confirm trends with several sources before believing it’s a reversal.

Importance of Dow Theory

 Understanding Market Trends: The Dow’s Theory helps investors understand the
direction of the overall market trend. By analyzing the primary, secondary, and minor
trends, investors can make more informed investment decisions.

 Identifying Stock Trends: Dow Theory can help investors identify the trends of individual
stocks. By understanding the stock’s trend, investors can make better decisions about
when to buy or sell.

 Technical Analysis: The Dow Theory is a key tool in technical analysis. It helps investors
identify support and resistance levels, as well as important trend lines.

 Risk Management: Dow’s Theory can help investors manage risk. By understanding the
trend of the market, investors can adjust their portfolios to protect against potential losses.

 Long-Term Dow Investing: The Dow Theory is useful for long-term investors who are
interested in investing in the stock market. By understanding the long-term trends,
investors can make better decisions about which stocks to invest in.

The Three Trends in Dow Theory

There are three Dow Theory trend that are important to understand for analyzing the stock
market:

 The Primary Trend in Dow Theory: The primary trend is the long-term trend that
generally lasts for a year or more. This trend is characterized by a sustained movement in
one direction, either upward or downward. It also represents the overall market sentiment.
 The Secondary Trend in Dow Theory: The secondary trend is a corrective movement
that lasts for several weeks to several months. It moves in the opposite direction of the
primary trend and represents a counter-trend movement. However, this trend does not
necessarily reverse the primary trend but rather is a temporary pullback or correction.
 The Minor Trend: The minor trend is the short-term trend that lasts for a few days to a
few weeks. Therefore, this trend moves in the same direction as the primary trend and is
often caused by short-term fluctuations in supply and demand.

Dow Theory Trading Strategy

The Dow Theory trading strategy is based on the principles outlined in the Dow Theory. It
emphasizes the importance of trend stock analysis in making investment decisions. Here are the
key steps involved in using the Dow Theory in trading:

Step 1: Identify the Primary Trend

The first step in the Dow Theory trading strategy is to identify the primary trend of the market.
This is done by analyzing the long-term price movements of the market, typically over a period

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of several months to years. If the market is moving consistently higher, it is said to be in an

uptrend, while if it is constantly moving lower, it is in a downtrend.

Step 2: Confirm the Trend

Once the primary trend has been identified, the next step is to confirm it. This involves looking
for other indicators, such as trading volume, to confirm the direction of the trend. In general, if
trading volume is increasing as the market moves in the direction of the trend, it is seen as
confirmation of the trend.

Step 3: Identify Secondary Trends

Within the primary trend, there will be secondary trends that can provide opportunities for traders
to enter or exit the market. Secondary trends are typically shorter-term movements within the
primary trend, lasting several weeks to a few months.

Step 4: Look for Trend Reversals

One of the key principles of the Dow Jones Theory is that trends tend to continue until there is
evidence of a reversal. Traders using this strategy will look for signs that the trend is weakening
or reversing. Such as a change in trading volume or a break in key support or resistance levels.

Step 5: Use Dow Theory Technical Analysis

Technical stock analysis plays a key role in the Dow Theory trading strategy. Traders will use
charts and technical indicators to identify key support and resistance levels, trend lines, and other
patterns that can provide insight into the direction of the market.

Step 6: Implement Risk Management

As with any trading strategy, risk management is critical when using the Dow Theory. Traders
should set stop-loss orders to limit their losses in the event the market moves against them, and
they should use position sizing and other risk management techniques to manage their exposure
to the market.

Advantages Of Dow Theory

 Time-Tested Approach: Dow Theory has been used for over a century, offering a proven
framework for analyzing stock market trends and guiding investment decisions.
 Simplifies Market Analysis: By categorizing trends into primary, secondary, and minor, it
simplifies the complex nature of market movements, making analysis more accessible.
 Informed Decision Making: It assists investors in making strategic decisions by
identifying the beginning and end of market trends, especially useful for long-term
investment planning.
 Risk Management: Identifying market trends can help in risk mitigation. Investors can
adjust their portfolios according to the identified trend, reducing potential losses and
capturing gains.

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 Distinguishing Market Noise: Dow Theory helps in differentiating between significant

long-term market movements and short-term market fluctuations, allowing investors to
focus on impactful trends rather than daily market volatility.
 Comprehensive View of Market Health: It provides a broad perspective of market health,
considering both industrial and transportation sectors, offering a more holistic view of
economic conditions.
 Flexibility: Applicable to various markets and timeframes, Dow Theory can be used by
different types of investors, from day traders to long-term investors, enhancing its utility in
diverse investment scenarios.

Limitations

 Subjective Interpretation: Dow Theory can be subjective, as different analysts might

interpret market trends differently. This ambiguity can lead to varied conclusions about the
market’s direction and appropriate investment strategies.
 Lag in Signalling Reversals: The theory often identifies trend reversals after they have
occurred. This delay can result in missed opportunities or holding onto investments longer
than necessary
 Less Effective in Fast-Paced Markets: In today’s high-frequency trading environment,
market dynamics change rapidly. Dow Theory, which focuses on longer-term trends, may
not capture these quick shifts effectively.
 Doesn’t Account for Modern Market Factors: The theory doesn’t fully incorporate the
impact of contemporary factors like algorithmic trading, global economic events, and
central bank policies, which can significantly influence market movements.
 Overemphasis on Averages: Relying heavily on market averages, as Dow Theory does,
may overlook the nuances of individual stock performance, potentially leading to a
generalized view of the market.
 Limited to Equity Markets: While versatile, Dow Theory is primarily applicable to stock
markets. Its principles are less relevant to other asset classes like commodities,
currencies, or fixed-income securities.
 Overlooking Microeconomic Factors: The theory primarily focuses on macroeconomic
and broad market indicators, often overlooking microeconomic factors that can
significantly impact individual stocks or sectors.

ELLIOT WAVE THEORY

Elliott wave theory is used to predict price variations primarily in the stock market;
the creator of Elliott wave theory is Ralph Nelson Elliott, an American accountant, and author;
hence the theory is named after him. He introduced it in 1930. Typically, the wave theory suggests
that the price movements are repetitive and historic, and when looked at from a broader
perspective, they look like ocean waves in long patterns.

It is essential to identify where one wave segment finishes and another starts and analyze
whether a significant correction is the completion of a wave or merely a deviation from the general
trend. As a result, it is one of the most popular forms of technical analysis used by
many portfolio managers globally.

Elliott believed that every action would give a reaction; he studied long-form and historical data
patterns and introduced the wave theory based on this. It is often compared to the Dow theory.
He proposed that the investors’ sentiment and psychological behavior can make waves in price

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movements rather than just straight lines. When he studied long-form historical data, he
concluded that these waves are repetitive.

Types of waves

In Elliott Wave Theory, there are two main types of waves: impulse waves and corrective
waves. These waves alternate in sequence to form larger patterns in financial markets.

 Impulse Waves: An impulse wave is a five-wave pattern that moves in the direction of the
main trend. The five-wave pattern consists of three impulse waves (1, 3, and 5) and two
corrective waves (2 and 4). In an uptrend, impulse waves move upwards, while in a
downtrend, impulse waves move downwards. Impulse waves are the primary directional
movement of a trend.
 Corrective Waves: A corrective wave is a three-wave pattern that moves against the
direction of the main trend. Corrective waves are labeled as A, B, and C. The corrective

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waves follow the impulse waves, and their job is to correct or retrace some of the gains or
losses made during the impulse waves. Corrective waves are temporary movements
against the trend, and they are not as powerful as impulse waves.

Principles/Rules

 Elliott wave theory patterns provide a comprehensive framework for understanding

market cycles and predicting future price movements by applying a set of rules and
guidelines to the observed wave patterns. Let us understand them through the discussion
below.

 Wave Structure: The theory identifies two types of waves—impulse waves and corrective
waves. Impulse waves move in the direction of the main trend, while corrective waves
move against it.
 Wave Count: An Elliott wave sequence consists of impulsive and corrective waves,
typically labeled as 5-3-5-3-5. This represents the rhythm of market price movements.
 Wave Degrees: Elliott Wave Theory categorizes waves into different degrees, including
Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, and Minuette,
indicating the scale of the waves.
 Wave Direction: Impulse waves (1, 3, and 5) follow the main trend and are labeled with
numbers, while corrective waves (2 and 4) move against the trend and are labeled with
letters.
 Fibonacci Ratios: The theory incorporates Fibonacci ratios to determine potential
reversal points and wave extensions, providing a quantitative basis for analyzing wave
retracements and extensions.
 Wave Equality: In certain patterns, particularly within corrective waves, there is a
tendency for specific waves to achieve equality in terms of price or time, providing insights
into potential turning points.
 Wave Alternation: Elliott Wave Theory suggests that waves of similar degree do not
usually exhibit the same pattern, promoting the idea of alternation in wave structures.
 Channeling: Price movements often adhere to trend channels, and Elliott Wave analysts
use trendlines to identify potential reversal or continuation points based on wave patterns.
 Confirmation: Analysts use additional technical indicators and price confirmation to
strengthen the validity of Elliott Wave analysis, enhancing the reliability of forecasted price
movements.

Note on Fibonacci: The Fibonacci retracement is a trading chart pattern that traders use to
identify trading levels and the range at which an asset price will rebound or reverse. The reversal
may be upward or downward and can be determined using the Fibonacci trading ratio.

Fibonacci retracement is a method of technical analysis for determining support and

resistance levels.

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Trading With Elliott Waves

Using the Elliott Wave Theory in trading involves identifying potential market trends and
reversals based on wave patterns. Here are some steps to consider when using Elliott Waves in
trading:

1. Identify the trend: The first step in using Elliott Waves in trading is to identify the current
trend in the market. The Elliott Wave Theory is based on the idea that markets move in
waves of sentiment, so it’s important to determine the current direction of the trend.
2. Look for the five-wave impulse pattern: Once the trend has been identified, traders
should look for the five-wave impulse pattern that moves in the direction of the trend. This
pattern consists of three impulse waves (1, 3, and 5) and two corrective waves (2 and 4).
3. Identify the corrective wave patterns: After the five-wave impulse pattern has been
identified, traders should look for the corrective wave patterns that follow it. These
corrective patterns can take the form of zigzags, flats, triangles, or other wave patterns.
4. Look for key levels of support and resistance: As wave patterns develop, traders
should look for key levels of support and resistance, which can provide entry and exit
points for trades. These levels can be identified by looking at previous highs and lows in
the market.
5. Confirm with other technical and fundamental analysis tools: Finally, traders should
confirm their trading decisions with other technical and fundamental analysis tools, such
as moving averages, oscillators, and economic indicators. This can help to increase the
accuracy of trading decisions and reduce the risk of false signals.

Using Elliott Waves in trading involves identifying potential wave patterns and key levels
of support and resistance to determine entry and exit points for trades.

Elliott Wave Patterns

In Elliott Wave Theory, there are several patterns that impulse and corrective waves form, each
with its own unique characteristics and rules. Here are some of the most common Elliott Wave
patterns:

1. Impulse Wave: As mentioned earlier, the impulse wave is a five-wave pattern that moves
in the direction of the trend. The pattern consists of three impulse waves (1, 3, and 5) and
two corrective waves (2 and 4).

2. Zigzag: The zigzag is a three-wave corrective pattern that is labeled A, B, and C. It is the
most common corrective wave pattern and is characterized by a sharp move in one
direction (wave A), a smaller correction in the opposite direction (wave B), and another
sharp move in the original direction (wave C).

3. Flat: The flat is a three-wave corrective pattern that is labeled A, B, and C. It is

characterized by a price movement that is sideways, with little or no progress made in the
direction of the trend.

4. Triangle: The triangle is a five-wave corrective pattern that is labeled A, B, C, D, and E. It

is characterized by a series of waves that move in a narrowing range, forming a triangular
shape.

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5. Double Zigzag: The double zigzag is a three-wave corrective pattern that is composed of
two zigzags (A-B-C, X, A-B-C). It is a more complex pattern and is sometimes referred to
as a “W-X-Y” pattern.

6. Triple Zigzag: The triple zigzag is a three-wave corrective pattern that is composed of
three zigzags (A-B-C, X, A-B-C, X, A-B-C). It is even more complex than the double zigzag
and is sometimes referred to as a “W-X-Y-X-Z” pattern.

These patterns can occur in any timeframe and in any market.

Merits and Demerits of Elliot Wave Theory

Pros/Merits

1. Provides a framework for understanding market cycles: The Elliott Wave Theory
provides a framework for understanding market cycles and how they move in waves of
sentiment. By analyzing wave patterns, traders can identify potential trends and reversals
in the market.

2. Offers a high degree of flexibility: The Elliott Wave Theory can be applied to any market
and any timeframe, providing a high degree of flexibility for traders.

3. Can provide specific entry and exit points: By identifying key levels of support and
resistance, the Elliott Wave Theory can provide specific entry and exit points for trades,
which can help manage risk and maximize profits.

4. Can be used in conjunction with other technical and fundamental analysis

tools: The Elliott Wave Theory can be used in conjunction with other technical and
fundamental analysis tools to confirm or refute trading decisions.

Cons/Demerits

1. Subjective interpretation: The interpretation of wave patterns can be subjective, and

different analysts may identify different wave patterns in the same market data.

2. Complex and time-consuming: The Elliott Wave Theory is a complex tool that requires
a significant amount of time and effort to learn and apply effectively.

3. Not always accurate: While the Elliott Wave Theory can be useful for identifying potential
trends and reversals, it is not always accurate and can lead to false signals.

4. Requires discipline and patience: The Elliott Wave Theory requires discipline and
patience, as it may take time for wave patterns to develop and confirm trading decisions.

CHARTS

Charts are graphical presentations of price information of securities over time. Charts plot
historical data based on a combination of price, volume as well as time intervals.

Types of Charts

Line chats: Line chart is a series of points connected by a line. It is plotted using only the closing
prices. It is simple and display trends with clarity. The trends can be determined by observing the
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line’s slope between a series of points. Prices of multiple stocks or indices can be plotted at once
for comparative studies. It is not used for intraday trading. The main disadvantage is they do not
show the price range (high and low of the day or the accounting period) for the day

Bar Chart: As the name suggests, they are a vertical bar or line that carries the price information
for the day or accounting period. Also known as open, high, low and close (OHLC) charts. It
provides four sets of prices for a day or period - opening, closing, high and low. The bar chart
uses four prices, and therefore, the price range is visible in bar charts

You can observe from the above diagram that the top of the vertical line is the high of the day,
while the bottom of the vertical line is the lowest price of the day. There are two small horizontal
lines attached to either side of the bar or line. The horizontal line attached to the left is the opening
price, while the one on the right is the closing price for the day.
There is a colour aspect to the chart too. If the closing price of a bar is more than the closing
price of the previous bar, the colour is either blue or green, indicating a positive close. However,
if the closing price of a bar is lower than the previous bar, the colour of the bar is red, indicating
a negative close. Coincidentally, if the closing price of a bar is similar to the closing price of the
previous bar, the colour of the previous bar is the colour of the current bar.

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Candlesticks charts: It was introduced by a Japanese rice trader, Munehisa Homa, in the 18th
century. The pattern is named so because it resembles a candle. It has a thick body with wicks
on top and bottom of the candle, known as shadows. Similar to bar charts, candlestick charts
also carry information about the open, high, low and close for the day or accounting period.
 The body of the candle is positive green or bullish if the close is greater than the open of
the day or period.
 It is negative red or bearish if the close is less than the opening.
 If the open and close are the same, then the colour of the previous candle is the colour of
the current candle.

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 The top of the wick is the high of the day.

 The bottom of the wick is the low of the day.
However, there are some peculiarities to a candle. This pattern has body language that conveys
different meanings. Candlesticks are the most popularly used charting method by technical
analysts for trading. Many patterns are either based on single candles or two or more candles
forming a pattern.
A single candle pattern like a Doji, hammer, shooting star, Marubozu, hanging man, etc., are
trend reversal patterns that convey the reversal of an existing trend. Candlestick patterns of two
or more candles like the harami, engulfing, morning or evening stars, 3 white soldiers or 3 black
crows, etc., are also trend reversal patterns

Renko Charts: The name ‘Renko charts’ is derived from the Japanese word ‘Renga’ which
means a brick/block of stone. Renko charts focus only on price changes and ignore the time axis.
They use bricks that are either hollow or filled. A brick is made of a pre-defined value.
For example, if a value is set at 10 points, a brick will be made only if there is a movement of 10
points or more. At every 10 or more points, a new brick will be made. Smaller prices that move
below 10 points are also ignored.

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Point and Figure chart: Point and Figure charts plot price movements for assets like equity and
commodities without considering time intervals. Point and figure charts appear distinct as they
utilize a series of stacked ‘X’s and ‘O’s. These ‘X’s and ‘O’s represent a set price movement. The
‘X’s represent rising prices, whereas ‘O’s indicate falling prices. Although Point and Figure charts
are easy to understand, they share a significant disadvantage. The Point and Figure charts are
typically slow to react to price changes.

Kagi:
Another notable contribution of the Japanese to the financial world is the Kagi chart. It was
developed in the late 1800s. These charts do not change direction at the end of a time frame but
at a price reversal. The chart will continue to move in that direction until there is a confirmed price
reversal.

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Heikin Ashi chart: It is another important contribution by the Japanese in the field of Technical
analysis. The term “Heiken Ashi” is Japanese for ‘average bar’. Heikin Ashi is similar to a
candlestick chart but is different in a few aspects. This chart is smoother since it takes an average
of the movement. Moreover, this chart stays red or green depending on whether the stock is in
an uptrend or downtrend, unlike the candlestick chart which changes daily.
However, there is a grave issue with this type of chart. Since it takes the average of the
movement, the price does not match the current trading price of the asset. Therefore, traders are
unable to view the current price of the asset.

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Trend Analysis
Trend refers to the direction in which the price of a stock is moving. Share prices usually move
upwards or downwards based on bullish or bearish market sentiments. Usually, they do not move
in a straight line as stock prices can be subject to high volatility in the short term. Investors need
to consider a specific timeframe to consider the stock price movements as a trend.
Share market trend analysis is a process that allows investors to estimate the future price
movements of stocks by analyzing the ongoing Market Trend. Trend Analysis is a technique of
analysis of historical data to estimate the long-term route of market movements. Thus, through
this method, investors can try to predict whether a sector that’s expanding will continue to grow
or not.
Trend Analysis involves analyzing extensive data. In short, Trend Analysis helps in comparing
the performance of a firm in order to provide investors with an idea of whether the business will
move forward or backward. Trend Analysis is also known as Horizontal Analysis.
Types of Trends
 Uptrend: An uptrend is formed when a stock price of a trade is rising in value. When the
market begins, several traders take advantage of an uptrend and enter a long position to
reach high price levels. For example: If the share price of a particular increase by Rs.30
and reduces by Rs. 15, and then again rises by Rs. 20, the share price is facing an upward
trend since it is evidenced as higher highs and higher lows in price.
 Downtrend: A trader can see a downtrend when the stock price is falling in value. In the
case of a downtrend, trend traders make their way and enter a short position, i.e., when
the price is going down to the lowest possible point. For example: If the stock price
decreases by Rs. 60 and then increases by Rs. 30 and then again falls by Rs. 20, a trader
will see a formation in a downward trend. However, it is evidenced through lower highs
and lower lows in the stock price in a downtrend.
 Sideways trend: The sideways trend is formed when the market remains static, i.e., the
stock price neither reaches the highest or lowest price points. Several professional
traders involved in trend trading ignore this sideways trend. However, scalpers benefit with
the help of short-term investments in the market to take advantage of a sideways trend.
Merits of Trend analysis
 Can help identify opportunities for buying or selling securities
 Can identify potential risks or warning signs that a security or market may be headed for
a downturn
 Provides insight into market psychology and momentum
Demerits of Trenf analysis
 If markets are efficient, trend analysis is not as useful
 If the data is incomplete, inaccurate, or otherwise flawed, the analysis may also be
misleading or inaccurate
 May not take into account changes in a company's management, changes in industry
regulations, or other external factors that could affect the security's performance
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 Different statistical measures can yield different results

Trend Reversal
A reversal pattern indicates a change in direction from a rising market to a falling market and vice
versa. We can use this pattern to predict the upcoming movement and open or close our trades
accordingly.
Reversal patterns might signal that either the bulls or bears have lost control and that there might
be a change of trend imminent. The current trend will see a pause and then the price will move
in a new direction from the other side (bull or bear).
A trend reversal in technical analysis marks the end of an existing trend and a beginning of a
brand-new trend. The aim of the trader should be to take the opportunity of the reversal that can
happen in any timeframe.
Trend reversal Patterns
1. Head and shoulders pattern
Head and Shoulders consist of three parts: a peak to the left (shoulder), a higher peak (the head),
and another peak to the right (shoulder). The "neckline" is drawn by connecting the two bottoms
- the one prior to and the one after the head formation. This line is important, as a break below
triggers the signal. The bullish reversal pattern and bearish reversal pattern can be seen in the
image below.
The inverse head and shoulders – or 'head and shoulders bottom' – is a reversal chart pattern
similar to the head and shoulders, except it is inverted.
The pattern contains three successive lows with the middle low (the head) being deeper than the
two outside lows (the shoulders), which are shallower. When this pattern is complete it is usually
a signal for a bullish trend reversal.

Inverse and normal head and shoulders pattern

2. Double tops and bottoms patterns

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Double tops and double bottoms represent two failed attempts by the price to break beyond either
a key resistance level or below a key support level. This may be an indicator that momentum has
been lost in this trend, increasing selling pressure after an uptrend moving into overbought
territory or increased buying pressure after dipping too deeply during downtrends.
There is a similar reversal pattern known as triple tops and triple bottoms. This movement is even
more powerful since the price did not break out three times instead of just two, signifying a
stronger support or resistance level.

Double top and double bottom pattern

3. Triple tops and bottoms patterns
A triple top consists of three peaks that nearly hit the same price level and signals the asset may
no longer be trending upwards, with lower prices expected to be on the way. The triple top can
occur on all time frames but it must follow an uptrend for the pattern to be considered. This chart
reversal pattern looks like the letter 'M' on a candlestick chart.
The triple bottom is the opposite of the triple top, where the chart pattern looks like the letter 'W'
and will occur after a downtrend, with the three bottoms hitting around the same price level before
it breaks through resistance levels.

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Triple top and triple bottom pattern

4. Wedge pattern
A wedge pattern can be a signal for either bullish or bearish price reversals, characterized by
three common features: converging trend lines, declining volume as the pattern progresses, and
a breakout from one of the trend lines. The two forms of the wedge pattern are the rising wedge
(indicating a bearish reversal) and the falling wedge (signaling a bullish reversal).
Rising Wedge: As a rising wedge pattern suggests the potential for falling prices after a breakout
of the lower trend line, traders should consider entering a short position or using derivatives after
the breakout occurs.
Falling Wedge: For a falling wedge pattern, traders should look for bullish reversal signals and
consider entering a long position or using derivatives that benefit from the security's increase in
price after the breakout above the upper trend line.

5. Sushi Roll Reversal Pattern

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The sushi roll reversal pattern is a candlestick pattern that consists of ten bars—or ten
candlesticks—wherein each bar represents a well-defined period. So, on a chart using daily
candles, each candle represents one trading day. The first five bars are confined within a narrow
range of highs and lows, and the remaining five bars surround the first five with both lower lows
and higher highs. Hence, this creates a pattern that resembles a sushi roll.

6. Quasimodo Pattern
Quasimodo pattern is a reversal chart pattern consisting of a left shoulder level and a break of
the previous trend. It forms at the end of the previous trend. It is also known as the QM pattern.
Most traders don’t know about the Quasimodo chart pattern, but it is one of the advanced chart
patterns. Traders use it to predict the trend reversal along with the pinpoint trade entry, which
gives a high-risk reward ratio and less floating drawdown

Moving Averages
The moving average is a popular tool used in trading. It shows the average price of an instrument
over a set period of time, displayed as a line on a chart. This line is created by averaging prices
over a specific number of periods, often using closing prices.
Moving averages are computed to determine a stock's trend direction or support level and
resistance levels.
Primarily, when the price level of a stock rises above the moving average line, traders consider
it as an indication to buy. And when the price falls below this line, traders contemplate it as a
signal to sell.
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Types of moving averages

 Simple MA Indicator: The SMA Is the simplest moving average that is obtained by adding
the most recent data points set and then dividing the total by the number of time periods.
The SMA indicator is used for traders to generate signals of when to enter or exit the stock.
An SMA is a lagging indicator as it is based on the past price data for a given period that
can be computed for different types of prices such as high, low, open, and close. Traders
use this indicator for determining buy, sell signals for securities and also helps to identify
support and resistance zones. For example, a stock trader wants to calculate the simple
moving average for a stock by taking its closing price for the last five days.
 Exponential MA Indicator (EMA): EMA is the other type of moving average that gives
more weight to the most recent price points and makes it more responsive to recent data
points. EMA is more responsive to recent price change when compared to the SMA as it
applies the same weight to all price changes in the given specific period.
 Weighted MA Indicator (WMA): WMA is another type of moving average which traders
use for generating trade direction and making a buy or sell decision. It gives greater
weightage to the recent data points and less weightage on past data points. Traders use
the weighted average for generating trade signals. For example, when the prices are
above the weighted moving average, then it signals that the trend is an uptrend. But if the
prices are below the weighted moving, then it indicates the trend is down.
 Double Exponential MA Indicator (DEMA): DEMA is an improved version of EMA as it
allocates more weight to the most recent data points. It reduces lag results and is more
responsive that helps short-term traders in spotting trend reversals quickly.
 The Triple Exponential MA Indicator (TEMA): TEMA reduces the lag of EMAs and
makes them more responsive to the prices. After the Double Exponential Moving Average
(DEMA) was developed in 1994, Patrick Mulloy created the Triple Exponential Moving
Average (TEMA). Just like DEMA, the TEMA reduces the lag difference between different
EMA.
Merits of Moving Average Method
Advantages
 Trend identification: Moving averages help traders to identify the direction of the trend
and filter out market noise. They smooth out the price action and make it easier to see the
overall trend.
 Support and resistance levels: Moving averages act as dynamic support and resistance
levels. Traders can use them to identify potential entry and exit points.
 Easy to use: Moving averages are easy to calculate and apply. Most charting platforms
have built-in moving average indicators that traders can use.
 Multiple time frame analysis: Moving averages can be applied to multiple time frames to
get a better understanding of the overall trend.
 Versatility: Moving averages can be used in combination with other technical indicators
to increase the accuracy of trading signals.
Demerits of Moving Averages
 Lagging indicator: Moving averages are lagging indicators, which means they are based
on past price action. They may not provide accurate signals in fast-moving markets.

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 False signals: Moving averages can provide false signals in choppy or sideways markets.
Traders need to be aware of this and use other indicators to confirm trading signals.
 Whipsaw trades: Moving averages can generate whipsaw trades, where the price
crosses the moving average multiple times in a short period. This can result in losses for
traders.
 Not suitable for all markets: Moving averages may not be suitable for all markets. They
work best in trending markets and may not be effective in range-bound markets.
 Over-reliance: Traders may become over-reliant on moving averages and ignore other
important technical indicators or fundamental analysis.

Oscillators
An oscillator is a mathematical tool used by traders to forecast future market movements. It
generates a value that fluctuates above and below a center line, usually indicating overbought
(high value) or oversold (low value) conditions in a market.
Oscillators are typically used in conjunction with other technical analysis tools to confirm signals
and prevent false indications.
Types
 Relative Strength Index (RSI): The Relative Strength Index is a momentum oscillator
that measures the speed and change of price movements. It ranges from 0 to 100 and is
typically used to identify overbought or oversold conditions.
An RSI above 70 suggests an overbought condition, while an RSI below 30 indicates an
oversold condition.
 Stochastic Oscillator: The Stochastic Oscillator is another momentum indicator that
compares a particular closing price of a security to a range of its prices over a certain
period.
The oscillator's value ranges from 0 to 100, with a reading above 80 usually considered
overbought, and a reading below 20 considered oversold.
 Moving Average Convergence Divergence (MACD): MACD is a trend-following
momentum oscillator. It calculates the difference between two Exponential Moving
Averages (EMA) and compares it to a signal line. The MACD triggers technical signals
when it crosses above (bullish) or below (bearish) its signal line.
Additionally, the MACD histogram can provide insights into the strength of a price
movement.
 Commodity Channel Index (CCI): The Commodity Channel Index is a versatile oscillator
used to identify cyclical trends in commodities but can also be applied to other asset
classes.
The CCI compares the current price with an average price over a specific period and then
measures the variation from the mean. It is often used to spot overbought and oversold
conditions, divergences, and generate trade signals.
Market Efficiency and Behavioural Finance
Market efficiency describes the extent to which available information is quickly reflected in the
market price. In other words, an efficient market is one in which the price of every stock or

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security incorporates all the available information, and hence the price is the “true” investment
value.
Efficient market hypothesis or EMH is an investment theory which suggests that the prices of
financial instruments reflect all available market information. Hence, investors cannot have an
edge over each other by analysing the stocks and adopting different market timing strategies.
When efficient market hypothesis is considered, the assumption is that the price of stock
market will reach equilibrium since prices are informationally efficient. However, behavioral
finance claim that investors tend to have some psychological and emotional biases which lead
to irrationality.
Forms/Types of Efficient Market Hypothesis
EMH has three variations which constitute different market efficiency levels. They are discussed
below
1. Weak Form efficient market hypothesis: This is based on the assumption that the market
prices of all financial instruments represent all public information related to the market. It does
not reflect any information that is not yet disclosed publicly. Moreover, the efficient market
hypothesis assumes that historical data like price and returns have no relation with the future
price of a financial instrument.
The weak form EMH implies that technical trading strategies cannot provide consistent excess
returns because past price performance can’t predict future price action that will be based on
new information. The weak form, while it discounts technical analysis, leaves open the possibility
that superior fundamental analysis may provide a means of outperforming the overall market
average return on investment.
2. Semi Strong efficient market hypothesis: The semi-strong form of market efficiency
assumes that stocks adjust quickly to absorb new public information so that an investor cannot
benefit over and above the market by trading on that new information. This implies that neither
technical analysis nor fundamental analysis would be reliable strategies to achieve superior
returns, because any information gained through fundamental analysis will already be available
and thus already incorporated into current prices. Only private information unavailable to the
market at large will be useful to gain an advantage in trading, and only to those who possess the
information before the rest of the market doe
3. Strong Form efficient market hypothesis: The strong form of the EMH holds that prices
always reflect the entirety of both public and private information. This includes all publicly
available information, both historical and new, or current, as well as insider information. Given
the assumption that stock prices reflect all information (public as well as private), no investor,
including a corporate insider, would be able to profit above the average investor even if he were
privy to new insider information
Factors that Affect a Market’s Efficiency
 Market Participants: In general, as the number and sophistication of participants within
a market increase, the market becomes more efficient.
 Information Availability and Financial Disclosure: The more information market
participants have, the more accurate the market’s estimates of intrinsic value, thus

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creating greater market efficiency. In highly efficient markets, information is provided to all
market participants at the same time, and the advantage of insider trading is limited.
 Limits to Trading: Regulatory limits on activities such as short selling influence the
actions of investors who may want to explore market inefficiencies and take advantage to
make risk-free profits. The more stringent the restrictions, the more likely the market will
be inefficient.
 Transaction and Other Costs: The efficiency of a market is defined by the ease and
availability of information regarding security prices. If the cost of obtaining and analyzing
extra information results in more profits, then investors may look to explore more of active
management, thus affecting the overall efficiency of the market.
Random Walk Market Theory
Random walk theory suggests that changes in asset prices are random. This means that stock
prices move unpredictably, so that past prices cannot be used to accurately predict future prices.
Random walk theory also implies that the stock market is efficient and reflects all available
information.
Example: LMN garments company’s stock is trading at $100. Suddenly there was news of the fire in the
factory, and Stock Price fell by 10%. The next day when the market started, the stock price fell by another
10%. Hence, what Random Walk Theory says is that they fell on the fire day was due to the news of the
fire, but they fell on the next day was not on the news of the fire again. Due to any updated news on fire,
say, an exact number of fabrics burned that caused the fall on the next day.

Therefore, Stock Prices are not dependent on each other. Each day stock reacts to various news
and is independent of each other.
Advantages
 Efficient Market Perspective: The Random Walk Theory asserts that stock prices rapidly
adjust to new information, ensuring that market prices accurately reflect all available
information. This viewpoint highlights the efficiency of financial markets in processing and
incorporating information, aiding investors in making informed decisions.
 Balanced Investment Approach: By assuming that stock price movements are
unpredictable, the theory encourages a diversified and balanced investment strategy.
Investors are urged to focus on long-term goals rather than attempting to time the market,
ultimately reducing the risk associated with trying to predict short-term price movements.
 Mitigated Illusion of Patterns: The theory dispels the illusion of discernible patterns in
stock price movements. Recognizing that prices follow a random and independent
trajectory helps investors avoid falling prey to misleading patterns that might lead to poor
investment decisions, promoting a more rational approach to investing.
Disadvantages
 Markets are not entirely efficient. Information asymmetry is there, and many insiders react
much earlier than other investors due to the information edge.
 In many cases, stock prices have shown a trend year on year.
 One lousy news affects a stock price for several days, even months
Behavioural Finance

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Behavioral finance refers to the study focusing on explaining the influence of psychology in the
decision-making process of investors. Behavioral finance is the study of the influence of
psychology on the behavior of investors or financial analysts. It also includes the subsequent
effects on the markets. It focuses on the fact that investors are not always rational, have limits to
their self-control, and are influenced by their own biases.
Biases of Behavioral Finance
 Confirmation bias: The confirmation bias occurs when the investors align to the
information that matches with their beliefs. The data could be wrong, but as long as it fits
with their views, they end up relying on it.
 Experiential bias: It occurs when an investor’s memories or experiences from past
events make them choose sides even when such a decision is not rational. For instance,
previous or current bad experience leads them to avoid similar positions.
 Loss aversion: Loss aversion makes investors avoid taking a risk even if it earns high
returns. They give priority to restraining from experiencing losses rather than experiencing
high returns.
 Overconfidence: Overconfidence reflects when investors overestimate their abilities or
trading skills and make decisions forgoing factual evidences.
 Disposition bias: It explains the propensity of investors to hold on to the stocks even if
the prices are declining, believing that the prices will appreciate in the future and, at the
same time, sell the well-performing stocks. Such investors tend to hold on to a stock losing
money, hoping that the price will soon increase. In their minds, it’s only a matter of time
before the tides change for them, and they can then make profits on all their positions in
a market.
 Familiarity bias: The familiarity bias is reflected when investors place their investment in
the stocks from the industry they know and understand rather than going after securities
from an unrelated field. In this process, they may lose new or innovative opportunities that
are revolutionary.
 Mental accounting: People’s budgeting process or spending habits may vary based on
circumstances. That is, they don’t maintain a consistent pace. For instance, people may
spend for luxury in a mall or while on vacation, and they also possess a modest lifestyle
at home or when they are back from vacation.

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