FUNDAMENTALS OF INVESTMENT

A. TECHNICAL ANALYSIS – MEANING

Technical analysis is a process used to examine and predict the future prices of
securities by looking at things like price movement, charts, trends, trading
volume and other factors.
Technical analysis focuses on trading signals to delineate good investments and
trading opportunities by examining an investment's trends through its trading
data and other statistical elements.
Technical analysis prizes the current or past price of a security as the best
indicator of the future price of that security. Technical analysis relies heavily on
financial charts, data and statistics to uncover an investment's strengths or
possible weaknesses and forecast trends in order to help analysts and investors
decide if a security is viable or not, and for what action

ASSUMPTIONS OF TECHNICAL ANALYSIS

1. Market Discounts Everything

Technical analysts consider fundamental analysis largely unnecessary due to the
fact that many of the things that fundamental analysts examine about a security
or company are already factored in to the price of that security, thereby making
technical analysis more important
2. Prices Are Trend-Driven
Technical analysis involves examining data and chart patterns of historical
prices as well as current ones, as technical analysts believe those prices move in
trends of different lengths like short term, medium term and long term.
3. History tends to repeat itself
Technical analysts maintain that prices move in a cyclical nature over time,
especially when considering market behaviour and human emotions. Looking at
things like alternating bull markets and bear markets, the "history-repeating-
itself" hypothesis makes sense in a broader sense of market psychology.
Because of this assumption, technical analysis frequently looks at chart patterns
to track how the market acts over time and how prices change, using that as a
potential predictor for future price movements.

B. ELLIOT WAVE THEORY

The Elliott Wave Theory was developed by Ralph Nelson Elliott to describe
price movements in financial markets, in which he observed and identified
recurring, fractal wave patterns. Waves can be identified in stock price
movements and in consumer behaviour. Investors trying to profit from a
market trend could be described as "riding a wave."

1. Elliott Wave Theory is a method of technical analysis that looks for

redcurrant long-term price patterns related to persistent changes in investor
sentiment and psychology.

2. The theory identifies waves identified as impulse waves that set up a

pattern and corrective waves that oppose the larger trend.

3. Each set of waves is itself nested within a larger set of waves that adhere to
the same impulse/corrective pattern, described as a fractal approach to
investing.

Elliott Waves Basics

A move in the direction of the trend is considered an “impulsive” move, and will
constitute 5 waves in the primary direction. A count-trend move is considered a
“corrective” move, and constitutes 3 waves, which are counter to the primary
direction.
C. DOW THEORY

The Dow theory is a theory that says the market is in an upward trend if one of
its averages (industrial or transportation) advances above a previous
important high and is accompanied or followed by a similar advance in the
other average.

 The Dow Theory is a technical framework that predicts the market is in

an upward trend if one of its average’s advances above a previous
important high, accompanied or followed by a similar advance in the
other average
 The theory is predicated on the notion that the market discounts
everything in a way consistent with the efficient market’s hypothesis.

 In such a paradigm, different market indices must confirm each other in

terms of price action and volume patterns until trends reverse.

Tenets of Dow Theory

1. The Market Discounts Everything

The Dow theory operates on the efficient markets hypothesis (EMH), which
states that asset prices incorporate all available information. Earnings
potential, competitive advantage, management competence—all of these
factors and more are priced into the market, even if not every individual knows
all or any of these details. In more strict readings of this theory, even future
events are discounted in the form of risk.

2. There Are Three Primary Kinds of Market Trends

Markets experience primary trends which last a year or more, such as a bull or
bear market. Within these broader trends, they experience secondary trends,
often working against the primary trend, such as a pullback within a bull
market or a rally within a bear market; these secondary trends last from three
weeks to three months. Finally, there are minor trends lasting less than three
weeks, which are largely noise.

3.Trends Have Three Phases

The theory says that there are three phases to each primary trend:
Accumulation Phase, Public Participation Phase, Panic Phase.

The beginning of a primary upward (or downward) trend in a bull (or bear)
market is known as the Accumulation phase. Here, traders enter the market to
buy (or sell) stocks against common market opinions.

In the public participation phase, more investors enter the market as business
conditions improve and positive sentiments become evident. This results in
higher (or lower) prices in the market.

The panic phase is marked by excessive buying by investors. This could result
in great speculation. At this stage, it is ideal for investors to book profits and
exit.

4. Indices Must Confirm Each Other

In order for a trend to be established, Dow postulated indices or market

averages must confirm each other. This means that the signals that occur on
one index must match or correspond with the signals on the other. If one
index, such as the Dow Jones Industrial Average, is confirming a new primary
uptrend, but another index remains in a primary downward trend, traders
should not assume that a new trend has begun.

5. Volume Must Confirm the Trend

Volume should increase if the price is moving in the direction of the primary

trend and decrease if it is moving against it. Low volume signals a weakness
in the trend. For example, in a bull market, the volume should increase as the
price is rising, and fall during secondary pullbacks. If in this example the
volume picks up during a pullback, it could be a sign that the trend is reversing
as more market participants turn bearish.

6. Trends Persist Until a Clear Reversal Occurs

Reversals in primary trends can be confused with secondary trends. It is

difficult to determine whether an upswing in a bear market is a reversal or a
short-lived rally to be followed by still lower lows, and the Dow theory
advocates caution, insisting that a possible reversal be confirmed.

D. Techniques of Technical Analysis

Price patterns are identified using a series of lines and/or curves, it is helpful
to understand trendlines and know how to draw them. Trendlines help
technical analysts spot areas of support and resistance on a price chart.
Trendlines are straight lines drawn on a chart by connecting a series of
descending peaks (highs) or ascending troughs (lows). A trendline that is
angled up, or an up trendline, occurs where prices are experiencing higher
highs and higher lows. The up trendline is drawn by connecting the ascending
lows. Conversely, a trendline that is angled down, called a down trendline,
occurs where prices are experiencing lower highs and lower lows.

1. Uptrends occur where prices are making higher highs and higher lows. Up
trendlines connect at least two of the lows and show support levels below
price.

2. Downtrends occur where prices are making lower highs and lower lows.
Down trendlines connect at least two of the highs and indicate resistance
levels above the price.

3. Consolidation, or a sideways market, occurs where price is oscillating

between an upper and lower range, between two parallel and often horizontal
trendlines

Continuation and Reversal Patterns

The reversal patterns are those which indicate a reversal of existing trend.
The continuation patterns suggest that there is only a pause in the market and
the old trend will continue again after the pause.

a) Continuation Patterns
If price continues on its trend, the price pattern is known as a continuation
pattern. Common continuation patterns include:

Pennants

Pennants are drawn with two trendlines that eventually converge. A key
characteristic of pennants is that the trendlines move in two directions- one
will be a down trendline and the other an up trendline. Often, volume will
decrease during the formation of the pennant, followed by an increase when
price eventually breaks out

Flags

Flags are constructed using two parallel trendlines that can slope up, down or
sideways (horizontal). In general, a flag that has an upward slope appears as
a pause in a down trending market; a flag with a downward bias shows a
break during an up-trending market. Typically, the formation of the flag is
accompanied by a period of declining volume, which recovers as price breaks
out of the flag formation
Triangle

Triangles are among the most popular chart patterns used in technical
analysis since they occur frequently compared to other patterns. The three
most common types of triangles are symmetrical triangles, ascending
triangles, and descending triangles. These chart patterns can last anywhere
from a couple weeks to several months.

Cup and Handles

The cup and handle is a bullish continuation pattern where an upward trend
has paused, but will continue when the pattern is confirmed. The "cup" portion
of the pattern should be a "U" shape that resembles the rounding of a bowl
rather than a "V" shape with equal highs on both sides of the cup. The
"handle" forms on the right side of the cup in the form of a short pullback that
resembles a flag or pennant chart pattern. Once the handle is complete, the
stock may breakout to new highs and resume its trend higher.
b) Reversal Patterns
A price pattern that signals a change in the prevailing trend is known as a
reversal pattern. These patterns signify periods where either the bulls or the
bears have run out of steam. The established trend will pause and then head
in a new direction as new energy emerges from the other side (bull or bear)
When price reverses after a pause, the price pattern is known as a reversal
pattern. Examples of common reversal patterns include:

Head and Shoulders

Head and shoulders patterns can appear at market tops or bottoms as a

series of three pushes: an initial peak or trough, followed by a second and
larger one and then a third push that mimics the first. An uptrend that is
interrupted by a head and shoulders top pattern may experience a trend
reversal, resulting in a downtrend. Conversely, a downtrend that results in a
head and shoulders bottom will likely experience a trend reversal to the
upside. Horizontal or slightly sloped trendlines can be drawn connecting the
peaks and troughs that appear between the head and shoulders. Volume may
decline as the pattern develops and spring back once price breaks above (in
the case of a head and shoulders bottom) or below (in the case of a head and
shoulders top) the trendline.
Double tops and bottoms

Double tops and bottoms signal areas where the market has made two
unsuccessful attempts to break through a support or resistance level. In the
case of a double top, which often looks like the letter M, an initial push up to a
resistance level is followed by a second failed attempt, resulting in a trend
reversal. A double bottom, on the other hand, looks like the letter W and
occurs when price tries to push through a support level, is denied, and makes
a second unsuccessful attempt to breach the support level. This often results
in a trend reversal.

Triple tops and bottoms

Triple tops and bottoms are reversal patterns that aren’t as prevalent as head
and shoulders or double tops or double bottoms. But they act in a similar
fashion and can be a powerful trading signal for a trend reversal. The patterns
are formed when a price tests the same support or resistance level three
times and is unable to break through.
Charts
a) Line Charts
Line charts are the most basic form of charts, they are composed of a single
line from left to right that links the closing prices. Generally, only the closing
price is graphed, presented by a single point. This is a popular type of chart
used in presentations and reports to give a very general view of the historical
and current direction.

b) Bar Chart
Bar charts enable traders to discover patterns more easily as they take into
account all the prices, open, high, low and close. The opening price is the
horizontal dash on the left side of the horizontal line and the closing price is
located on the right side of the line. If the opening price is lower than the
closing price, the line is often coloured black (or green) to represent a rising
period. The opposite is true for a falling period, which is represented by a red
colour.
c) Candlestick Chart
Another kind of chart used in the technical analysis is the candlestick chart, so
called because the main component of the chart which represents prices looks
like a candlestick, with a thick ‘body’ and usually, a line extending above and
below it, called the upper shadow and lower shadow, respectively.

The top of the upper shadow represents the high price, while the bottom of the
lower shadow shows the low price. Patterns are formed both by the real body
and the shadows. Candlestick patterns are most useful over short periods of
time, and mostly have significance at the top of an uptrend or the bottom of a
downtrend, when the patterns most often indicate a reversal of the trend.

The wider part of the candlestick is shown between the opening and closing
price. It is usually coloured in black/red when the security closes on a lower
price and white/green the other way around.

The thinner parts of the candlestick are commonly referred to as the

upper/lower wicks or as shadows. These show us the highest and/or lowest
prices during that timeframe, compared to the closing as well as opening
price.

The relationship between the bodies of candlesticks is important to candlestick

patterns. Candlestick charts make it easy to spot gaps between bodies.

A slight drawback of the candlestick chart is that candlesticks take up more

space than OHLC bars. In most charting platforms, the most you can display
with a candlestick chart is less than what you can with a bar chart.
d) Point and Figure Charts
Point-and-figure is not very well known or used by the average investor, but
they have a long history of use dating back to the first technical traders. These
simple charts only focus on the significant price moves, while filtering out
‘noise’.

Point & Figure charts consist of columns of X’s and O’s that represent filtered
price movements. X-Columns represent rising prices and O-Columns
represent falling prices. Each price box represents a specific value that price
must reach to warrant an X or an O. Time is not a factor in P&F charting. No
movement in price means no change in the P&F chart.

There are many varied ways to mark P&F charts from using just the close or
the highs and lows. The box size can be set to be a fixed value or a set %.
The construction of point-and-figure charts simplifies the drawing of trend
lines, and support and resistance levels, which is why point-and-figure charts
are ideal for detecting trends, and determining support and resistance levels.

Support and resistance

Support is the price level at which demand is thought to be strong enough to
prevent the price from declining further. The logic dictates that as the price
declines towards support and gets cheaper, buyers become more inclined to
buy and sellers become less inclined to sell.

Resistance is the price level at which selling is thought to be strong enough to

prevent the price from rising further. The logic dictates that as the price
advances towards resistance, sellers become more inclined to sell and buyers
become less inclined to buy.
Moving averages
It refers to average level of closing prices, calculated on regular basis. A
sequence of averages is calculated by calculating averages on daily basis.

Relative Strength Index

RSI The relative strength index (RSI) is a momentum indicator that measures
the magnitude of recent price changes to evaluate overbought or oversold
conditions in the price of a stock or other asset. The RSI is displayed as an
oscillator (a line graph that moves between two extremes) and can have a
reading from 0 to 100. The indicator was originally developed by J. Welles
Wilder Jr. and introduced in his seminal 1978 book, New Concepts in
Technical Trading Systems.
Traditional interpretation and usage of the RSI are that values of 70 or above
indicate that a security is becoming overbought or overvalued and may be
primed for a trend reversal or corrective pullback in price. An RSI reading of
30 or below indicates an oversold or undervalued condition.

RSI = 100 - 100/(1 + rs*)

Where RS = average of x days' up closes / average of x days' down closes.

E. Difference between technical analysis

and Fundamental analysis