chapter -3

Technical analysis
 Technical analysis

Technical analysis is a method used to evaluate and predict the future price movements of
financial securities by analyzing past market data, primarily price and volume. Technical
analysis can be applied to any security with historical trading data, including stocks, bonds,
commodities, and currencies. It is widely used by traders and investors to make decisions on
when to buy, sell, or hold a security, aiming to gain profits by forecasting its price direction.
 ASSUMPTION OF TECHNICAL
ANALYSIS

Market Prices Discount Everything: This assumption posits that all known and relevant information
is already reflected in the market prices of securities. This includes fundamental factors, investor
sentiment, and external factors. Therefore, the analysis focuses solely on price movements rather than
external data.
Price Movements are Not Random: Technical analysts believe that price movements follow trends
and patterns that are not random but are instead influenced by various factors, including investor
psychology and supply and demand dynamics. This predictability allows analysts to use historical data
to forecast future price movements.
History Tends to Repeat Itself: The assumption that history repeats itself is central to technical
analysis. It is believed that market participants often react similarly to comparable market
conditions over time, which results in recurring patterns and trends in price charts. This consistent
psychology. repeatability is attributed to human behavior and market
Prices Move in Trends: Technical analysis operates on the premise that prices move in trends,
which can be upward (bullish), downward (bearish), or sideways (range-bound). Once a trend has
been established, it is likely to continue for a period of time. Identifying these trends early is key
to making profitable trading decisions.
Volume Confirms the Trend: Volume, or the number of shares or contracts traded in a given
period, is an important aspect of technical analysis. It is assumed that volume should increase in
the direction of the trend. For example, in an uptrend, increasing volume confirms the strength of
the trend, while decreasing volume might signal its weakness.
 APPROACHES OF TECHNICAL
ANALYSIS

Chart Patterns: This approach involves identifying specific patterns within price charts that suggest future
movements. Common patterns include head and shoulders, triangles (ascending, descending, and symmetrical),
double tops and bottoms, and flags and pennants. Each pattern has its own set of implications for potential market
direction (upward, continuation of the current trend). downward,
Trend Analysis: The trend analysis approach focuses on determining the direction of the market or as pecific asset's
prices. Analysts look for up trends, downtrends, and sideways or range-bound trends to make predictions about
future price movements. The saying "the trend is your friend" encapsulates the essence of trend analysis.
Technical Indicators and Oscillators: Technical analysts use a wide range of indicators and oscillators to assess
market conditions and potential price movements. These tools can indicate momentum, trend strength, overbought or
oversold conditions, and potential reversal points. Popular indicators include moving averages, Relative Strength
Index (RSI), Moving Average Convergence Divergence (MACD), Bollinger Bands, and Stochastic Oscillator.
Volume Analysis: Analyzing trading volume alongside price movements provides insights into the strength or
weakness of a trend. High volume during an uptrend suggests strong buying interest, while high volume during a
downtrend indicates strong selling pressure. Volume analysis can confirm trends and signal potential reversals.
Candlestick Patterns: Originating from Japan, candlestick patterns are a popular method used in technical
analysis to predict short-term price movements based on the shape, color, and position of candlestick formations
on a chart. Each pattern, such as doji, engulfing, and hammer, carries specific interpretations about market
sentiment and potential price direction.
Elliott Wave Theory: This approach is based on the theory that market prices move in predictable, repeating
cycles or waves influenced by investor psychology. Analysts using the Elliott Wave Theory attempt to identify
the current position within these wave patterns to predict future market movements psychology. Analysts using
the Elliott Wave Theory attempt to identify the current position within these wave patterns to predict future
market movements.
Fibonacci Analysis: analysis uses a series of numbers and ratios derived from the Fibonacci sequence to
identify potential support and resistance levels, as well as reversal points. It is often used in conjunction with
other technical analysis methods to refine predictions.
Market Sentiment Analysis: This approach gauges the overall sentiment or mood of the market through
various indicators, such as the Bull/Bear Ratio, the Volatility Index (VIX), and more. Market sentiment analysis
helps in understanding whether the majority of traders are bullish or bearish, offering insights into potential
market moves.
 Advantages of technical analysis

Applicability across Markets: Technical analysis can be applied to a wide range of markets,
including stocks, bonds, commodities, and currencies. This versatility allows traders to use similar
tools and techniques across different asset classes.
Focus on Price Action: Since technical analysis primarily focuses on price movements and volume,
it can cut through the noise of market news and economic data, providing a clearer picture of market
sentiment and trends.
Timeliness: Technical analysis can provide immediate insights into market trends and potential
reversals, offering timely opportunities for entry and exit. This is particularly valuable in fast- moving
markets where quick decision-making is essential.
Identification of Trends and Patterns: One of the core strengths of technical analysis is its ability
to identify existing trends and forecast potential market movements based on historical patterns.
Recognizing these trends can help traders align their trades with the market's momentum.
Risk Management: Technical analysis tools can help traders set stop-loss orders and define risk levels,
enhancing risk management. By identifying support and resistance levels, traders can make more
informed decisions about where to enter and exit positions.
Cost-Effectiveness: For individual traders, technical analysis can be a cost-effective method of market
analysis. Many charting tools and software are readily available, often at low cost or even free, reducing
the barriers to entry for new traders.
Complements Fundamental Analysis: While some traders rely exclusively on technical analysis, it can
also complement fundamental analysis. For example, a trader might use fundamental analysis to select a
stock and technical analysis to time their trades.
Psychological Insights: Technical analysis considers the psychological aspects of market behavior,
helping traders understand and anticipate collective market reactions to price movements or news
events.
Technical analysis limations

Self-Fulfilling Prophecy: Some argue that technical analysis can sometimes become a self-fulfilling prophecy.
When a large number of traders follow the same patterns and indicators, their collective actions can drive the
market in a predicted direction, not necessarily because of underlying economic fundamentals.
Historical Data Dependency: Technical analysis relies heavily on historical market data. However, just because a
market acted a certain way in the past does not guarantee it will do so in the future. Market dynamics and external
factors are constantly changing.
Overlooks fundamentals: By focusing mainly on price movements and trading volumes, technical analysis can
overlook fundamental factors such as a company's financial health, industry conditions, and macroeconomic
indicators, which can significantly impact a security's value.
Subjectivity: Many technical analysis tools and patterns can be interpreted in different ways by different analysts.
This subjectivity can lead to conflicting predictions and uncertainty in decision-making.
Late Signals: Technical analysis often gives trading signals after a trend has already started. Traders who rely
solely on technical indicators might enter the market too late, missing out on the initial phase of a trend.
Noise: Short-term market fluctuations, or "noise," can often lead to false signals from technical
indicators, which might mislead traders into making poor decisions.
Not Universally Applicable: Certain assets or markets might not lend themselves well to
technical analysis. For example, markets with low liquidity or new assets without much historical
data might not provide reliable indicators.
Quantitative Only: Technical analysis does not consider qualitative aspects, such as company
management or industry innovation, which could influence an asset's value.
Efficient Market Hypothesis (EMH)Challenge: The EMH suggests that all known information
is already reflected in stock prices, challenging the premise of technical analysis that past price
movements can predict future price movements.
Variability in Time Frames: Different technical analysts may use different time frames for their
charts, which can lead to different conclusions and recommendation seven when looking at the
same data.
 Dow jones theory

Dow Theory (Dow Jones Theory) is a trading approach developed by Charles Dow. Theory
is the basis of technical analysis of financial markets. The basic idea of Dow Theory is that
market price action reflects all available information and the market price movement is
comprised of three main trends.
 Trends of dow

Primary (compared to tide, reaching further and further inland until the ultimate point is
reached).
Secondary (compared to waves and representing corrections in the primary trend, normally
retracing between one-third and two-thirds of the previous trend movement and most
frequently about half of the previous move)
Minor (ripples) (fluctuations in the secondary trend).
 Major trends have three phases

Dow mainly paid attention to the primary (major) trends in which he distinguished three
phases:
Accumulation phase: The most astute investors are entering the market feeling the change
in the current market direction.
Public participation phase: A majority of technicians begin to join in as the price is rapidly
advancing.
Distribution phase: A new direction is now commonly recognized and well hiked;
economic news are all confirming which all ends up in increasing speculative volume and
wide public's participation.
 Dow theory principals

The Averages Discount Everything. Every knowable factor that may possibly affect both
demand and supply is reflected in the market price.
The Market Has Three Trends. According to Dow an uptrend is consistently rising peaks and
troughs. And a downtrend is consistently rising lowering peaks and troughs. Dow believed
that laws of action and reaction apply to the markets just as they do to the physical universe,
meaning that each significant movement is followed by a certain pullback.
 Eliot wave theeory

Eliot Wave Theory, developed by Ralph Nelson Elliott in the 1930s, is a form of technical
analysis that investors use to forecast market trends by identifying extremes in investor
psychology, highs and lows in prices, and other collective factors. As with any investment
strategy, it should be used in conjunction with other forms of analysis and risk management
techniques to make informed decisions in the dynamic world of financial markets.
 charts

Charts are essential tools in technical analysis, providing visual representations of historical
price movements and patterns in financial markets. They help traders and analysts make
informed decisions based on past trends.
 Types of charts

Line Chart: Connects closing prices over a specific period with a line, providing a simple
overview of price movements.
Bar Chart: Represents price information using bars, with each bar indicating the high, low,
open, and close for a given period.
Candlestick Chart: Similar to a bar chart but uses candlesticks, providing visual cues about
the relationship between the open and close prices.
Point and Figure Chart: Uses Xs and Os to represent price movements, filtering out minor
fluctuations to focus on significant price changes.
Renko Chart: Displays price movements in bricks, with each brick representing predefined
price movement.
 Trend patterns

Uptrend: Higher highs and higher lows characterize an uptrend, indicating a bullish market
sentiment.
Downtrend: Lower highs and lower lows signify downtrend, suggesting a bearish sentiment.
Sideways (or Range-bound) Trend: Price movements fluctuate within a horizontal range,
indicating indecision or consolidation.
 Common trend reversal patterns

Head and Shoulders: A bearish reversal pattern with three peaks - a higher peak (head) between two
lower peaks (shoulders).
Inverse Head and Shoulders: A bullish reversal pattern with three troughs - a lower trough (head)
between two higher troughs (shoulders).
Double Top: A bearish reversal pattern with two peaks at approximately the same price level.
Double Bottom: A bullish reversal pattern with two troughs at approximately the same price level.
Triple Top: Similar to a double top but with three peaks.
Triple Bottom: Similar to a double bottom but with three troughs.
Rounding Top (or Bottom):Indicates a gradual shift in trend direction.
Wedge Patterns: Rising or falling wedges suggest potential trend reversals
 Mathematical indicators

Mathematical indicators are tools used by traders and analysts to interpret market data and identify potential trends, reversals,
or trading opportunities. Here are explanations of some commonly used mathematical indicators:
 Moving Averages (MA):
 Moving averages smooth out price data by calculating the average price over a specified period, such as 10, 20, or 50 days.
 Simple Moving Average (SMA) is the arithmetic mean of prices over the chosen period.
 Exponential Moving Average (EMA) gives more weight to recent prices, making it more responsive to recent price changes.
 Moving averages help identify trends by showing the direction of price movement and potential support or resistance levels.
 Rate of Change (ROC):
 Rate of Change measures the percentage change in price over a specified period, typically expressed as a percentage.
 It is calculated as the current price minus the price n periods ago, divided by the price n periods ago, multiplied by 100.
 ROC helps traders identify the momentum of price changes. Positive ROC indicates upward momentum, while negative ROC
indicates downward momentum.
• Relative Strength Index (RSI):
• RSI is a momentum oscillator that measures the speed and change of price movements.
• It oscillates between 0 and 100 and is typically calculated over a 14-period timeframe.
• RSI compares the magnitude of recent gains and losses to determine whether a security is
overbought or oversold. A reading above 70 indicates overbought conditions, while a reading below
30 indicates oversold conditions.
• Market Indicators:
• Market indicators provide broader insights into market sentiment and overall market health.
• Examples include the Advance-Decline Line, which measures the number of advancing stocks
minus the number of declining stocks, and the Volatility Index (VIX), which measures investor
expectations of future market volatility.
• Market indicators help traders gauge the overall direction and strength of the market, as well as
potential turning points or reversals.
 Market efficiency

 Market efficiency refers to the degree to which prices of assets or securities in financial
markets reflect all available information. In an efficient market, prices reflect all
available information accurately and instantaneously, making it difficult for investors to
consistently achieve above-average returns without taking on additional risk.
 Features of an market efficiency

 Quick Price Adjustment: In an efficient market, prices adjust rapidly to new

information as it becomes available. This means that any new information is almost
instantly reflected in asset prices, leaving little opportunity for investors to exploit price
discrepancies.
 Absence of Predictable Patterns: Efficient markets do not exhibit predictable patterns
or trends that investors can consistently exploit to achieve abnormal returns. This
includes patterns identified through technical analysis (e.g., chart patterns) as well as
anomalies identified through fundamental analysis (e.g., undervalued stocks).
 Fair Valuation: Assets in efficient markets are generally priced at their fair value,
reflecting all available information about their intrinsic worth. This implies that there are
no overvalued or undervalued assets persistently available for purchase or sale.
• Low Transaction Costs: Efficient markets tend to have low transaction costs, as
competition among market participants drives down the costs of trading. Low
transaction costs make it easier for investors to buy and sell assets without
significantly impacting prices.
• Active Information Flow: Efficient markets are characterized by a continuous flow
of information, both public and private, that is quickly incorporated into asset prices.
This information flow ensures that market participants have access to the same
information, reducing the possibility of one party having a significant informational
advantage over others.
• Arbitrage Opportunities Quickly Exploited: In an efficient market, any arbitrage
opportunities that arise due to temporary price discrepancies are quickly exploited
by arbitrageurs, leading to price convergence. This process helps to ensure that
prices remain efficient and reflect underlying fundamentals.
• Random Price Movements: Price movements in efficient markets are generally
random and unpredictable in the short term. This randomness makes it difficult for
investors to consistently profit from short-term trading strategies based on price
movements alone.
 Types of market efficiency

 Weak Form Efficiency: In a weak form efficient market, asset prices reflect all past trading information,
such as historical prices and trading volumes. This implies that technical analysis, which relies on historical
price data to predict future price movements, would not be effective in consistently outperforming the
market. However, other forms of analysis, such as fundamental analysis, may still provide opportunities for
investors to achieve abnormal returns.
 Semi-Strong Form Efficiency: In a semi-strong form efficient market, asset prices reflect not only past
trading information but also all publicly available information. This includes information from financial
statements, news releases, economic indicators, and other public sources. In such markets, neither technical
analysis nor fundamental analysis can consistently provide investors with an advantage, as all relevant
information is already reflected in asset prices.
 Strong Form Efficiency: In a strong form efficient market, asset prices reflect all information, whether
public or private. This means that even insider information, which is not available to the general public, is
already incorporated into prices. In such markets, it is virtually impossible for any investor, including
insiders, to consistently outperform the market by trading on private information.
 Behavioral finance

 Behavioral finance is a field of study that combines principles of psychology with

finance to understand how cognitive biases and emotional factors influence financial
decision-making. Unlike traditional finance theories, which assume that investors are
rational and always act in their best interest, behavioral finance recognizes that human
behavior can deviate from rationality and be influenced by psychological factors.
 Behavioral finance function

 Understanding Investor Behavior: One of the primary functions of behavioral finance is to study and understand how individuals and
market participants make financial decisions. By examining the psychological biases, heuristics, and emotional influences that affect
decision-making, behavioral finance seeks to explain why investors sometimes deviate from rationality and how these deviations impact
financial markets.
 Explaining Market Anomalies: Behavioral finance helps to explain market anomalies that cannot be fully accounted for by traditional
finance theories, such as the underreaction or overreaction of stock prices to new information, the existence of momentum and value effects,
and the occurrence of bubbles and crashes. By recognizing the role of psychological factors in driving these anomalies, behavioral finance
provides insights into market dynamics and price movements.
 Improving Investment Strategies: Behavioral finance offers practical implications for investors and financial professionals by highlighting
the importance of understanding and managing behavioral biases. By being aware of common biases such as overconfidence, loss aversion,
and herd behavior, investors can make more informed decisions and develop strategies to mitigate the negative effects of these biases on their
investment performance.
 Enhancing Financial Education: Behavioral finance contributes to financial education by raising awareness about the psychological aspects
of financial decision-making. By educating investors about the common biases and pitfalls that can affect their choices, behavioral finance
empowers individuals to make better-informed decisions and avoid costly mistakes.
 Informing Policy and Regulation: Behavioral finance research can inform policymakers and regulators about the potential implications of
human behavior for financial markets and consumer protection. By understanding how individuals may be susceptible to manipulation or
exploitation due to cognitive biases, policymakers can design regulations and interventions to promote market integrity and investor welfare.
 Behavioral finance types

 Heuristics and Biases: This branch examines the cognitive shortcuts (heuristics) that individuals use to make
decisions and the systematic errors (biases) that can result from these shortcuts. Examples include availability
bias (placing greater importance on information that is readily available) and confirmation bias (seeking out
information that confirms existing beliefs).
 Prospect Theory: Prospect theory, developed by Daniel Kahneman and Amos Tversky, is a foundational
concept in behavioral finance. It describes how individuals evaluate risks and make decisions under uncertainty,
emphasizing the role of reference points, loss aversion, and diminishing sensitivity to gains and losses.
 Market Anomalies: Behavioral finance identifies various market anomalies or patterns that cannot be fully
explained by traditional finance theories. These anomalies include the momentum effect (assets that have
performed well in the past tend to continue performing well) and the value effect (value stocks tend to
outperform growth stocks over time).
 Overconfidence and Self-attribution Bias: This branch focuses on the tendency of individuals to overestimate
their knowledge, skills, and abilities in financial matters. Overconfidence can lead to excessive trading, failure
to diversify portfolios adequately, and other suboptimal investment decisions.
Herding Behavior: Herding behavior refers to the tendency of individuals to follow the actions of the
crowd, even when those actions may not be rational or based on accurate information. Herding can lead
to market bubbles and crashes as investors collectively overreact to news or trends.
Loss Aversion: Loss aversion is the tendency of individuals to prefer avoiding losses over acquiring
equivalent gains. Loss aversion can lead to risk-averse behavior, reluctance to sell losing investments
(due to the pain of realizing a loss), and suboptimal portfolio allocation decisions.
Behavioral Finance and Corporate Finance: This branch examines how behavioral biases influence
corporate decision-making, including capital budgeting, mergers and acquisitions, and corporate
governance. For example, managerial overconfidence may lead to value-destroying acquisitions or
excessive risk-taking.
Neurofinance: Neurofinance combines principles from neuroscience and behavioral finance to study the
neural mechanisms underlying financial decision-making. By using techniques such as brain imaging,
researchers aim to understand how the brain processes financial information and emotions, and how this
affects decision-making.
advantages

 Explains Market Anomalies: Behavioral finance offers insights into market phenomena
that traditional finance theories struggle to explain, such as bubbles, crashes, and persistent
patterns in asset prices. By considering psychological biases and irrational behavior, it
provides a more nuanced understanding of market dynamics.
 Improves Predictive Power: By incorporating psychological factors into financial models,
behavioral finance can enhance the accuracy of predictions about market behavior and
investor responses to various stimuli. Understanding how cognitive biases influence
decision-making allows for more realistic modeling of market outcomes.
 Guides Investment Strategies: Behavioral finance research informs investment strategies
by identifying common biases and psychological tendencies that may lead to suboptimal
decision-making. Investors can develop strategies to mitigate these biases, potentially
improving their investment outcomes.
• Enhances Risk Management: Behavioral finance helps investors and financial professionals
better understand the sources of risk in financial markets, including behavioral biases that may
exacerbate volatility and lead to market inefficiencies. Risk management strategies can be
enhanced to account for human behavior.
• Facilitates Investor Education: Insights from behavioral finance can be used to educate
investors and improve their financial literacy. By understanding common biases and pitfalls,
individuals can make more informed decisions and avoid costly mistakes.
• Informs Policy and Regulation: Policymakers and regulators can use insights from behavioral
finance to design more effective policies and regulations aimed at promoting market stability,
investor protection, and financial inclusion. By considering the behavioral biases of market
participants, policymakers can better anticipate unintended consequences.
• Encourages Interdisciplinary Research: Behavioral finance fosters collaboration between
finance, psychology, economics, and other disciplines, leading to a more holistic understanding
of financial markets and decision-making processes. Integrating insights from multiple fields
allows for the development of comprehensive theories and models.
 Random walk theory

 The Random Walk Theory is a hypothesis about the behavior of stock prices. It suggests
that the movement of stock prices over time is similar to the path of a "random walk,"
where each price change is independent of previous movements and unpredictable. In
other words, the theory implies that future price changes cannot be forecasted based on
past price movements or patterns.
 Efficient market hypothesis theory

 The Efficient Market Hypothesis (EMH) is a theory in financial economics that suggests
that asset prices in financial markets fully reflect all available information. It is based on
the idea that financial markets are efficient in processing information and incorporating it
into asset prices.
 Form of market efficiency

 Weak Form Efficiency: In a weak form efficient market, asset prices reflect all past trading information, such as
historical prices and trading volumes. This implies that all past price movements and patterns are already
incorporated into current prices. Consequently, technical analysis, which relies on historical price data to predict
future price movements, would not be effective in consistently outperforming the market. Essentially, in a weak form
efficient market, investors cannot gain an advantage by analyzing past trading data alone.
 Semi-Strong Form Efficiency: In a semi-strong form efficient market, asset prices reflect all publicly available
information. This includes not only past trading data but also information from financial statements, news releases,
economic indicators, and other public sources. In such markets, neither technical analysis nor fundamental analysis
can consistently provide investors with an advantage. This means that even if investors have access to all public
information, they cannot consistently outperform the market.
 Strong Form Efficiency: In a strong form efficient market, asset prices reflect all information, both public and
private. This means that even insider information, which is not available to the general public, is already
incorporated into prices. In such markets, it is virtually impossible for any investor, including insiders, to consistently
outperform the market. Strong form efficiency represents the highest degree of market efficiency and implies that no
individual or entity can consistently earn abnormal returns, regardless of the information they possess.
 Empirical test for different forms of market
efficiency

 Weak Form Efficiency:

 Random Walk Test: This test examines whether past price movements are independent and unpredictable.
Researchers use statistical tests such as autocorrelation and runs tests to assess the randomness of price changes.
 Filter Rules Test: Researchers apply trading rules based on past price data (e.g., moving averages, trading
bands) to determine whether they can consistently generate abnormal returns. If such rules do not consistently
outperform a buy-and-hold strategy, it suggests weak form efficiency.
 Event Studies: Event studies analyze the impact of new information on stock prices. Researchers examine
whether stock prices react instantaneously to announcements or news events, indicating that the information
was already incorporated into prices.
 Semi-Strong Form Efficiency:
 Market Reaction Tests: Similar to event studies, market reaction tests analyze the impact of new public
information on stock prices. Researchers assess whether prices adjust immediately to new information,
indicating that it was already incorporated into prices.
 Analyst Forecast Studies: Analyst forecast studies examine whether stock prices adjust to new information
contained in analysts' earnings forecasts or recommendations. If stock prices quickly adjust to analyst forecasts,
it suggests semi-strong form efficiency.
Portfolio Tests: Researchers construct portfolios based on publicly available information (e.g., price-to-
earnings ratios, dividend yields) and assess whether these portfolios consistently outperform the market. If no
consistently profitable trading strategy is found, it suggests semi-strong form efficiency.
• Strong Form Efficiency:
Insider Trading Studies: Insider trading studies analyze the trading activity of corporate insiders to determine
whether they earn abnormal returns. If insiders cannot consistently outperform the market, it suggests strong
form efficiency.
Market Microstructure Analysis: Market microstructure analysis examines the behavior of market
participants, including high-frequency traders and market makers, to assess whether they possess private
information that allows them to consistently profit from trading.
Private Information Studies: Private information studies analyze the trading behavior of institutional
investors or other market participants who may have access to non-public information. If these investors cannot
consistently outperform the market, it suggests strong form efficiency.