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Presentation on:

Technical Analysis

Presented By:
Hitesh Punjabi
Technical Indicators
Technical Indicators broadly serve three functions: To alert, to confirm and to predict. Indicator acts as an alert t
o study price action, sometimes it also gives a signal to watch for a break of support. A large positive divergence
can act as an alert to watch for a resistance breakout.
Indicators can be used to confirm other technical analysis tools. Some investors and traders use indicators to pre
dict the direction of future prices.
There are a large number of Technical Indicators that can be used to assist you in selection of stocks and in tracki
ng the right entry and exit points.
In short, indicators indicate, but it doesnt mean that traders should ignore the price action of a stock and focus s
olely on the indicator.
Indicators just filter price action with formulas. As such, they are derivatives and not direct reflections of the pric
e action.
While applying the indicators, the analyst should consider: What is the indicator saying about the price action of
a security? Is the price action getting stronger? Is it getting weaker?
The buy and sell signals generated by the indicators, should be read in context with other technical analysis tools
like candlesticks, trends, patterns etc.

Types of indicators
Indicators can broadly be divided into two types LEADING and LAGGING.
Leading indicators
Leading indicators are designed to lead price movements. Benefits of leading indicators are early signaling for en
try and exit, generating more signals and allow more opportunities to trade.
They represent a form of price momentum over a fixed look-back period, which is the number of periods used to
calculate the indicator. Some of the popular leading indicators include Commodity Channel Index (CCI), Moment
um, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Technical Indicators
Lagging Indicators
Lagging Indicators are the indicators that would follow a trend rather then predicting a reversal. A lagging indicator fo
llows an event.
These indicators work well when prices move in relatively long trends. They dont warn you of upcoming changes in p
rices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly.
These trend following indicators makes you buy and sell late and, in exchange for missing the early opportunities, the
y greatly reduce your risk by keeping you on the right side of the market. Moving averages and the MACD are exampl
es of trend following, or lagging, indicators.
Moving averages
One of the most common and familiar trend-following indicators is the moving averages. They smooth a data series a
nd make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building
blocks for many other technical indicators and overlays.
Trend-following indicator:- Moving averages are used to determine the direction of trend and are basis of many tren
d following systems. Moving averages smooth out a data series and make it easier to identify the direction of the tre
nd. Instead of predicting a change in trend, moving averages follow behind the current trend because past price data
is used to form moving averages, they are considered lagging or trend following. Therefore, you can use moving aver
ages for trend identification and trend following purposes, not for prediction.
The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving A
verage (EMA).
Moving Average
Simple moving average (SMA)
A simple moving average is formed by computing the average (mean) price of a security over a specified number
of periods. It places equal value on every price for the time span selected.
While it is possible to create moving averages from the Open, the High, and the Low data points, most moving av
erages are created using the closing price. For example: a 5-day simple moving average is calculated by adding th
e closing prices for the last 5 days and dividing the total by 5.
Eg:10+11+12+13+14=60
60/5=12
The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curvin
g line - the moving average line. Continuing our example, if the next closing price in the average is 15, then this
new period would be added and the oldest day, which is 10, would be dropped
The new 5-day simple moving average would be calculated as follows:
11+12+13+14+15=65
65/5=13
Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will be subtracted and t
he moving average will continue to move over time.
Exponential moving average (EMA)
Exponential moving average also called as exponentially weighted moving average is calculated by applying more
weight to recent prices relative to older prices.
In order to reduce the lag in simple moving averages, technicians often use exponential moving averages. The we
ighting applied to the most recent price depends on the specified period of the moving average.
The shorter the EMAs period, weight is applied to the most recent price.
Moving Average
The important thing to remember is that the exponential moving average puts more weight on recent prices. As su
ch, it will react quicker to recent price changes than a simple moving average.

Simple versus exponential which one traders should choose


Regardless of the type you choose, the basic principle is that if there is more buying pressure than selling pressure,
prices will move above the average and the market will be in an uptrend.
On the other hand heavy selling pressure will make the prices drop below the moving average, indicating a downtr
end.
The choice of moving average depends on various factors like your trading frequency, investing style and the stock
which has been traded by you.
The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker break
s. Some traders prefer to use exponential moving averages for shorter time periods to capture changes quicker.
Some investors prefer simple moving averages over long time periods to identify long-term trend changes. In additi
on, much will depend on the individual security in question. A 50- day SMA might work great for identifying suppor
t levels in TCS but a 100-day EMA may work better for the Tata Steel.
Moving average type and length of time will depend greatly on the individual security and how it has reacted in th
e past.
Shorter moving averages are very sensitive and generate more signals. The EMA, which is generally more sensitive
than the SMA, will also be likely to generate more signals. But along with it numbers of false signals are also high.
Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable,
but they also may come late.
Thus it requires every investor to experiment on different moving averages lengths and their types to examine the
trade-off between sensitivity and signal reliability.
When to use? Moving Average
Because moving average is a trend following indicator, you should use it when a security is trending. Application
of moving averages would be ineffective when a security moves in a trading range.
With this in mind, investors and traders should first identify securities that display some trending characteristics
before attempting to analyze with moving averages. With a simple visual assessment of the price chart you can d
etermine if a security exhibits characteristics of trend.
Using price chart you can analyse whether a stock is trending up, trending down or trading in a range. When a se
curity forms a series of higher highs and higher lows it is said to be in uptrend. A downtrend is established when
a security forms a series of lower lows and lower highs.
A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading r
ange, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the l
ower boundary is broken.
It is sometimes difficult to determine when a trend will stop and a trading range will begin or when a trading ran
ge will stop and a trend will begin. The basic rules for trends and trading ranges laid out above can be applied.
Moving average Period Selection
Once the security exhibiting the above characteristics is selected the next task is to select the number of moving
average periods and type of moving average. The number of periods in a moving average will depend upon the s
ecuritys volatility, trend and personal preferences.
Shorter length moving averages are more sensitive and identify new trends earlier, but also give more false alar
ms. Longer moving averages are more reliable but less responsive, only picking up the big trends.
There is no predetermined or fixed length of moving averages, but some of the more popular lengths include 21,
50, 89, 150 and 200 days as well as 10, 30 and 40 weeks. Short-term traders may look for evidence of 2-3 week tr
ends with a 21-day moving average, while longer-term investors may look for evidence of 3-4 month trends with
a 40-week moving average.
Moving Average
Exponential moving averages are usually best for short-term situations that require a responsive moving averag
e. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity.

Uses of moving averages


There are many uses for moving averages, but three basic uses stand out:
Trend identification/confirmation
Support and resistance level identification/confirmation
Trading systems
Trend identification/ Confirmation
Moving averages are helpful in keeping you in line with the price trend by providing buy signals shortly after the
market bottoms out and sell signals shortly after it tops, rather than trying to catch the exact bottom or top.
There are three ways to identify the trend with moving averages: direction, location and crossovers.
The first trend identification technique uses the direction of the moving average to determine the trend. The tre
nd is considered up when moving average is continuously rising. If the moving average is declining, the trend is
considered down. The direction of a moving average can be determined simply by looking at a plot of the movin
g average or by applying an indicator to the moving average. In either case, we would not want to act on every s
ubtle change, but rather look at general directional movement and changes.
The second technique for trend identification is price location. The basic trend can be determined through locat
ion of the price relative to the moving average. If the price is located below the moving average then there is a
downward trend in place and visa versa for the price being located above the moving average
The third technique for trend identification is the location of the shorter moving average relative to the longer
moving average. The trend will go up is going up if the shorter moving average is above the longer moving avera
ge. If the shorter moving average is below the longer moving average, the trend is considered down.
Moving Average
Interpretation
Signals to buy or sell are generated when the price crosses the MA or when one MA crosses another, in the case of
multiple MAs. Buy when prices move above the moving average line on the chart and sell when prices drop below t
he moving average line
Another method used by technical analysts is using the two moving averages on the same chart with different time
periods. Since the MA is a lagging indicator, a crossover will usually signal a trend reversal well after a new trend has
begun and is used largely for confirmation.
Generally speaking, the longer the time span covered by an MA, the greater the significance of a crossover signal. F
or example, the crossover of a 100 or 200-day MA is significantly more important then the crossover of a 20-day MA
.
Moving averages differ according to the weight assigned to the most recent data. Simple moving averages apply equ
al weight to all prices. More weight is applied to recent prices in the case of exponential and weighted averages. Var
iable moving averages change the weighting based on the volatility of prices.
When prices fluctuate up and down in a broad sideways pattern for an extended period (trading-range market), lon
ger term MAs are slow to react to reversals in trend, and when prices move sideways in a narrow range shorter term
MAs often produce false signals. Flat and conflicting MAs generally indicate a trading-range market and one to avoid
, unless there is pronounced rounding that suggests a possible new trend.

Signals - moving average price crossover


A price break upwards through an MA is generally a buy signal, and a price break downwards through an MA is gene
rally a sell signal. As we have seen, the longer the time span or period covered by an MA, the greater the significanc
e of a crossover signal.
If the MA is fl at or has already changed direction, its violation is fairly conclusive proof that the previous trend has r
eversed.
Moving Average
Whenever possible try to use a combination of signals. MA crossovers that take place at the same time as tren
d line violations or price pattern signals often provide strong confirmation.

Signals - multiple moving averages


It is usually advantageous to employ more than one moving average.
With two MAs the double crossover is used. When the short term moving average crosses the long term movin
g average to the downside, then a sell signal would be triggered and visa versa. For example, two popular com
binations are the 5 and 20-day averages and the 20 and 100-day averages. The technique of using two average
s together lags the market a bit more than a single moving average but produces fewer whipsaws.

Type of MA Description Methods Used


Crossover of short term throug
Simple Use of multiple MAs can provide good signals h long term
Useful periods Convergence/ Divergence
Short term 10-30 day Crossover of MA by price
Mid term 30-100-day
Long term 100-200+day
An exponential (or exponentially weighted) movin
g average is calculated by applying a percentage of
today's closing price to yesterday's moving average
value. Exponential moving averages place more we Crossover of short term throug
Exponential ight on recent prices h long term
Convergence/ Divergence
Crossover of MA by price
Glance of Moving Average

A moving average is an average of the stock price plotted over a period of time
The moving average smoothes out daily price fluctuations to allow the Technical Analyst to better understand the
trend of the security
Tracks data (usually stock price) as average value over time
Used to smooth out daily fluctuations and focus on underlying trends
Usually calculated over periods ranging from 10 to 200 days

Buy signal is generated when

1. Price crosses above a moving average


2. A shorter term moving average crosses above a longer term moving average

Sell signal is generated when

1. Price crosses below a moving average


2. A shorter term moving average crosses below a longer term moving average

Moving averages can also provide support and resistance in trends


Example of Moving Average
Example of Moving Average
Example of Moving Average

P ri c e
50-D ay Movi ng A verage
200-D ay Movi ng A verage
51

50

49

48

47

46

45

44

43

42

May J un J ul A ug S ep Oc t N ov D ec J an Feb Mar A pr


Example of Moving Average
Example of Moving Average
Example of Moving Average
Example of Moving Average
Oscillators Relative Strength Index (RSI)

Relative Strength Index (RSI)


The RSI is part of a class of indicators called momentum oscillators.
There are a number of indicators that fall in this category, the most common being Relative Strength Index, Stochas
tic, Rate of Change, Williams %R. Although these indicators are all calculated differently.
An oscillator is an indicator that moves back and forth across a reference line or between prescribed upper and low
er limits. When an oscillator reaches a new high, it shows that an uptrend is gaining speed and is likely to continue.
When an oscillator traces a lower peak, it means that the trend has stopped accelerating and a reversal can be exp
ected from there, much like a car slowing down to make a U-Turn.
In the same way watching a stock for impending momentum change can provide a glimpse of what may happen in
the future momentum oscillators, such as RSI are referred to as trend leading indicators.
Application of RSI
RSI is a momentum oscillator generally used in sideways or ranging markets where the price moves between suppo
rt and resistance levels. It is one of the most useful technical tool employed by many traders to measure the velocit
y of directional price movement.
Overbought and Oversold
The RSI is a price-following oscillator that ranges between 0 and 100. Generally, technical analysts use 30% oversol
d and 70% overbought lines to generate the buy and sell signals.
Go long when the indicator moves from below to above the oversold line.
Go short when the indicator moves from above to below the overbought line.
Note here that the direction of crossing is important; the indicator needs to first go past the overbought/oversold li
nes and then cross back through them.
Example of RSI
Example of RSI
Example of RSI
Moving Average Convergence/Divergence (MACD)

MACD stands for Moving Average Convergence / Divergence. It is a technical analysis indicator created by Geral
d Appel in the late 1970s. The MACD indicator is basically a refinement of the two moving averages system and
measures the distance between the two moving average lines.
What is the MACD and how is it calculated?
The MACD does not completely fall into either the trend-leading indicator or trend following indicator; it is in fa
ct a hybrid with elements of both. The MACD comprises two lines, the fast line and the slow or signal line.
These are easy to identify as the slow line will be the smoother of the two
Step1. Calculate a 12 period exponential moving average of the close price.
Step2. Calculate a 26 period exponential moving average of the close price.
Step3. Subtract the 26 period moving average from the 12 period moving average. This is the fast MACD line o
r MACD Line
Step4. Calculate a 9 period exponential moving average of the fast MACD line calculated above. This is the slo
w or Signal MACD line.

MACD benefits
The importance of MACD lies in the fact that it takes into account the aspects of both momentum and trend in
one indicator.
As a trend-following indicator, it will not be wrong for very long. The use of moving averages ensures that the in
dicator will eventually follow the movements of the underlying security. By using exponential moving averages,
as opposed to simple moving averages, some of the lag has been taken out.
As a momentum indicator, MACD has the ability to foreshadow moves in the underlying security. MACD diverge
nces can be key factors in predicting a trend change.
MACD

The set of moving averages used in MACD can be tailored for each individual security. For weekly charts, a faste
r set of moving averages may be appropriate. For volatile stocks, slower moving averages may be needed to hel
p smooth the data. No matter what the characteristics of the underlying security, each individual can set MACD
to suit his or her own trading style, objectives and risk tolerance.

Use of MACD lines


MACD generates signals from three main sources:
Moving average crossover
Centerline crossover
Divergence

Crossover of fast and slow lines


The MACD proves most effective in wide-swinging trading markets. We will first consider the use of the two MA
CD lines. The signals to go long or short are provided by a crossing of the fast and slow lines. The basic MACD tr
ading rules are as follows:
Go long when the fast line( MACD Line) crosses above the slow line or Signal MACD line
Go short when the fast line ( MACD Line) crosses below the slow line or Signal MACD line
These signals are best when they occur some distance above or below the reference line. If the lines remain nea
r the reference line for an extended period as usually occurs in a sideways market, then the signals should be ig
nored.
Example of MACD
Example of MACD
MACD

Center line crossover


A bullish centerline crossover occurs when MACD moves above the zero line and into positive territory. This is a cl
ear indication that momentum has changed from negative to positive or from bearish to bullish. After a positive di
vergence and bullish moving average crossover, the centerline crossover can act as a confirmation signal. Of the th
ree signals, moving average crossover are probably the second most common signals.
A bearish centerline crossover occurs when MACD moves below zero and into negative territory. This is a clear ind
ication that momentum has changed from positive to negative or from bullish to bearish. The centerline crossover
can act as an independent signal, or confirm a prior signal such as a moving average crossover or negative diverge
nce. Once MACD crosses into negative territory, momentum, at least for the short term, has turned bearish.

To Summarize
The MACD is a hybrid trend following and trend leading indicator.
The MACD consists of two lines; a fast line and a slow signal line.
A long position is indicated by a cross of the fast line from below to above the slow line.
A short position is indicated by a cross of the fast line from above to below the slow line.
MACD should be avoided in trading markets
The MACD is useful for determining the presence of divergences with the price data.
Example of MACD
Bollinger Bands

Bollinger bands are trading bands developed by John Bollinger.


It consists of a 20 period simple moving average with upper and lower bands. The upper band is 2 standard deviat
ion above the moving average and similarly lower band is 2 standard deviation below the moving average. This m
akes these bands more dynamic and adaptive to volatility.

Interpretation of Bollinger Bands

1. Big move in price is witnessed on e


ither side when bands tightens/contra
cts as volatility
lessens.

2. The upper band act as area of resi


stance and lower band act as area of
support.

3. When prices move outside the ban


d, it signifies breakout, hence continu
ation of the trend.

4. Bottoms and tops made outside th


e band, followed by tops and bottoms
made inside the band suggests rever
sal of the trend.
Example of Bollinger Bands
Example of Bollinger Bands
Fibonacci Analysis
Fibonacci tools utilize special ratios that naturally occur in nature to help predict points of support or resistance.

Fibonacci numbers are 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc

The main ratio used is .618, this is found by dividing one Fibonacci number into the next in sequence Fibonacci numb
er (55/89=0.618). The logic most often used by Fibonacci based traders is that since Fibonacci numbers occur in
nature and the stock, futures, and currency markets are creations of nature - humans. Therefore, the Fibonacci
sequence should apply to the financial markets.

By identifying a prior down trend and drawing Fibonacci Lines from the absolute high to the absolute low we can pr
oject future levels of support and resistance.

Application of Fibonacci:

1. Used to generate levels of support and resistance


2. Used to generate targets
Fibonacci Analysis
Fibonacci Analysis

Notice after the bottom in th


e S&P 500, that price rallied
to the 23.6% retracement le
vel and then was promptly r
ejected downwards.

After breaking resistance a


few months later, the 23.6%
retracement became suppor
t . Price rallied up to the 50
% retracement level, where i
t ran up against resistance.

Price continued to fluctuate


between the 38.2% retrace
ment level (acting as suppor
t) and the 50% retracement l
evel (acting as resistance).

Note that a trendline was drawn from a significant low (beginning of trend) to a significant high (e
nd of trend); the trading software calculated the retracement levels.
Fibonacci Analysis
Fibonacci Arcs
Fibonacci Arcs are percentage arcs
based on the distance between m
ajor price highs and price lows. Th
erefore, with a major high, major l
ow distance of 100 units, the 31.8
% Fibonacci Arc would be a 31.8 u
nit semi-circle.
As is seen in the chart above, after
the significant bear market, the ral
ly was stopped by the 50% arc; the
50% arc retracement acted as resis
tance. The S&P 500 then used the
38.2% arc as support, bouncing be
tween the 50% arc and the 38.2%
arc for many months.
After price broke through the resis
tance arc at 50%, price moved up t
o the next significant Fibonacci rati
o, 61.8%, where it found a new res
istance level. The prior resistance l
evel at 50%, after being broken, be
came a new support level. The nex
t Fibonacci arc was at 100%, wher
e price met resistance.
Fibonacci Fans

Fibonacci Fans use Fibonacci ratio


s based on time and price to cons
truct support and resistance tren
dlines; also, Fibonacci Fans are us
ed to measure the speed of a tre
nd's movement, higher or lower.
If prices move below a Fibonacci
Fan trendline, then price is usuall
y expected to fall further until the
next Fibonacci Fan trendline level
; therefore, Fibonacci Fan trendlin
es are expected to serve as suppo
rt for uptrending markets .
Likewise, in a downtrend, if price
rises to a Fibonacci Fan trendline,
then that trendline is expected to
act as resistance; if that price is pi
erced, then the next Fibonacci Fa
n trendline higher is expected to
act as resistance.
Dow Theory
Basic Tenents:
1. The Averages Discount Everything
2. The Market has Three Trends
3. Major Trends have Three Phases
4. The Averages must confirm each other
5. Volume must confirm trend
6. A trend is in effect until it gives definite signals that it has reversed

1. The Averages Discount Everything


The market reflects every possible knowable factor that affects overall supply and demand. This is also a bas
ic premise of technical analysis
This theory applies to market averages as well as individual securities.
While markets cannot anticipate events such as earthquakes, they quickly discount such occurrences and as
similate their affects into price action
2. The Market has Three Trends

Dow defined an uptrend as a situation in which each successive rally high closes higher than the previous ral
ly high and each successive rally low closes higher than the previous rally low.
In other words, an uptrend has a pattern of rising peaks and troughs and a downtrend has a pattern of lowe
r peaks and troughs
Three parts to a Dow Theory Trend
1. Primary represents the tide (if it keeps getting higher)
- at least a year
2. Secondary represents the waves that make up the tide
- 3 weeks to 3 months
- usually retrace 1-2 thirds of previous trend movement, or half the previous move
3. Minor represent the ripples on the waves
- less than 3 weeks
Dow Theory
3. Major Trends have Three Phases
Dow focused his analysis mostly on the Major Trends
Accumulation Phase represents informed buying by the most astute investors. They believe all the bad ne
ws has been priced in.
Public Participation Phase Where technical trend followers begin to participate, a time of rapidly increasing
prices and business news improves
Distribution Phase begins when newspapers begin to print increasingly bullish stories, when economic new
s is better than ever, and when speculative volume and public participation increase. The accumulation inv
estors begin to distribute their positions
4. The Averages must confirm each other

The Averages are:


- The Dow Jones Industrial Average
- The Dow Jones Transportation Average (previously the Rail Avg)

No important bull or bear market could take place unless the averages confirmed each other.

Confirmation = If one index makes a new high, so does the other. If one makes a new low, so does the other.
Otherwise there is a divergence in the market place and the prior trend is still intact.
5. Volume must confirm trend

Dow considered volume a secondary indicator


He based his buy and sell signals entirely on closing prices
Simply stated: Volume should expand in the direction of the major trend.
In an uptrend, volume should increase as price rises and decrease as price falls
In a down trend, volume should increase as price falls and decrease as price increases.
Dow Theory

6. A trend is in effect until it gives definite signals that it has reversed

An object in motion remains in motion until acted upon by a strong enough force.

The study of moving averages, support and resistance, price patterns, trend lines, etc are just some of the ind
ications that there may be a strong enough force.
Theory on Dow Theory for Reference

Any attempt to trace the origins of technical analysis would inevitably lead to Dow theory. While more than 100
years old, Dow theory remains the foundation of much of what we know today as technical analysis.

Dow theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 190
0 until the time of his death in 1902.

Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the
economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the
direction of major market trends and the likely direction of individual stocks.

Dow first used his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index (now Transporta
tion Index), which were originally compiled by Dow for The Wall Street Journal. Dow created these indexes becau
se he felt they were an accurate reflection of the business conditions within the economy because they covered t
wo major economic segments: industrial and rail (transportation). While these indexes have changed over the las
t 100 years, the theory still applies to current market indexes.
Theory on Dow Theory for Reference

The Market Discounts Everything


The first basic premise of Dow theory suggests that all information - past, current and even future - is discounted
into the markets and reflected in the prices of stocks and indexes .

That information includes everything from the emotions of investors to inflation and interest-rate data, along wit
h pending earnings announcements to be made by companies after the close. Based on this tenet, the only infor
mation excluded is that which is unknowable, such as a massive earthquake. But even then the risks of such an e
vent are priced into the market.

It's important to note that this is not to suggest that market participants, or even the market itself, are all knowin
g, with the ability to predict future events. Rather, it means that over any period of time, all factors - those that h
ave happened, are expected to happen and could happen - are priced into the market. As things change, such as
market risks, the market adjusts along with the prices, reflecting that new information.

The idea that the market discounts everything is not new to technical traders, as this is a major premise of many
of the tools used in this field of study. Accordingly, in technical analysis one need only look at price movements, a
nd not at other factors such as the balance sheet.

Like mainstream technical analysis, Dow theory is mainly focused on price. However, the two differ in that Dow t
heory is concerned with the movements of the broad markets, rather than specific securities.
For example, a follower of Dow theory will look at the price movement of the major market indexes. Once they h
ave an idea of the prevailing trend in the market, they will make an investment decision. If the prevailing trend is
upward, it follows that an investor would buy individual stocks trading at a fair valuation. This is where a broad u
nderstanding of the fundamental factors that affect a company can be helpful.
Theory on Dow Theory for Reference

The Three-Trend Market


An important part of Dow theory is distinguishing the overall direction of the market. To do this, the theory uses
trend analysis.
First, it's important to note that while the market tends to move in a general direction, or trend, it doesn't do so
in a straight line. The market will rally up to a high (peak) and then sell off to a low (trough), but will generally m
ove in one direction.
Theory on Dow Theory for Reference

An upward trend is broken up into several rallies, where each rally has a high and a low. For a market to be consi
dered in an uptrend, each peak in the rally must reach a higher level than the previous rally's peak, and each lo
w in the rally must be higher than the previous rally's low.
A downward trend is broken up into several sell-offs, in which each sell-off also has a high and a low. To be consi
dered a downtrend in Dow terms, each new low in the sell-off must be lower than the previous sell-off's low an
d the peak in the sell-off must be lower then the peak in the previous sell-off.
Theory on Dow Theory for Reference

Dow theory identifies three trends within the market: primary, secondary and minor. A primary trend is the lar
gest trend lasting for more then a year, while a secondary trend is an intermediate trend that lasts three weeks
to three months and is often associated with a movement against the primary trend. Finally, the minor trend o
ften lasts less than three weeks and is associated with the movements in the intermediate trend.

Primary Trend In Dow theory, the primary trend is the major trend of the market, which makes it the most i
mportant one to determine. This is because the overriding trend is the one that affects the movements in sto
ck prices. The primary trend will also impact the secondary and minor trends within the market.
Dow determined that a primary trend will generally last between one and three years but could vary in some i
nstances.
Theory on Dow Theory for Reference

Regardless of trend length, the primary trend remains in effect until there is a confirmed reversal
For example, if in an uptrend the price closes below the low of a previously established trough, it could be a sig
n that the market is headed lower, and not higher. When reviewing trends, one of the most difficult things to d
etermine is how long the price movement within a primary trend will last before it reverses. The most importa
nt aspect is to identify the direction of this trend and to trade with it, and not against it, until the weight of evi
dence suggests that the primary trend has reversed .

Secondary, or Intermediate, Trend


In Dow theory, a primary trend is the main direction in which the market is moving. Conversely, a secondary tr
end moves in the opposite direction of the primary trend, or as a correction to the primary trend
For example, an upward primary trend will be composed of secondary downward trends. This is the movement
from a consecutively higher high to a consecutively lower high. In a primary downward trend the secondary tre
nd will be an upward move, or a rally. This is the movement from a consecutively lower low to a consecutively
higher low.
Below is an illustration of a secondary trend within a primary uptrend. Notice how the short-term highs (show
n by the horizontal lines) fail to create successively higher peaks, suggesting that a short-term downtrend is pr
esent. Since the retracement does not fall below the October low, traders would use this to confirm the validit
y of the correction within a primary uptrend.
Theory on Dow Theory for Reference

In general, a secondary, or intermediate, trend t


ypically lasts between three weeks and three mo
nths, while the retracement of the secondary tre
nd generally ranges between one-third to two-th
irds of the primary trend's movement. For exam
ple, if the primary upward trend moved the DJIA
from 10,000 to 12,500 (2,500 points), the second
ary trend would be expected to send the DJIA do
wn at least 833 points (one-third of 2,500).

Another important characteristic of a secondary


trend is that its moves are often more volatile th
an those of the primary move.
Theory on Dow Theory for Reference

Minor Trend
The last of the three trend types in Dow theory is the minor trend, which is defined as a market movement las
ting less than three weeks. The minor trend is generally the corrective moves within a secondary move, or tho
se moves that go against the direction of the secondary trend
Theory on Dow Theory for Reference

Due to its short-term nature and the longer-term focus of Dow theory, the minor trend is not of major concern t
o Dow theory followers. But this doesn't mean it is completely irrelevant; the minor trend is watched with the lar
ge picture in mind, as these short-term price movements are a part of both the primary and secondary trends.
Most proponents of Dow theory focus their attention on the primary and secondary trends, as minor trends tend
to include a considerable amount of noise. If too much focus is placed on minor trends, it can to lead to irrational
trading, as traders get distracted by short-term volatility and lose sight of the bigger picture .

The Dow Theory says primary trend have three phases


a. Accumulation Phase
b. Participation Phase
c. Distribution Phase
The Dow Theory says that the accumulation phase is made up of buying by intelligent investor who thinks stock i
s undervalued and expects economic recovery and long term growth. During this phase environment is totally pe
ssimistic and majority of investors are against equities and above all nobody at this time believes that market co
uld rally from here. This is because accumulation phase comes after a significant down move in the market and e
verything appears at its worst. Practically this is the beginning of the new bull market.
The participation phase is characterized by improving fundamentals, rising corporate profits and improving publi
c sentiment. More and more trader participates in the market, sending prices higher. This is the longest phase of
the primary trend during which largest price movement takes place. This is the best phase for the technical trade
r.
The distribution phase is characterized by too much optimism, robust fundamental and above all nobody at this t
ime believes that market could decline. The general public now feels comfortable buying more and more in the
market. It is during this phase that those investors.
Theory on Dow Theory for Reference

who bought during accumulation phase begin to sell in anticipation of a decline in the market. This is time wh
en Technical Analyst should look for reversal in the trend to initiate sell side position in the stock market.
Theory on Dow Theory for Reference
Accumulation phase from April 2003 to June 2003 during which nobody believed that markets could rally but int
elligent investor took buy side positions in the stock market.
Participation phase from July 2003 to January 2004 during which largest and longest price movement occurred.
Distribution phase from February 2004 to May 2004 during which smart money closed buy side positions in the
market.

Fourth Principle: Stock Market Indexes Must Confirm Each Other


Charles H Dow believed that stock market as a whole reflected the overall business condition of the country. In o
ther words stock market as a whole is a benchmark indicator to measure the economic condition of the country.
Dow first used basis of his theory to create two indexes namely (i) Dow Jones Industrial Index and (ii) Dow Jones
Rail Index (now Transportation Index).Dow created these two indexes because those days U.S was a growing ind
ustrial nation and urban centers and production centers were apart. Factories have to transport their goods to ur
ban centers by rail road. Hence these two indexes covered two major economic segments i.e. Industrial and tran
sportation.
Dow felt these two indexes would reflect true business condition within the economy.
According to Dow
(a) Rise in these two indexes reflects that overall business condition of the economy is good .The basic concept b
ehind this is that if production is increasing then transportation of goods to customer should also increase i.e. pe
rformance of companies transporting goods to consumer should improve. According to Dow Theory, two average
s should move in the same direction and rising Industrial Index is not sustainable as long as Transportation Index
is not rising.
Theory on Dow Theory for Reference

(b) The divergence in these two indexes is a warning signal. Under Dow Theory, a reversal from a bull market to
bear market or vice versa is not signaled until and unless both indexes i.e. Industrial Index and Transportation In
dex confirm the same.
In simple words, if one index is confirming a new primary uptrend but another index remains in a primary down
trend, then there is no clear trend.
Basically Dow Theory says that stock market will rise if business conditions are good and stock market would de
cline if business conditions are poor.

Fifth Principle: Volume Must Confirm the Trend


Dow Theory says that trend should be confirmed by the volume. It says volume should increase in the direction
of the primary trend i.e.
If primary trend is down then volume should increase with the market decline.
If primary trend is up then volume should increase with the market rally.
Basically volume is used as a secondary indicator to confirm the price trend and once the trend is confirmed by
volume, one should always remain in the direction of the trend.

Sixth Principle: Trend Remains Intact Until and Unless Clear Reversal Signals Occur
As we are dealing in stock market which is controlled by only one M i.e. Money and this money flows very fast
across borders. Hence stock prices do not move smoothly in a single line, one day its up next day it might be do
wn.
Basically Dow Theory suggests that one should never assume reversal of the trend until and unless clear reversa
l signals are there and one should always trade in the direction of the primary trend.
Theory on Dow Theory for Reference
Significance of Dow Theory
Its Dow Theory which gave birth to concept of higher top-higher bottom formations and lower top-lower bottom f
ormations which is the basic foundation of Technical Analysis. This helps investors to improve their understanding
on the market so that they could succeed in their investment/trading decisions. Most of the technical analysts follo
w this concept and if you go through any technical write up, you would definitely find this concept.
Problems with Dow Theory
a. One misses the large gain due to conservative nature of a trend reversal signal i.e. uptrend would reverse when s
tock prices make lower top-lower bottom formation and downtrend would reverse when stock prices make higher
top-higher bottom formation.
b. Charles Dow considered only two indexes namely Industrial and Transportation which is not major part of the ec
onomy today. Technology and financial services i.e. banking constitutes major part of the economy today. We have
seen in 1998-1999, one sided rally in Nifty led by technology stocks. In this rally none of industrial stock participate
d and if one waited for buy confirmation from Industrial and Transportation indexes then one must have missed th
e classic bull run of technology stocks.
Thank You