Technical Analysis [Exam Prep - fill in the blanks]
Capital Market - General Concepts
Capital Market - A segment of the financial market where businesses raise capital by issuing securities.
Financial Market - A broad term encompassing capital markets, money markets, and other financial institutions.
Investment Process - The selection of an asset based on factors like investment objective, risk tolerance, knowledge, and decision-making skills.
Key Features of the Capital Market
Raising Capital - Companies issue financial instruments (e.g., stocks, bonds) to obtain funds.
Risk Consideration - Investors must evaluate the level of risk they are willing to accept.
Hedging Objective - Investments are made for profit but also to hedge against inflation and economic uncertainty.
Knowledge & Skills - Successful investment requires an understanding of financial instruments and market trends.
Investor’s Personality - Decision-making skills and risk tolerance significantly impact investment choices.
Investment Considerations
1. Objective - Why is the investment being made? (e.g., wealth accumulation, retirement, risk hedging).
2. Risk Tolerance - How much risk is the investor willing to take?
3. Market Knowledge - Does the investor understand financial instruments and economic conditions?
4. Decision-Making Style - Some investors are aggressive, while others prefer a conservative approach.
Types of Capital Market Analysis
Technical Analysis - Uses historical price and volume data to predict future trends.
Fundamental Analysis - Assesses a company's financial health through economic indicators and financial statements.
Portfolio Analysis - Focuses on asset diversification to optimize returns and minimize risk.
The Role of Financial Econometrics in Capital Markets
Financial Econometrics - The use of statistical methods to analyze financial data and market trends.
Key Applications:
Rate of Return Analysis - Evaluate price changes and investment performance.
Market Interdependencies - Studies relationships between asset prices and economic factors.
Decision Optimization - Enhances investment decisions by analyzing financial patterns.
Market Liquidity & Risk
Market Liquidity - The ease with which securities can be bought or sold without affecting prices.
High Liquidity - Allows for quick transactions at stable prices (e.g., blue-chip stocks).
Low Liquidity - Makes transactions difficult, often causing price fluctuations (e.g., small-cap stocks).
Risk Considerations -
Excessive Risk Can Lead to Bankruptcy - Investors should avoid overly speculative strategies.
Diversification Helps Reduce Risk - A balanced portfolio minimizes losses from market fluctuations.
Dow Theory - General Principles
Charles Dow - Founder of Dow Theory and the first to introduce stock market indices.
Dow Market Index - A weighted average of selected financial instruments at a given time.
Main Purpose of Dow Theory - To recognize the emergence of bull or bear markets, not to predict their direction.
The Six Key Principles of Dow Theory
1. Averages Discount Everything -
Market prices reflect all available information, including economic and psychological factors.
External events (e.g., natural disasters, interest rate changes) are already factored into stock prices.
2. The Market Has Three Trends -
Primary Trend - Lasts from a year to several years and is the main market movement.
Secondary Trend - A correction lasting from 3 weeks to 3 months.
Minor Trend - Short-term fluctuations lasting less than 3 weeks.
3. Major Trends Have Three Phases -
Accumulation Phase - Informed investors buy stocks at low prices.
Public Participation Phase - Prices rise as general investors join the market.
Distribution Phase - Smart investors sell, prices peak, and a downturn begins.
4. Averages Must Confirm Each Other -
If one index (e.g., Industrial) shows a new trend, another (e.g., Transport) should confirm it.
If indices diverge, the existing trend is expected to continue.
5. Volume Must Confirm the Trend -
Volume should increase in the direction of the main trend.
In an uptrend, higher volume on rising prices confirms strength.
In a downtrend, lower volume on price declines confirms weakness.
6. A Trend is in Effect Until a Definite Reversal Occurs -
A trend remains in force until clear signals indicate a reversal.
Reversals are hard to detect early and require confirmation.
Tools like support & resistance, price patterns, and moving averages help identify reversals.
Additional Dow Theory Concepts
Closing Prices Are Crucial -
Dow focused on closing prices, not intraday fluctuations, to determine trends.
Support and Resistance in Trends -
Support levels act as buying zones in an uptrend.
Resistance levels act as selling zones in a downtrend.
Line (Consolidation) Patterns -
A horizontal movement in prices during market corrections indicates indecision.
Criticism of Dow Theory
Delayed Signals - Buy and sell signals often appear late, causing missed opportunities.
Does Not Specify Individual Stocks - Dow Theory applies to market trends but does not guide which stocks to buy.
Focus on Trend Recognition, Not Prediction - The theory identifies trends but does not forecast their direction.
Types of Charts in Technical Analysis
Line Chart -
The simplest method of illustrating stock prices.
Connects the closing prices of consecutive days.
Provides a general trend but lacks detailed price movements.
Bar Chart -
Displays four price points: opening, closing, high, and low.
Each bar represents one trading session.
The opening price is marked on the left, closing price is on the right.
Candlestick Chart -
Uses the same four price points as the bar chart.
Real Body - Represents the range between the open and close prices.
Wick (Shadow) - Shows the highest and lowest prices of the session.
Green/white candlestick = price increase, Red/black candlestick = price decrease.
Key Chart Patterns
Head and Shoulders -
A reversal pattern indicates a shift from bullish to bearish trends.
Consists of three peaks: a higher middle peak (head) and two lower peaks (shoulders).
A break below the "neckline" confirms the trend reversal.
Double Top -
A bearish reversal pattern is formed by two peaks at the same price level.
Occurs when the price fails to break resistance twice and then declines.
Double Bottom -
A bullish reversal pattern with two low points at the same support level.
Indicates a price rebound after failing to break lower twice.
Triangles -
Ascending Triangle - Bullish continuation pattern with a horizontal resistance line and rising support.
Descending Triangle - Bearish continuation pattern with a horizontal support line and declining resistance.
Symmetrical Triangle - Indicates market indecision and potential breakout in either direction.
Support & Resistance in Chart Analysis
Support Level -
A price level where demand is strong enough to prevent further decline.
Often identified at previous low points on the chart.
Resistance Level -
A price level where selling pressure prevents further price increases.
Found at previous high points on the chart.
Breakout -
When the price moves beyond a support or resistance level, signalling a potential new trend.
False Breakout -
A temporary move beyond support/resistance that quickly reverses.
Trendline Analysis
Trendline -
A straight line connecting important price points to determine the trend direction.
Uptrend Line -
Drawn along successive lows (support levels) to indicate an upward movement.
Downtrend Line -
Drawn along successive highs (resistance levels) to indicate a downward movement.
Breaking a Trendline -
A significant break of a trendline suggests a potential trend reversal.
Price Formations in Charts
Flags and Pennants -
Flags - Small rectangular patterns that slope against the prevailing trend.
Pennants - Small symmetrical triangles that form after strong price movements.
Both indicate a brief consolidation before the trend resumes.
Cup and Handle -
A bullish continuation pattern where the price forms a U-shape followed by a small downward drift (handle).
Wedges -
Rising Wedge - Bearish pattern with an upward-sloping, narrowing price range.
Falling Wedge - Bullish pattern with a downward-sloping, narrowing price range.
Volume & Chart Patterns
High Volume in Breakouts - Confirms the strength of a breakout.
Low Volume in Trends - This may indicate a weak trend or potential reversal.
Volume Divergence - When the price moves in one direction but the volume decreases, signalling possible trend reversal.
Basic Trend Concepts
Trend - The general direction of stock prices over a given period.
Three Types of Trends:
Uptrend - A series of higher highs and higher lows. Strategy: Buy (Long Position).
Downtrend - A series of lower highs and lower lows. Strategy: Sell (Short Position).
Sideways Trend - Horizontal price movement with no clear direction. Strategy: Wait (Stand Aside).
Key Trend Analysis Tools
Support Level - A price level where demand is strong enough to prevent further declines.
Resistance Level - A price level where selling pressure prevents further increases.
Trendlines - Lines drawn on a chart to indicate the general price direction.
Moving Averages - Used to smooth price fluctuations and identify trend direction.
Price Formations - Patterns on charts that signal trend continuation or reversal.
Support and Resistance Concepts
Support Becomes Resistance -
When a support level is broken, it may act as future resistance.
Resistance Becomes Support -
When resistance is broken, it may act as future support.
Breakout - When the price moves beyond a support or resistance level, indicating a new trend.
False Breakout - A temporary movement beyond support/resistance that quickly reverses.
Trend Reversal Signals
Breaking a Trendline - A significant break of a trendline suggests a potential trend reversal.
Support Level Violation - If a stock price falls below an established support level, it may indicate a downtrend.
Resistance Level Violation - If a stock price breaks above resistance, it may indicate an uptrend.
Divergence in Volume and Price - When the price moves in one direction, but volume does not support the movement, a reversal may occur.
Trendline Analysis
Trendline - A straight line connecting important price points to determine trend direction.
Uptrend Line - Drawn along successive lows (support levels) to indicate an upward movement.
Downtrend Line - Drawn along successive highs (resistance levels) to indicate a downward movement.
Trendline Reversal -
A Rising Support Line Becomes Resistance when the price breaks below it.
A Falling Resistance Line Becomes Support when the price breaks above it.
Trendline Strength Factors
Number of Touch Points - The more times a trendline is touched, the stronger it is.
Duration of the Trendline - Longer trendlines are more reliable than short ones.
The angle of the Trendline -
Too steep (sharp rise) - Unstable, likely to break.
Too flat (weak slope) - Not a strong trend.
Ideal trendline - Around a 45-degree angle.
Trendline Break Confirmation
Closing Price Above/Below Trendline - A more reliable signal than an intraday break.
Volume Confirmation - A trendline break with high volume is more valid than a break with low volume.
Filters to Avoid False Signals -
Price filter - Ensuring the price moves significantly beyond the trendline before confirming a break.
Time filter - Waiting a few trading sessions to confirm a trendline break.
Corrections & Adjustments in Trend Analysis
Retracement - A temporary reversal in a prevailing trend before continuing in the original direction.
Adjusting a Trendline - If a trendline is too far from price action, it may need to be redrawn.
Accelerating Trendlines - If an uptrend strengthens, a new steeper trendline may be needed.
Decelerating Trendlines - If momentum weakens, a flatter trendline may be needed.