Technical Analysis: Meaning and Major Theories

While Fundamental Analysis looks at the "value" of a company, Technical Analysis looks at the "behavior" of the market. It is the study of historical price and volume data to predict future price movements.

1. Meaning of Technical Analysis

Technical Analysis is based on the idea that "History repeats itself." Analysts believe that all information about a company (its profits, management, economic environment) is already reflected in its Stock Price. Therefore, they study price charts instead of financial statements.

The 3 Core Assumptions:

1. The Market discounts everything: Everything that can affect a stock's price—economic, fundamental, or psychological—is already reflected in the price.
2. Price moves in Trends: Prices are more likely to continue a past trend than move randomly.
3. History tends to repeat itself: Human psychology (greed and fear) doesn't change, which creates repeatable patterns on charts.

2. The Dow Theory

Developed by Charles Dow (the father of modern technical analysis), this theory is the foundation of all technical studies.

Key Tenets of Dow Theory:

• The Averages Discount Everything: Just like the individual stock, the overall market index reflects all known information.
• The Market has Three Trends:
  1. Primary Trend: The long-term direction (1 to 3 years). This is the "Tide."
  2. Secondary Trend: The medium-term correction (3 weeks to 3 months). This is the "Wave."
  3. Minor Trend: Short-term day-to-day fluctuations. This is the "Ripple."
• Volume Must Confirm the Trend: In a Bull market, volume should increase when prices rise and decrease when prices fall.

3. Major Trading Theories

A. Elliot Wave Theory

Proposed by Ralph Nelson Elliott, this theory suggests that market movements follow a specific cycle of 5 Waves in the trend direction followed by 3 Corrective Waves.

• Logic: Markets move like a physical wave, pushed by the psychological mood of the crowd.

B. Random Walk Theory

This theory is the "Enemy" of technical analysis. It suggests that stock price changes are random and unpredictable.

• Logic: Since all information is already known, new price changes only happen due to "News" (which is unpredictable). Therefore, technical analysis is "useless" according to this theory.

4. Fundamental vs. Technical Analysis (Revisited)

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Exam Pattern Questions and Answers

Question 1: "Define Technical Analysis and explain its core principles." (6 Marks)

Answer: Technical Analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.

Core Principles:

1. Price Discounts Everything: This means all fundamental information is already included in the current price. There is no need to study balance sheets separately.
2. Price Moves in Trends: Market prices do not move randomly. They follow trends (Upward, Downward, or Sideways). Once a trend is established, it is likely to continue for some time.
3. History Repeats: Because investors are humans, they react to market situations in repetitive ways (e.g., panic selling during a crash). These reactions create patterns on charts that can be identified and used for prediction.

Question 2: "Explain the three types of trends as per the Dow Theory." (6 Marks)

Answer: Charles Dow compared the market trends to the movements of the ocean:

1. Primary Trend (The Tide): This is the most important trend. It lasts for several years and defines whether the market is in a 'Bull' phase (Upward) or a 'Bear' phase (Downward).
2. Secondary/Intermediate Trend (The Waves): These are temporary corrections within the primary trend. For example, in a long-term bull market, prices might fall for 2 months before rising again. This fall is a secondary trend.
3. Minor Trend (The Ripples): These are day-to-day fluctuations in price caused by news or local events. They are considered "market noise" and are generally ignored by serious technical analysts.

Summary

• Technical analysis focuses on Price and Volume.
• Dow Theory is the bedrock of chart analysis.
• Elliot Wave explains the psychological cycles of the market.
• A technical analyst is more interested in "The Trend" than the company's "Value."

Quiz Time! 🎯

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