Unit III Capital Market & Asset Pricing (6 Hrs)

Technical Analysis: Dow Theory, Support and Resistance level, Type of charts &
its interpretations, Trend line, Gap Wave Theory, Relative strength analysis,
Technical Versus Fundamental analysis. Nature of Stock Markets: EMH (Efficient
Market Hypothesis) and its implications for investment decision. Capital market
theorem, CAPM (Capital Asset Pricing Model) and Arbitrage Pricing Theory. Case
Studies.

TECHNICAL ANALYSIS

Technical analysis is a method of evaluating and forecasting financial markets and asset
prices by analyzing historical price and volume data, as well as various chart patterns and
indicators. It is primarily used by traders and investors to make trading decisions.

Assumption in Technical Analysis

Unlike fundamental analysts, technical analysts don’t worry about the company’s valuation. The
only thing that matters is the stock’s historical trading data (price and volume) and the insights the
past data provides about the future movement in stock price.

Technical Analysis is based on a few key assumptions which are as follows:-

1) Markets discount everything – This assumption tells us that all known and unknown
information in the public domain is reflected in the latest stock price. For example, an insider could
buy the company’s stock in large quantities in anticipation of a good quarterly earnings
announcement. While the insider does this secretively, the price reacts, revealing to the technical
analyst that something is about to happen in the stock price.

2) The ‘how’ is more important than the ‘why’ – This is an extension of the first assumption.
Going with the same example discussed above – the technical analyst would not be interested in
questioning why the insider bought the stock as long as the technical analyst knows how the price
reacted to the insider’s action.

3) Price moves in trend – All major moves in the market are an outcome of a trend. The concept
of trend is the foundation of technical analysis. For example, the recent upward movement in the
NIFTY 50 Index to 18500 from 14750 did not happen overnight. This move happened in a phased
manner in over 11 months. Another way to look at it is that once the trend is established, the price
moves in the direction of the trend.

4) History tends to repeat itself – In the technical analysis context, the price trend tends to repeat
itself. This happens because the market participants consistently react to price movements in
remarkably similar ways every time the price moves in a certain direction. For example, in an
uptrend, market participants get greedy and want to buy irrespective of the high price. Likewise,
market participants want to sell in a downtrend irrespective of the low and unattractive prices. This
human reaction has been the same towards stock prices over time, ensuring that history repeats
itself.

Dow Theory
Dow Theory is a fundamental concept in technical analysis used to understand and analyze
the movement of stock market indices. It was developed by Charles Dow, the co-founder
of Dow Jones & Company, in the late 19th century. Dow Theory is based on a set of
principles that help investors and traders make sense of market trends and anticipate future
movements. The theory has three primary components: the Dow Theory tenets, the Dow
Theory signals, and the Dow Theory principles.

Dow Theory Tenets:

1. The Market Discounts Everything: This tenet suggests that all information, whether
public or private, is already reflected in the current market price of a security. This means
that future events are influenced by the ongoing supply and demand for a particular asset.

2. Markets Have Three Trends: Dow Theory asserts that markets move in three primary
trends:

a. The Primary Trend: The main trend, which can last for a year or more and is usually
bullish (upward) or bearish (downward).

b. The Secondary Trend: These are corrective movements within the primary trend
and typically last from a few weeks to a few months.

c. The Minor Trends: Short-term fluctuations that can last a few hours to a few days.
 3. Trends Have Three Phases: A primary trend is comprised of three phases: accumulation,
public participation, and distribution. These phases reflect changes in investor sentiment
and activity during a trend.

The different phases of Market

Dow Theory suggests the markets are made up of three distinct phases, which are self-repeating.
These are called the Accumulation phase, the markup phase, and the Distribution phase.
The Accumulation phase usually occurs right after a steep sell-off in the market. The steep sell-off
in the markets would have frustrated many market participants, losing hope of any sort of uptrend
in prices. The stock prices would have plummeted to rock bottom valuations, but the buyers would
still be hesitant to buy fearing there could be another sell-off. Hence the stock price languishes at
low levels. This is when the ‘Smart Money’ enters the market.
Smart money is usually the institutional investors who invest from a long-term perspective. They
invariably seek value investments that are available after a steep sell-off. Institutional investors
start to acquire shares regularly, in large quantities over an extended period. This is what makes
up an accumulation phase.
This also means that the sellers who are trying to sell during the accumulation phase will easily
find buyers, and therefore the prices do not decline further. Hence invariably the accumulation
phase marks the bottom of the markets. More often than not, this is how the support levels are
created. The accumulation phase can last up to several months.
Once the institutional investors (smart money) absorb all the available stocks, short-term traders
sense the occurrence of a support. This usually coincides with improved business sentiment. These
factors tend to take the stock price higher. This is called the markup phase. During the markup
phase, the stock price rallies quickly and sharply. The most important feature of the markup phase
is the speed.
Because the rally is quick, the public at large is left out of the rally. New investors are mesmerized
by the return and everyone from the analysts to the public sees higher levels ahead.
Finally, when the stock price reaches new highs (52-week high, all-time high) everyone around
would be talking about the stock market. The news reports turn optimistic, the business
environment suddenly appears vibrant, and everyone (the public) wants to invest in the markets.
The public, by and large, wants to get involved in the markets as there is a positive sentiment. This
is when the distribution phase occurs.
The judicious investors (smart investors) who got in early (during the accumulation phase) will
start offloading their shares slowly. The public will absorb all the volumes offloaded by the
institutional investors (smart money) thereby giving them the well-needed price support. The
distribution phase has similar price properties as that of the accumulation phase. In the distribution
phase, whenever the prices attempt to go higher, the smart money offloads their holdings. Over
some time, this action repeats several times and thus the resistance level is created.
Finally, when the institutional investors (smart money) completely sell off their holdings, there
would be no further support for prices, and hence what follows after the distribution phase is a
complete sell-off in the markets, also known as the markdown of prices. The selloff in the market
leaves the public in an utter state of frustration.
Completing the circle, what follows the selloff phase is a fresh round of accumulation phase, and
the whole cycle repeats. It is believed that the entire cycle from the accumulation phase to the
selloff spans over a few years.
It is important to note that no two market cycles are the same. For example, in the Indian context,
the bull market of 2006 – 07 is very different from the bull market of 2013-14. Sometimes the
market moves from the accumulation to the distribution phase over a prolonged multi-year period.
On the other hand, the same move from the accumulation to the distribution can happen over a few
months. The market participant needs to tune himself to the idea of evaluating markets in the
context of different phases, as this sets the stage for developing a view of the market.
 Dow Theory Principles

Dow Theory includes several key principles, such as trends persist until they reverse, the
market averages must confirm each other, and volume should confirm the trend. The theory
emphasizes the importance of studying market behavior over time and avoiding making
hasty investment decisions based on short-term fluctuations.

Example: Suppose an investor is analyzing the stock market using the Dow Theory. They
observe the following:

• The DJIA has been in a primary uptrend for over a year, making higher highs and higher
lows.

• The DJTA is also in an uptrend, confirming the bullish trend in the DJIA.

• Volume has been increasing as the market advances, suggesting strong participation by
investors.

Based on these observations, the investor would conclude that the market is in a confirmed
primary bullish trend. This information can guide their investment decisions, indicating
that it may be a good time to buy or hold onto investments.

The Dow Patterns

1. The Double bottom & Double top formation
2. The Triple Bottom & Triple Top
3. Range formation, and
4. Flag formation

The Double bottom and top formation

A double bottom formation is considered bullish.
The triple top and bottom
A triple formation is similar to a double formation, except that the price level is tested thrice as
opposed twice in a double bottom.

Trading Range
The concept of range is a natural extension to the double and triple formation. In a range, the stock
attempts to hit the same upper and lower price level multiple times for an extended period of time.
This is also referred to as the sideways market. As the price oscillates in a narrow range without
forming a particular trend, it is called a sideways market or sideways drift. So, when both the
buyers and sellers are not confident about the market direction, the price would typically move in
a range, and hence typical long term investors would find the markets a bit frustrating during this
period.
However, the range provides multiple opportunities to trade both ways (long and short) with
reasonable accuracy for a short term trader. The upside is capped by resistance and the downside
by the support. Thus it is known as a range bound market or a trading market as there are enough
opportunities for both the buyers and the sellers.

The range breakout

Stocks do breakout of the range after being in the range for a long time. The direction in which the
stock will breakout depends on the nature of the trigger or the outcome of the event. A trader will
take a long position when the stock price breaks the resistance levels and will go short after the
stock price breaks the support level.
The stock attempted to breakout of the range three times, however the first two attempts were false
breakouts. The first 1st breakout (starting from left) was characterized by low volumes, and low
momentum. The 2nd breakout was characterized by impressive volumes but lacked momentum.
However the 3rd breakout had the classic breakout attributes i.e high volumes and high
momentum.
The Flag formation
The flag formation usually takes place when the stock posts a sustained rally with almost a vertical
or a steep increase in stock prices. Flag patterns are marked by a big move which is followed by a
short correction. In the correction phase, the price would generally move within two parallel lines.
Flag pattern takes the shape of a parallelogram or a rectangle and they have the appearance of a
flag on the pole.
The price decline can last anywhere between 5 and 15 trading session.
With these two events (i.e price rally, and price decline) occurring consecutively a
flag formation is formed. When a flag forms, the stock invariably spurts back all of a
sudden and continues to rally upwards.

Support and Resistance level

Support is a price level where a stock or market tends to stop falling and may even bounce
back up. Resistance is a price level where an asset tends to stop rising. For example:
Imagine a stock's price has consistently bounced off a support level at $50 over several
months. Traders may use this information to make buy orders near $50, anticipating a
rebound.

The best way to identify the target price is to identify the support and the resistance
points.
The resistance level is always above the current market price. The resistance often acts as a
trigger to sell.

The support level is always below the current market price.

VOLUMES
Volume plays a very integral role in technical analysis as it helps us to confirm trends and patterns.
Consider volumes as means to gain insights into how other participants perceive the market.
 Type of charts & its interpretations

1. Line chart

2. Bar Chart

3. Japanese Candlestick

The Line and Bar chart

A line chart is formed by plotting a stock’s closing prices.

If we are looking at 60-day data, then the line chart is formed by connecting the closing prices’
dots for 60 days.
Bar chart – It shows all four price variables: open, high, low, and close.

example, assume the OHLC data for a stock as follows:

Open – 65
High – 70
Low – 60
Close – 68

For the above data, the bar chart would look like this:

If (close > open), it means a positive day for the markets. For example consider this: O = 46, H =
51, L = 45, C = 49. To indicate it is a bullish day, the bar is represented in blue colour.
 Likewise, if (close <open), it means a negative day for markets. For example consider this: O =
74, H=76, L=70, C=71. To indicate it is a bearish day, the bar is represented in red colour.

While the bar chart displays all the four data points, it still lacks a visual appeal. This is probably
the biggest disadvantage of a bar chart. It becomes tough to spot potential patterns brewing when
one is looking at a bar chart. The complexity increases when a trader has to analyze multiple charts
during the day.

Japanese Candlestick

In a candlestick chart, candles can be classified as a bullish or bearish candle usually represented
by blue and red candles. Let us look at the bullish candle.

The Central real body – The real body, rectangular connects the opening and closing price.

1. Upper shadow – Connects the high point to the close.

2. Lower Shadow – Connects the low point to the open.

This is best understood with an example. Let us assume the prices as follows.

Open = 62
High = 70
Low = 58
Close = 67

This is how a bearish candle would look like:

This is best understood with an example. Let us assume the prices as follows.

Open = 456
High = 470
Low = 420
Close = 435
 To sum up, candlesticks are easier to interpret in comparison to the bar chart.

One of the popular time frames that technical analysts use are:

• Monthly Charts

• Weekly charts

• Daily or End of day charts

• Intraday charts – 30 Mins, 15 mins and 5 minutes

One can customize the time frame as per their requirement. For example, a high-frequency trader
may want to use a 1-minute chart instead of any other time frame.

Candlestick pattern
The candlesticks are used to identify trading patterns. Candlesticks can be broken down into single
candlestick patterns and multiple candlestick patterns.
Under the single candlestick pattern we will be learning the following…
1. Marubozu
1. Bullish Marubozu
2. Bearish Marubozu
2. Doji
3. Spinning Tops
4. Paper umbrella
1. Hammer
2. Hanging man
5. Shooting star
Multiple candlestick patterns are a combination of multiple candles. Under the
multiple candlestick patterns we will learn the following:
1. Engulfing pattern
1. Bullish Engulfing
2. Bearish Engulfing
2. Harami
1. Bullish Harami
2. Bearish Harami
3. Piercing Pattern
4. Dark cloud cover

5. Morning Star
6. Evening Star

Few assumptions specific to candlesticks

o Buy strength and sell weakness – Strength is represented by a bullish (blue)
candle and weakness by a bearish (red) candle. Hence whenever you are buying
ensure it is a blue candle day and whenever you are selling, ensure it’s a red candle
day.
o Be flexible with patterns (quantify and verify) – While the text book definition of
a pattern could state a certain criteria, there could be minor variations to the
pattern owing to market conditions. So one needs to be a bit flexible. However one
needs to be flexible within limits, and hence it is required to always quantify the
flexibility.
o Look for a prior trend – If you are looking at a bullish pattern, the prior trend
should be bearish and likewise if you are looking for a bearish pattern, the prior
trend should be bullish.

SINGLE CANDLESTICK PATTERN

A single candlestick pattern is formed by just one candle. So, the trading signal is generated based
on 1 day’s trading action. One needs to pay some attention to the length of the candle while trading
based on candlestick patterns. The length signifies the range for the day. In general, the longer the
candle, the more intense is the buying or selling activity. If the candles are short, it can be
concluded that the trading action was unresponsive.
The Marubozu
The Marubozu is a single candlestick pattern. There are two types of marubozu – the bullish
marubozu and the bearish marubozu.

The red candle represents the bearish marubuzo and the blue represents the
bullish marubuzo.
Bullish Marubuzo
When Open = Low and High = close, a bullish marubuzo is formed. It does not matter what the
prior trend has been, the action on the marubuzo day suggests that the sentiment has changed and
the stock in now bullish.
As per the text book definition of a marubozu Open = Low, and High
= Close. However in reality there is a minor variation to this definition. This is
where the 2nd rule applies – Be flexible, Quantify and Verify.
The risk taker would buy the stock on the same day as the marubozu is being
formed. However the trader needs to validate the occurrence of a marubozu.
Validating is quite simple. Indian markets close at 3:30 PM. So, around 3:20 PM one
needs to check if the current market price (CMP) is approximately equal to the
high price for the day, and the opening price of the day is approximately equal
to the low price the day. If this condition is satisfied, then you know the day is
forming a marubozu and therefore you can buy the stock around the closing price.
It is also very important to note that the risk taker is buying on a bullish/blue candle
day, thereby following rule 1 i.e buy on strength and sell on weakness.
The risk averse trader would buy the stock on the next day i.e the day after the
pattern has been formed. However before buying the trader needs to ensure that
the day is a bullish day to comply with the rule number 1. This means the risk averse
buyer can buy the stock only around the close of the day. The disadvantage of
buying the next day is that the buy price is way above the suggested buy price.
The trade trap

One should avoid trading on candles that are either too short or too long. A small candle indicates
subdued trading activity and hence it would be difficult to identify the direction of the trade. On
the other hand a long candle indicates extreme activity.

The Spinning Top

Unlike the Marubuzo, it does not give the trader a trading signal with specific entry or an exit
point. However the spinning top gives out useful information with regard to the current situation
in the
market.

It just conveys indecision as both bulls and bears were not able to influence the markets. The
spinning top candle shows confusion and indecision in the market with an equal probability of
reversal or continuation.
The Dojis
The Doji’s are very similar to the spinning tops, except that it does not have a real body at all. This
means the open and close prices are equal.

The classic definition of a doji suggests that the open price should be equal to theclose price with
virtually a non existant real body. The upper and lower wicks can be of any length. However
keeping in mind the 2nd rule i.e ‘be flexible, verify and quantify’ even if there is a wafer thin body,
the candle can be considered as a doji. The dojis and spinning tops appear in a cluster indicating
indecision in the market.

Paper Umbrella
The paper umbrella is a single candlestick pattern which helps traders in setting up directional
trades. The interpretation of the paper umbrella changes based on where it appears on the chart.
A paper umbrella consists of two trend reversal patterns namely the hanging man and the hammer.
The hanging man pattern is bearish and the hammer pattern is relatively bullish. A paper umbrella
is characterized by a long lower shadow with a small upper body.
If the paper umbrella appears at the bottom end of a downward rally, it is called the ‘Hammer’.
If the paper umbrella appears at the top end of an uptrend rally, it is called the ‘Hanging man’.
To qualify a candle as a paper umbrella, the length of the lower shadow should be at least twice
the length of the real body.

Notice the blue hammer has a very tiny upper shadow, which is acceptable considering the “Be
flexible – quantify and verify” rule. A hammer can be of any color as it does not really matter as
long as it qualifies ‘the shadow to real body’ ratio. However, it is slightly more comforting to see
a blue
colored real body.The prior trend for the hammer should be a down trend.
The Hanging man

If a paper umbrella appears at the top end of a trend, it is called a Hanging man. The hanging man
is classified as a hanging man only if is preceded by an uptrend. Since the hanging man is seen
after a high, the bearish hanging man pattern signals selling pressure.
A hanging man can be of any color and it does not really matter as long as it qualifies ‘the shadow
to real body’ ratio. The prior trend for the hanging man should be an uptrend.

The shooting star

The shooting star looks just like an inverted paper umbrella.

The shooting star is a bearish pattern; hence the prior trend should be bullish.

Multiple Candlestick Patterns

The Engulfing Pattern

The engulfing pattern needs 2 trading sessions to evolve. In a typical engulfing pattern, you will
find a small candle on day 1 and a relatively long candle on day 2 which appears as if it engulfs
the candle on day 1. If the engulfing pattern appears at the bottom of the trend, it is called the
“Bullish Engulfing” pattern. If the engulfing pattern appears at the top end of the trend, it is called
the “Bearish Engulfing” pattern.
The Bullish Engulfing Pattern
1.The market is in down trend with prices steadily moving down
2. On the first day of the pattern (P1), the market opens low and makes a new low.
This forms a red candle in the process
3. On the second day of the pattern (P2), the stock opens near the closing prices of P1,
and attempts to make a new low. However, at this low point of the day there is a
sudden buying interest, which drives the prices to close higher than the previous
day’s open. This price action forms a blue candle
4. The price action on P2 also suggests that bulls made a very sudden and strong
attempt to break the bearish trend and they did so quite successfully. This is evident
by the long blue candle on P2

The bearish engulfing pattern

1. On P1, as expected the market moves up and makes a new high, reconfirming a
bullish trend in the market
2. On P2, as expected the market opens higher and attempts to make a new high.
However at this high point selling pressure starts. This selling comes unexpected
and hence tends to displace the bulls
4. The sellers push the prices lower, so much so that the stock closes below the
previous day’s (P1) open. This creates nervousness amongst the bulls
5. The strong sell on P2 indicates that the bears may have successfully broken down
the bull’s stronghold and the market may continue to witness selling pressure over
the next few days.
The Piercing Pattern
The piercing pattern is very similar to the bullish engulfing pattern with a very minor
variation. In a bullish engulfing pattern the P2’s blue candle engulfs P1’s red candle
completely. However in a piercing pattern P2’s blue candle partially engulfs P1’s red
candle, however the engulfing should be between 50% and less than 100%.

The Dark Cloud Cover

The dark cloud cover is very similar to the bearish engulfing pattern with a minor
variation. In a bearish engulfing pattern the red candle on P2 engulfs P1’s blue
candle completely. However in a dark cloud cover, the red candle on P2 engulfs
about 50 to 100% of P1’s blue candle.
The Harami Pattern
It is old Japanese word for ‘pregnant’.
The Bullish Harami
The bullish harami is a bullish pattern appearing at the bottom end of the chart. The bullish harami
pattern evolves over a two day period,similar to the engulfing pattern.
1. On day 1 of the pattern (P1) a red candle with a new low is formed, reinforcing the
bear’s position in the market
2. On day 2 of the pattern (P2) the market opens at a price higher than the previous
day’s close. On seeing a high opening price the bears panic ,as they would have
otherwise expected a lower opening price
3. The market gains strength on P2 and manages to close on a positive note, thus
forming a blue candle. However P2’s closing price is just below the previous days
(P1) open price
4. The price action on P2 creates a small blue candle which appears contained
(pregnant) within P1’s long red candle.

Bearish harami

Gap up opening – A gap up opening indicates buyer’s enthusiasm. Buyers are willing to buy
stocks at a price higher than the previous day’s close. Hence, because of enthusiastic buyer’s
outlook, the stock (or the index) opens directly above the previous day’s close.
Gap down opening

The Morning Star

It is a downtrend reversal pattern. The pattern is formed by combining 3 consecutive candlesticks.

1. On day 1 of the pattern (P1), as expected the market makes a new low and forms a
long red candle. The large red candle shows selling acceleration
2. On day 2 of the pattern (P2) the bears show dominance with a gap down opening.
This reaffirms the position of the bears
4. After the gap down opening, nothing much happens during the day (P2) resulting in
either a doji or a spinning top. Note the presence of doji/spinning top represents
indecision in the market
5. On the third day of the pattern (P3) the market/stock opens with a gap up followed
by a blue candle which manages to close above P1’s red candle opening.
The evening star
The evening star appears at the top end of an uptrend. Like the morning star, the evening star is a
three candle formation and evolves over three trading sessions.

Moving averages
Moving to the latest data point and discarding the oldest to calculate the latest 5 day average.
Hence the name “moving” average!
When one calculates the average across these numbers there is an unstated assumption. We are
essentially giving each data point equal importance. Meaning, we are assuming that the data point
on 22ndJuly is as important as the data point on 28th July. However, when it comes to markets,
this may not always be true.
Remember the basic assumption of technical analysis – markets discount everything. This means
the latest price that you see (on 28th July) discounts all the known and unknown information. This
also implies the price on 28th is more sacred than the price on 25th. Going by this, one would like
to assign weightage to data points based on the‘newness’ of the data. Therefore the data point on
28th July gets the highest weightage, 25th July gets the next highest weightage, 24th July gets the
3rd highest, and so on.
The average calculated on this scaled set of numbers gives us the Exponential Moving Average
(EMA).

The reason why EMA is quicker to react to the current market price is because EMA gives more
importance to the most recent data points. This helps the trader to take quicker trading decisions.
Hence for this reason, traders prefer the use of the EMA over the SMA(Simple moving average).
We can define the moving average trading system with the following rules:
Rule 1) Buy (go long) when the current market price turns greater than the 50 day
EMA. Once you go long, you should stay invested till the necessary sell condition is
satisfied
Rule 2) Exit the long position (square off) when the current market price turns lesser
than the 50 day EMA
In a MA crossover system, instead of the usual single moving average, the trader combines two
moving averages. This is usually referred to as ‘smoothing’.
A typical example of this would be to combine a 50 day EMA, with a 100 day EMA.
The shorter moving average (50 days in this case) is also referred to as the faster moving average.
The longer moving average (100 days moving average) is referred to as the slower moving average.
The shorter moving average takes lesser number of data points to calculate the average and hence
it tends to stick closer to the current market price, and therefore reacts more quickly. A longer
moving average takes more number of data points to calculate the average and hence it tends to
stay away from the current market price.Hence the reactions are slower.
The entry and exit rules for the crossover system is as stated below:
Rule 1) – Buy (fresh long) when the short term moving averages turns greater than the long term
moving average. Stay in the trade as long as this condition is satisfied
Rule 2) – Exit the long position (square off) when the short term moving average turns lesser than
the longer term moving average
A trader can use any combination to create a MA cross over system. Some of the
popular combinations for a swing trader would be:
1. 9 day EMA with 21 day EMA – use this for short term trades ( upto few trading
session)
2. 25 day EMA with 50 day EMA – use this to identify medium term trade (upto few
weeks)
3. 50 day EMA with 100 Day EMA – use this to identify trades that lasts upto few
months
4. 100 day EMA with 200 day EMA – use this to identify long term trades (investment
opportunities), some of them can even last for over a year or more.

Indicator
A technical indicator helps a trader analyze the price movement of a security.

Relative Strength Index

RSI is a leading momentum indicator that helps in identifying a trend reversal. The RSI indicator
oscillates between 0 and 100.
When the RSI reading is between 30 and 0, the security is supposed to be oversold and ready for
an upward correction. When the security reading is between 70 and 100, the security is supposed
to be heavily bought and is ready for a downward correction.

Moving Average Convergence and Divergence (MACD)

MACD is all about the convergence and divergence of the two moving averages. Convergence
occurs when the two moving averages move towards each other, and a divergence occurs when
the moving averages move away from each other.
A standard MACD is calculated using a 12 day EMA and a 26 day EMA. Please note, both the
EMA’s are based on the closing prices.We subtract the 26 EMA from the 12 day EMA, to estimate
the convergence and divergence (CD) value. A simple line graph of this is often referred to as the
‘MACD Line’.

As you can see the MACD line oscillates over a central zero line. This is also called
the ‘Center line’. The basic interpretation of the MACD indicator is that:
1. When the MACD Line crosses the center line from the negative territory to positive territory, it
means there is divergence between the two averages. This is a sign of increasing bullish
momentum; therefore one should look at buying opportunities.From the chart above, we can see
this panning out around 27thFeb
2. When the MACD line crosses the center line from positive territory to the negative territory it
means there is convergence between the two averages. This is a sign of increasing bearish
momentum; therefore one should look at selling opportunities.As you can see, there were two
instance during which the MACD almost turned negative (8th May, and 24th July) but the MACD
just stopped at the zero line and reversed directions.
Traders generally argue that while waiting for the MACD line to crossover the center line a bulk
of the move would already be done and perhaps it would be late to enter a trade. To overcome this,
there is an improvisation over this basic MACD line. The
improvisation comes in the form of an additional MACD component which is the 9
day signal line. A 9 day signal line is a exponential moving average (EMA) of the
MACD line. If you think about this, we now have two lines:
1. A MACD line
2. A 9 day EMA of the MACD line, also called the signal line
1. The sentiment is bullish when the MACD line crosses the 9 day EMA wherein MACD line is
greater than the 9 day EMA. When this happens, the trader should look at buying opportunities
2. The sentiment is bearish when the MACD line crosses below the 9 day EMA wherein the MACD
line is lesser than the 9 day EMA. When this happens, the trader should look at selling
opportunities

The indicator uses standard parameters of MACD:

1. 12 day EMA of closing prices
2. 26 day EMA of closing prices
3. MACD line (12D EMA – 26D EMA) represented by the black line
4. 9 day EMA of the MACD line represented by the red line
The vertical lines on the chart highlight the crossover points on the chart where a signal to either
buy or sell has originated.For example, the first vertical line starting from left points to a crossover
where the MACD line lies below the signal line (9 day EMA) lies and suggests a short trade.
The 2nd vertical line from left, points to a crossover where the MACD line lies above the signal
line, hence one should look at buying opportunity. So on and so forth.
The Bollinger Bands
BB are used to determine overbought and oversold levels, where a trader will try to sell when the
price reaches the top of the band and will execute a buy when the price reaches the
bottom of the band.
The BB has 3 components:
1. Middle line which is The 20 day simple moving average of the closing prices
2. An upper band – this is the +2 standard deviation of the middle line
3. A lower band – this is the -2 standard deviation of the middle line

Fibonacci retracements
It is believed that the Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% finds its application in stock
chart Whenever the stock moves either upwards or downwards sharply, it usually tends to retrace
back before its next move. For example if the stock has run up from Rs.50 to Rs.100, then it is
likely to
retrace back to probably Rs.70, before it can move Rs.120.

Two points on the chart, at Rs.380 where the stock started its rally and at Rs.489, where the stock
prices peaked. The move of 109 (380 – 489) as the Fibonacci upmove. As per the Fibonacci
retracement theory, after the upmove one can anticipate a correction in the stock to last up to
the Fibonacci ratios. For example, the first level up to which the stock can correct could be 23.6%.
If this stock continues to correct further, the trader can watch out for the 38.2% and 61.8% levels.
Notice in the example shown below, the stock has retraced up to 61.8%, which
coincides with 421.9, before it resumed the rally.
We can arrive at 421 by using simple math as well –
Total Fibonacci up move = 109
61.8% of Fibonacci up move = 61.8% * 109 = 67.36
Retracement @ 61.8% = 489- 67.36 = 421.6
Likewise, we can calculate for 38.2% and the other ratios.
Here is another example where the chart has rallied from Rs.288 to Rs.338.
Therefore 50 points move makes up for the Fibonacci upmove. The stock retraced back 38.2% to
Rs.319 before resuming its up move.

The stock started to decline from Rs.187 to Rs. 120.6 thus making 67 points
as the Fibonacci down move.
After the down move, the stock attempted to bounce back retracing back to Rs.162,
which is the 61.8% Fibonacci retracement level.

Fibonacci Retracement construction

Step 1) Identify the immediate peak and trough. In this case the trough is at 150 and
peak is at 240. The 90 point moves make it 100%.

Step 2) Select the Fibonacci retracement tool from the chart tools

Step 3) Use the Fibonacci retracement tool to connect the trough and the peak.
After selecting the Fibonacci retracement tool from the charts tool, the trader has to
click on trough first, and without un-clicking he has to drag the line till the peak.
While doing this, simultaneously the Fibonacci retracements levels starts getting
plotted on the chart. However, the software completes the retracement
identification process only after you finish selecting both the trough and the peak.
This is how the chart looks after selecting both the points.
 Trend line

A trend line in technical analysis is a simple yet powerful tool used to visually identify and
understand the overall direction of an asset's price movement. It's essentially a straight line drawn
on a price chart, connecting a series of key price points, typically highs or lows. By analyzing the
angle and position of the trend line, traders can gain valuable insights into the prevailing trend,
potential support and resistance levels, and future price movements.

Types of Trend Lines:

• Upward Trend Line: This line connects a series of rising lows, indicating a bullish trend where
prices are generally moving higher.

• Downward Trend Line: This line connects a series of falling highs, indicating a bearish trend
where prices are generally moving lower.

• Horizontal Trend Line: This line connects a series of price points at roughly the same
level, indicating a period of consolidation or sideways movement.
 Using Trend Lines for Analysis:

• Trend Confirmation: Trend lines help confirm an existing trend by visually highlighting the overall
direction of price movement.

• Support and Resistance: Trend lines can act as dynamic support and resistance levels, where prices
may bounce off or struggle to break through.

• Trend Breakouts: A break above an upward trend line or below a downward trend line can signal
a potential trend reversal.

• Entry and Exit Points: Trend lines can be used to identify potential entry and exit points for trades
based on support, resistance, and breakout levels.

Limitations of Trend Lines:

• Subjectivity: Drawing trend lines can be subjective, as different traders may interpret price
movements differently.

• False Signals: Trend lines can sometimes generate false signals, especially during periods of high
volatility or consolidation.

• Not Foolproof: Trend lines are just one tool among many in technical analysis and should not be
solely relied upon for trading decisions.
 Gap Wave Theory
Gap Wave Theory is a technical analysis technique that uses price gaps on charts to identify
potential trend changes and trading opportunities. It builds upon the Elliott Wave Theory, which
proposes that markets move in predictable five-wave patterns, and incorporates the significance of
gaps within those waves.

Gaps in Technical Analysis:

A gap is a space on a price chart where no trading activity occurred, leaving a visual break between
price bars. Gaps can be caused by various factors, such as unexpected news, earnings
announcements, or changes in investor sentiment. They can be classified into different types based
on their location and significance:

• Breakaway Gap:

• A breakaway gap occurs when the price gaps above a support or resistance area, like those
established during a trading range. When the price breaks out of a well-established trading
range via a gap, that is a breakaway gap. A breakaway gap could also occur out of another
type of chart pattern, such as a triangle, wedge, cup and handle, rounded bottom or top, or
head and shoulders pattern.
• Breakaway gaps are also typically associated with confirming a new trend. For example,
the prior trend may have been down, the price then forms a large cup and handle pattern,
and then has a breakaway gap to the upside above the handle. This would help confirm
that the downtrend is over and the uptrend is underway. The breakaway gap, which shows
strong conviction on the part of the buyers, in this case, is a piece of evidence that points
to further upside in addition to the chart pattern breakout.
• A breakaway gap with larger than average volume, or especially high volume, shows
strong conviction in the gap direction. A volume increase on a breakout gap helps confirm
that the price is likely to continue in the breakout direction. If the volume is low on a
breakaway gap there is a greater chance of failure. A failed breakout occurs when the price
gaps above resistance or below support but can't sustain the price and moves back into the
prior trading range.
 • Gaps can occur at any time but are highly likely to occur
following earnings announcements or other major corporate announcements.

Continuation Gap

A continuation gap is a price gap that leads to a price trend continuation in the same
direction as the gap. A continuation gap up indicates a bullish trend continuation and a
continuation gap down indicates a bearish trend continuation. A continuation gap forms
in the middle of an already-established price trend and is normally caused by earning
releases in stocks. A continuation gap is not typically filled in which means market prices
will not move to fill in the price gap between the opening price and th e previous closing
price. A continuation gap pattern is also known as a "runaway gap".
Exhaustion Gap
An exhaustion gap is a technical signal marked by a break lower in prices (usually on a daily
chart) that occurs after a rapid rise in a stock's price over several weeks prior.

This signal reflects a significant shift from buying to selling activity that usually coincides with
falling demand for a stock. The signal implies that an upward trend may be about to end soon.

The principle behind an exhaustion gap is that the number of likely buyers has diminished and
sellers have aggressively stepped into the market. The buyers may be largely exhausted implying
that the upward trend is likely about to stop as sellers take profits from a previously extended rise
in the price of the stock. The exhaustion gap has three particular features.

1. Several weeks or months of an upward trend in the share price of a stock.

2. A sizable gap between the lowest price of the day previous and the highest price of the
most recent trading day (roughly half the range, or better, of an average trading day for
that stock).
3. An above-average degree of trading volume taking place on the current day.
• Common Gap: This is a relatively small gap that doesn't fit into any specific category and doesn't
necessarily signal a significant trend change.
 Gap Wave Theory and Elliott Waves:

Gap Wave Theory posits that gaps can provide additional confirmation or reversal signals within
the five-wave structure of Elliott Waves.

• Wave 1: A breakaway gap can occur at the beginning of Wave 1, signifying the start of a new
uptrend.

• Wave 2: A common gap or a small continuation gap might occur within Wave 2, a corrective
pullback.

• Wave 3: A strong continuation gap can mark the start of Wave 3, the strongest impulsive wave of
the trend.

• Wave 4: Another common gap or a small continuation gap might appear within Wave 4, another
corrective phase.

• Wave 5: An exhaustion gap can occur at the end of Wave 5, indicating the potential culmination
of the trend and a possible reversal.

Using Gap Wave Theory:

Gap Wave Theory can be used for various purposes in trading, including:

• Trend Confirmation: Gaps can help confirm existing trends or signal potential trend changes.

• Support and Resistance: Gaps can act as temporary or dynamic support and resistance levels.
• Entry and Exit Points: Gaps can provide potential entry points for trades aligned with the trend or
exit points when a reversal is signaled.

Limitations of Gap Wave Theory:

Like any technical analysis tool, Gap Wave Theory has limitations:

• Subjectivity: Identifying and interpreting gaps can be subjective, depending on the trader's
experience and approach.

• False Signals: Gaps can sometimes generate false signals, especially during volatile markets.

• Not a Standalone Tool: Gap Wave Theory should be used in conjunction with other technical and
fundamental analysis methods for a more comprehensive market understanding.

Technical Versus Fundamental Analysis

Technical Analysis:

• Focus: Technical analysis primarily concentrates on the study of historical

market data and price movements to forecast future price movements.

• Data Used: It relies on charts, patterns, and technical indicators derived from
historical price and volume data.

• Assumptions: Technicians believe that historical price movements and patterns

tend to repeat themselves, and that price reflects all available information.

• Tools: Common tools include charts, trendlines, support and resistance levels,
moving averages, and various technical indicators (e.g., RSI, MACD).

• Time Horizon: Short to medium-term.

Fundamental Analysis:
 • Focus: Fundamental analysis involves evaluating a company's intrinsic value
by analyzing financial statements, economic factors, industry conditions, and
management quality.

• Data Used: It relies on financial statements, earnings reports, economic

indicators, and other relevant data to assess a company's health and potential
for growth.

• Assumptions: Fundamental analysts believe that the market may misprice

securities in the short term, but in the long run, a company's value will be
reflected in its stock price.

• Tools: Financial ratios (e.g., P/E ratio, EPS, ROE), income statements, balance
sheets, cash flow statements, economic indicators, and qualitative factors.

• Time Horizon: Long-term.

Key Differences:

Approach to Information:

• Technical analysis focuses on historical price and volume data, assuming that
price movements and patterns repeat.

• Fundamental analysis focuses on the underlying factors that affect a company's

value, such as financial health, earnings, and economic conditions.

Time Horizon:

• Technical analysis is often used for short to medium-term trading strategies.

• Fundamental analysis is more commonly associated with long-term investment

strategies.

Data Used:
 • Technical analysis uses quantitative data derived from price and volume, often
displayed in charts.

• Fundamental analysis involves both quantitative data (financial statements) and

qualitative data (management quality, industry conditions).

Assumptions:

• Technical analysis assumes that historical price movements provide insights

into future price movements and that the market discounts all information.

• Fundamental analysis assumes that a company's intrinsic value is not always

reflected in its stock price, and over time, the market will recognize the true
value.

Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) is a theory that suggests that financial
markets are efficient in reflecting all available information. According to EMH, it is
impossible to consistently achieve higher-than-average returns by using information
that is already available to the public because stock prices already incorporate and
adjust to all relevant information.

Key Concepts of the Efficient Market Hypothesis:

• Weak Form EMH:

Assumption: This form assumes that current stock prices fully reflect all
historical information, such as past prices and trading volumes.

Implication: Technical analysis, which relies on historical price and volume

patterns, is considered ineffective for consistently achieving abnormal returns.

• Semi-Strong Form EMH:

 Assumption: This form assumes that current stock prices fully reflect all
publicly available information, including both historical and public
information.

Implication: Fundamental analysis, which relies on publicly available financial

information, is considered ineffective for consistently achieving abnormal
returns.

• Strong Form EMH:

Assumption: This form assumes that current stock prices fully reflect all
information, including both public and private information.

Implication: No type of analysis or insider information can consistently lead to

abnormal returns.

• Implications for Investment Decisions:

Active vs. Passive Investing:

EMH View: If markets are truly efficient, actively trying to beat the market
through stock picking or market timing becomes challenging.

Implication: Investors might consider passive investment strategies, such as

index funds, which aim to replicate the performance of a market index rather
than trying to outperform it.

Value of Information:

EMH View: Information that is already known and available to the public is
reflected in stock prices.

Implication: Investors should carefully evaluate the value and uniqueness of

information before making investment decisions, as widely available
information may not provide a competitive edge.
 Market Anomalies:

EMH View: The existence of consistent and predictable patterns or anomalies

in the market contradicts the efficient market hypothesis.

Implication: Some investors and researchers argue that certain market

anomalies do exist, challenging the notion of market efficiency. However, these
anomalies may be challenging to exploit consistently.

• Long-Term Investment:

EMH View: Over the long term, stock prices should reflect the fundamental
value of the underlying assets.

Implication: Long-term investors might focus on the fundamentals of

companies, as the efficient market hypothesis suggests that stock prices will
eventually align with their intrinsic values.

It's important to note that while the efficient market hypothesis provides a theoretical
framework, real-world markets may not always operate perfectly efficiently. Market
participants can sometimes behave irrationally, leading to market inefficiencies and
anomalies. As a result, investors may still find opportunities for profit through careful
analysis and strategic decision-making, even in an environment influenced by the
principles of the Efficient Market Hypothesis.

Capital Asset Pricing Model (CAPM)

CAPM is a financial model that establishes a linear relationship between the expected
return on an investment and its systematic risk (beta). It helps in determining the
required rate of return for an asset.

Expected Return=Risk-Free Rate+β(Market Return−Risk-Free Rate)

 Key Concepts:

• Expected return is influenced by the risk-free rate, the market risk premium,
and the asset's beta.

• Beta measures the asset's sensitivity to market movements.

Implications: CAPM is widely used for pricing risky securities and estimating the cost
of equity for valuation purposes. It assumes a linear relationship between risk and
return.

Key Concepts:

• Expected return is influenced by the risk-free rate, the

market risk premium, and the asset's beta.

• Beta measures the asset's sensitivity to market movements.

CAPM is widely used for pricing risky securities and estimating

the cost of equity for valuation purposes. It assumes a linear
relationship between risk and return.

• Arbitrage Pricing Theory (APT):

APT is an alternative asset pricing model that allows for multiple

factors influencing asset prices. It doesn't assume a specific
relationship between risk and return but instead relies on the
existence of arbitrage opportunities to ensure that asset prices are
consistent with a set of factors.
 Expected Return=Risk-Free Rate+β1×Factor1+β2×Factor2+…+βn
×Factorn+Residual

Key Concepts:

• APT assumes that multiple macroeconomic factors (such as interest

rates, inflation, etc.) influence asset prices.

• Arbitrage opportunities are expected to be quickly exploited, leading to

price adjustments.

APT is used to understand the factors influencing asset prices in a multifactor model. It's
more flexible than CAPM but requires the identification of relevant factors.

In summary, CAPM is a single-factor model that relates the expected return of an asset
to its beta, while APT is a multifactor model that considers multiple macroeconomic
factors.