Technical Analysis [Exam Prep - questions]

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:

1. Uptrend - A series of higher highs and higher lows. Strategy: Buy (Long Position).

2. Downtrend - A series of lower highs and lower lows. Strategy: Sell (Short Position).

3. 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.