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Profitable Investment
Basic Principles
Do not invest in unlisted shares
This is the first basic principle for profitable stock market investment.
Invest in active shares
Invest only in shares that are trade frequently on the stock exchange, preferably at least 3-4 times a week. Give preference to shares that are traded regularly on more than one stock exchange.
Diversify your investments
Do not put all your money into shares of any one company or industry - spread it over ten or twenty companies. Diversification minimizes risks, lends stability to your portfolio and ensures safety of capital.
Don’t over – diversity
Excessive diversification, for example portfolio of shares of 80 to 90 companies, puts a limit on high returns without commensurate compensation in the form of added safety. Over diversification is nothing more or less than average investing for average returns. Shares in, say ten companies engaged in eight to ten different industries generally provide sufficient diversification.
Ensure liquidity of your investment
A liquid investment is one which can be easily sold. Buy only liquid shares, not shares which you may later have difficulty in selling. In other words, do not block your money by purchasing shares for which you may not be able to find ready buyers when you want to sell them.
In all investments there is a trade-off between reward and risk
High-return investments usually carry high risks, whereas low return investments carry lower risks. Try to strike a balance between reward and risk while making your investment selections.
Investment risks can be reduced through knowledge and experience
Calculated investment discussions carry lower risks than blind, impulsive decisions taken without adequate information and analysis. Experience and knowledge minimize exposure to investment risk. Therefore, keep yourself well informed, do your investment homework and get competent and informed investment advice before you take a buy or sell decision.
Understanding the stock markets
The stock markets always over-react
They over-react both when they rise and when they fall. This is a basic truth applicable to stock markets all over the world. Over reaction is what gives rise to booms and depressions. In a bull or rising market, share prices shoot past their intrinsic values to reach dizzy heights, whereas in a bear or falling market, they plummet to depths far below their intrinsic worth. These overreactions provide opportunities to intelligent investors for making money.
Stock market prices never go straight up or straight down
They always move in short up and down spurts, {i.e} in a zigzag pattern. Every rise is followed by a fall, called a reaction – and every fall is followed by a rise which is called a rally. You should make use of this universally observed stock market behavior for timing your buy and sell decisions.
Stock market prices never go straight up or straight down
They always move in short up and down spurts, {i.e} in a zigzag pattern. Every rise is followed by a fall, called a reaction – and every fall is followed by a rise which is called a rally. You should make use of this universally observed stock market behavior for timing your buy and sell decisions.
Greed and fear are the two most dominant emotions that influence stock market behavior
Greed is the dominant, all –pervasive emotion that fuels a boom, whereas fear eclipses all other emotions in a falling market. Greed and fear are what lead to stock market over – reactions.
The stock markets are irrational in the short-run, but rational over the long-term
Day-to-day, week-to-week share price movements are governed by rumors, gossip, tips, misinformation, crowd behavior, mass psychology and knee-jerk reactions to news headlines and breaking news. This is the main reason why it is so difficult to understand, interpret and predict short-term share price movements. In the long-term (generally over one year) on the other hand, the price of a share tends to converge towards its intrinsic value. In other words, over the long term violent price fluctuations tend to get flattened, out thus enabling price and value to math. This is also the main reason why it is generally easier to understand and forecast long-term price trends with greater accuracy. Therefore, it is always advisable to bank on the underlying long-term trends while making you investment decisions, and not focus on erratic short-term price fluctuations.
Tactics and strategy
Do not speculate unless you have a natural flair for it
Speculators do not always make more money than investors, On the other hand, they have been seen to lose more money, and in a far shorter period and selling of shares on margins, buying and selling with a view to making money form short – term fluctuations in share prices, and from short selling. Speculation is a high – risk business where the percentage of failure is very high and the potential rewards are not all that attractive to justify the risks taken.
When investing in shares go for the long – term investments
The long – term equity investor, who has a time horizon of three years or more, is on far safer ground than is the speculator. The former very rarely loses money and his investment returns are generally more certain and assured than those of the speculator. The long – term investor is also in a position to taken advantage of the various tax rebates and concessions available on long – term capital gains. On the whole, most long – term investors generally end up making far more money than do most speculators.
The stock markets are dominated by short – term traders and speculators.
Stockbrokers are, typically, commission – oriented, and tend to favor short – term traders and investors fro obvious reasons. Investment advisors and counselors also generally favor short – term investment because they function under constant pressure from clients to produce quick results. As a result, long – term investors face very little competition, and this explains why magnificent long – term investment opportunities often go a begging in the stock market. This is another reason in favor of long – term investments.
If you must buy and sell frequently, use the major cyclical swings in the market.
Watch the stock market indices to find out when such swing are likely to occur. Buy when the market is close to its cyclical bottom and cell when the market is close to its top. Buying and selling in line with the major cyclical swings is an easy –to – use and fairly successful stock market trading strategy. It also carries lower risks than short – term trading and speculation.
Vertically integrated, single – product companies’ office better investment opportunities than diversified companies.
A vertically integrated company is one which has integrated its operations from the raw material stage to the finished product. Reliance Industries and Tisco (Tata Iron & Steel Co) are examples of such companies.
Companies that manufacture and / or market consumer products are generally steadier and sounder investments.
Shares of such companies are less prone to volatile price fluctuations than of those that operate in the core sectors of the economy. This again is a broad generalization that admits of many exceptions.
Bank on growth, growth, growth
When selecting shares to buy, try to stack the odds in your favor. A good, time – tested way of doing this would be to duly shares in a growth company, managed or controlled by a growing business house, belonging to a growing industry, and operating in a growing sector of the economy.
Invest in companies with a low price earnings ratios (P/E)
Companies with low P/E ratios often better investment value than those which have a high P/E When you invest in a company with a low P/E, you give yourself two chances to win whereas with a company with a high P/E you have only one chance. In the former case, you gain not only form an improvement in the company’s profits and earnings per share but also from an upward re-rating of its P/E ratio. In the latter case, the opportunity to gain from an upward movement of the P/E ratio is limited, if not completely non – existent.
The best investment opportunities always exist in the most unlikely place.
This is and invaluable, rule – of – thumb technique for picking potential stock market winners. Therefore, develop the habit of looking closely at “neglected” and “overlooked” companies operating in the less visible sectors of the economy for high – growth investment opportunities.
Buy shares in companies that are currently out of favor.
Out – of – favor companies, particularly blue chip companies that are temporarily going through a spell of bad luck can be great investment opportunities. Since these shares are out of favor, their prices cannot fall any further because they have already touched rock – bottom levels.
Don’t confuse a share’s intrinsic worth with its market price
A share is high – priced or low – priced in relation to its intrinsic value and not on the strength of its ruling share price.
“Buy dear, sell dearer” is generally a better investment strategy than “buy cheap and sell dear”
Quite often cheap shares tend to remain cheap and apparent bargains sink further whereas apparently expensive shares tend to rise even higher over time.
Never hold on to a share which you wouldn’t buy at its current price.
The reasons for holding on to a share are the same as those for buying it, if you are not prepared to buy a particular share at its ruling market price, then there is no reason why you should hold on to it no it either. A share is either worth buying or worth selling, there is no such thing as holding on to a share. The mere fact that your wan or possess a particular share should not be allowed to alter or cloud your basic perception of what the share is worth. The decision to “hold” is basically a “buy” decision masquerading in a different garb and under a different name. Try to view and treat all “hold” decisions as different versions of a “buy” decision, for clearer investment thinking. (The decision to hold acquires a special significance of its own only when extraneous considerations like tax payments, set-off of capital losses against capital gains, etc, and enter into the decision – making process).
Beware of bargain hunting in the stock market.
There is a lot of competition in this filed. All investors, speculators, stockbrokers, investment analysts and investment advisors are engaged in it all the time. It is the most popular and widely played game in the market. The chances of you’re discovering and picking up a genuine bargain or super-bargain before somebody else does are quite remote. Whenever you spot a share that looks like a bargain, give it a closer look and subject it to detailed scrutiny and analysis, because there is bound to be a snag in it somewhere. Most shares which appear to be bargains generally turn out to be discarded shares with poor salability and dismal future prospects. Therefore, leave bargain hunting to investment professionals and specialists.
Don’t put too much reliance on charts and technical analysis
Charts and graphs do not foretell the future – they only give a picture of the past. Moreover, they function best in free and uncontrolled markets where the forces of demand and supply can interact with each other in an unrestricted manner. In the Indian stock markets where there are few effective checks on insider trading, where margin rates are changed frequently to moderate bull and bear pressures, and where financial institutions sometimes push up or force down prices on government dictated considerations, suitable conditions for the free interplay of market forces do not fully exist.
Be on the lookout for rights renunciations
A large number of shareholders sell their entitlement to rights shares in the stock market. These rights renunciations are generally available at a price far lower that the ruling market price for that particular company’s shares. Take advantage of this by buying rights renunciations of good companies.
Selecting which share to buy is always easier than when to buy it.
Selection depends on quantifiable and calculable criteria, whereas timing depends upon and offset the possible adverse effects of bad timing through superior investment selection.
It is harder to take good selling decisions than good buying decisions.
This is because too many emotional and other extraneous considerations tend to enter into a selling decision, which is not the case in a buying decision. This is another reason why long – term investment strategies generally give superior results than short – term, in – and – out trading strategies.
Averaging up is a sound investment strategy.
It works something like this. Once you decide to buy a share don’t buy all the number you want at one time. Buy a small number first and closely watch the share’s price movements. An upward movement of the share price will help to confirm that your earlier judgment was right. Then you buy more shares and expend your shareholding. This process is repeated. You buy more and more shares with each upward movement in the share price. This investment strategy is called averaging up or pyramiding.
Never average down.
It is a poor investment strategy. Most people resort to averaging down in the hope of bringing down their average purchase costs. This is undeniably true, but if share prices continue to side downwards and do not make the quick U-turn that you expect then you actually end up multiplying your losses. A better investment strategy would be to wait for the downtrend to reach the bottom of the “U” before you resume buying. Always on the upswing and never on the downswing.
Don’t invest in new issue of new companies promoted by unknown and untried managements.
Such companies have a high percentage of failure.
A company is generally as good or as bad as its management
You will never that a good company with a bad management or a bad company with a good management. The quality of a company’s management is often more important than its quantifiable financial indicators. If you bank on good management, you can never rally go wrong with your investment selections. As a corollary to this rule, avoid investing in companies that have a history or a back ground of factionalism and management infighting
Invest in companies which have a clearly identifiable Plus factor.
A distinct advantage gives a company leadership in its chosen field and makers all the difference between success and failure. This plus factor can be either superior technological skills, superior corporate planning superior marketing techniques combined with a bigger and more effective marketing networks, superior product or superior financial and tax planning.
Basic Chart Patterns
Symmetrical Triangle
Symmetrical triangles usually form as a result of a lack of conviction regarding which way the price of an asset will move. A technical trader searching for this pattern looks for two converging trendlines that meet at a central point: the apex. As you can see, the converging trendlines give this pattern its distinct triangular shape. Simply put, it is created by drawing two trendlines that connect a series of sequentially lower peaks and a series of sequentially higher troughs. As the pattern develops, these trendlines act as barriers that prevent the price from dramatically moving in any one direction. However, once the price does breach one of these levels, volatility increases and, consequently, the price can experience a sharp movement in the direction of the breakout.
Traders who are able to identify this setup prior to the breakout are in a desired position because gains from this sharp price movement can be substantial. A sideways movement before the breakout is regarded as a period of rest occurring just before the price continues in the direction of the original trend. In general, a trader will wish to see the price of the asset break through one of the trendlines around three quarters of the way between the beginning of the set-up and the apex. Once the price breaks above (below) the trendline, a price target is set equal to the entry price plus (minus) the height between the two trendlines.


Ascending Triangl
A cousin of the symmetrical triangle is the ascending triangle. This is a bullish pattern and can be easily recognized by the distinct shape created by two trendlines.As you can see from the diagram, the first trendline is drawn horizontally at a level that has prevented the price from moving higher on several occasions. The second trendline is drawn so that it connects a series of increasing troughs, which is often considered to be a graphical representation of an increase in demand. It may take the buyers a few tries to push the price past the upper resistance level, but once a breakout does occur, the buyers aggressively send the price of the asset higher,usually on very high volume. Price targets are generally set to be equal to the entry price plus the vertical height of the triangle. An ascending triangle is generally deemed to be a continuation pattern, meaning that once it breaks above the upper resistance,it usually continues in the direction of the prior trend. In practice, this pattern usually takes three or four weeks to develop and is well liked by technicians because of its clear entry and exit signals. Traders who are aware of this pattern have an edge over longer-term holders because they are able to enter a position and benefit from the same sharp increase that other longer-term investors have been waiting for.
Descending Triangle
The bearish counterpart to the ascending triangle is the descending triangle. The major difference between the two triangular chart patterns becomes apparent when you examine how the two trendlines are drawn. Notice how the horizontal trendline is drawn at a level that has prevented the price from heading lower, rather than preventing it from going higher like it was in the ascending version. This type of pattern is usually identified in downtrends, and it enables traders with short positions to recognize substantial profits when the price of the asset breaks below the horizontal trendline.reaks below the lower support, it is a clear indication that the downside momentum is likely to continue.
The reason this pattern is so popular is because it shows that the demand for the asset is weakening. When the price breaks below the lower support, it is a clear indication that the downside momentum is likely to continue. Price targets are generally set to equal the entry price minus the difference between the trendlines. The different signals provided by the ascending and descending triangles give traders unique opportunities to benefit from price changes whether the asset is set to move up or down. This strategic flexibility allows traders to have a wider view of the market without limiting themselves to trading in only one direction. After looking at the sizable gains that occur following a breakout of the patterns, the reason why these tools should be added to every trader's arsenal becomes clear.
Head and Shoulders
The head and shoulders pattern is undoubtedly one of the most reliable chart patterns used by technical traders. When the head and shoulders pattern is formed, it is used to predict a change in the direction of the current uptrend; therefore, it is considered a reversal pattern. It is discovered by finding an asset's price using the following characteristics: 1. Rises to a peak and subsequently declines
2. Rises above the former peak and declines again
3. And finally, rises again - but not to the second peak - and declines once more 
Looking at the chart , it is not difficult to see why this pattern got its name. The large middle peak creates what looks like a person's head and the two lower peaks resemble a person's shoulders. Transaction signals are generated when the price drifts below a trendline. In the case of a head and shoulders pattern, this is known as the neckline.
The neckline is simply an area of support that has prevented the sellers from drastically moving the price lower on previous occasions. The reason that this pattern is so popular is because it accurately depicts what is happening to the supply and demand of the security. Because this pattern is found at the top of an uptrend, the first trough is a signal that buying demand is starting to weaken. The head (large peak) is created because investors who missed the original run-up start entering into long positions because they think the asset is looking undervalued. This new buying interest causes the price to go to a new high, which is then interrupted by a flood of sellers. The sell-off at the top of the head is the second indication that sentiment is changing and that supply is outweighing demand. Once the price has touched the neckline a second time, buyers start to step in again and try to push it higher. This final attempt fails, which is used as confirmation that the trend is reversing. Transaction signals are generated from the move below the neckline, which is the time when traders start flooding the market with short-sale orders. The declines that generally follow the breakdown give traders a great opportunity to realize significant gains over a brief period of time.
Double Bottom
This pattern is used by traders to predict a shift from a previous downtrend to a new uptrend. This pattern is considered one of the most popular reversal patterns in technical analysis and, much like the head and shoulders pattern, it is easy to understand how it got its name.A double bottom is formed by a price that has created a series of two relatively equal lows with a small peak in the middle.Most technical analysts believe that the price should advance nearly 10-20% from the first bottom before it heads lower to make the second bottom.
The price level that has prevented the bears from pushing the asset lower on both occasions is regarded as a strong area of support and is used to determine the validity of the pattern. Many traders deem this pattern to be broken once the price falls below the support level by more than 3-4%. Traders will watch for volume to increase on the ascent from the second trough and will place a long position once the price breaks higher than the center peak. This pattern is often associated with the letter "W" because of the similarity of the two equal lows.

 

 

 

 






Double Top
The double top chart is classified as a reversal pattern; it is used by traders to predict a shift from an uptrend to a downtrend. As the name implies, the pattern is created by finding an asset that shows the following price characteristics:

1. The asset travels within a significant uptrend.
2. A strong area of resistance causes the price to decline, creating Top #1.
3. The price of the asset retraces by about 10-20% until it finds support.
4. The price rises again to the same level that was reached by Top #1.
5. The price level that caused the price to fall from Top #1 proves to be too strong of a resistance and the asset heads lower again.

Traders will take a short position once the price of the asset breaks below the support level that was established by the sell-off from the first top. Volume plays an important role in confirming the breakdown because a trader will look to see volume increase as the price of the asset moves below the support line. It is not uncommon for a broken support level to become an area of resistance and to see the price test this level several times before ultimately heading dramatically lower. This pattern is often associated with the letter "M" because of the commonality of the two peaks.







Triple Bottom
A triple bottom is a reversal pattern that is used to predict a shift from a longer-term downtrend to a new uptrend. As you can see from the chart, this pattern is found by identifying a situation in which the price of an underlying asset has traveled within a prolonged downtrend until it is stopped by a strong area of support.
Buyers enter at the support level, causing the price to climb and leaving Bottom #1 behind. Then, the price of the asset creates a peak and retraces back toward the prior support. This is when buyers enter again and push the price of the asset higher, creating Bottom #2. The price of the asset then creates another peak and subsequently heads downward for its final test of the lower support. The final bounce off the support creates Bottom #3; it is an early indication that demand is outweighing supply. Traders watch closely for increasing volume on the final ascent and purchase the asset once it breaks above the highest peak. 




Triple Top
The triple top pattern is classified as a reversal pattern and it is used by traders to predict the end of a prolonged uptrend. Traders identify this pattern by finding a situation in which the price of an asset has tested a resistance level three times without successfully climbing above it. The three consecutive tops make this pattern visually similar to the head and shoulders pattern but, in this case, the middle peak is nearly equal to the other peaks rather than being higher. The reversal signal generated by this pattern is considered to be very reliable because it clearly depicts the fact that supply is outweighing demand. Short positions are taken when the price of the asset drifts below the identified support level (shown by the white line).


Candle Stick Basics
In the 17th  century, Japanese rice merchants invented the candlestick charting.

The guiding principles of the Japanese candlesticks charting are :

 The price evolution is more important than what can explain it (financial information economic, results, etc).
 All known information is reflected by the price.
 Purchasers and salesmen act according to their expectations and their emotions.
Markets have fluctuations.
 Prices should not reflect the underlying value of firms.

Candlestick Layout

To draw a Japanese candlestick, it is necessary to know the opening price, the closing price, low and highest. If the period is in falling, the candlestick is black. For a rise, the candlestick is white.


Bullish candlestick
Bearish candlestick

Basic Patterns of the Japanese candlesticks

White candlestick with small body
 Little price movement and represent consolidation.
 
Black candlestick with small body
 Little price movement and represent consolidation.
 
White candlestick with long body
 Intense buying pressure.
 
Black candlestick with long body
 Intense selling pressure.
 
White Marubozu
White candlestick with long body. The opening price is equal to the lowest and the closing price is equal to the highest.
 Marked buying pressure. Sellers did not succeed to pushing price under opening price.
 
Black Marubozu 
Black candlestick with long body. The opening price is equal to the highest and the closing price is equal to the lowest.
 Marked selling pressure. Buyers did not succeed to pushing price on top of opening price.
 
White Candlesticks with a long upper shadow and short lower shadow
 Marked selling pressure but sellers did not succeed to pushing closing price under opening price.
 
Black Candlesticks with a long upper shadow and short lower shadow
 Bear signal. More the upper shadow is long, more the signal is strong.
 
White Candlesticks with a short upper shadow and long lower shadow
 Bull signal. More the lower shadow is long, more the signal is strong.
 
Black Candlesticks with a short upper shadow and long lower shadow 
 Marked buying pressure but buyers did not succeed to pushing closing price on top of opening price.
 
White Spinning Top
 Spinning tops represent indecision. It's a potential change or interruption in trend.
 
Black Spinning Top 
 Spinning tops represent indecision. It's a potential change or interruption in trend.
 
Hammer (White) and Hanging Man (Black)
White candlestick (or black) with a long lower shadow and a (almost) null upper shadow.
 It's potential trend reversal. Hammers can mark bottoms or support levels.
 
Inverted Hammer (White) and Shooting Star (Black) 
White candlestick (or black) with a (almost) null lower shadow and a long upper shadow.
 It's potential trend reversal. Inverted Hammers can mark support levels. A Shooting Star can mark a resistance level.
 
Doji
The doji appears when opening and closing price are (almost) equal.
 Neutral pattern, it often precedes an important price movement.
 
Long-legged Doji 
Long-legged doji have long shadows that are (almost) equal in length.
 Long-legged doji represent strong indecision.
 
Doji with a short upper shadow and long lower shadow
 Bull signal if it appears in a bear trend.
 
Doji with a long upper shadow and short lower shadow 
 Bear signal if it appears in a bull trend.
 
Dragon fly Doji
 Dragon fly Doji is a potential trend reversal. Strong signal if it appears in a bear trend.
 
Gravestone Doji 
 Gravestone Doji is a potential trend reversal. Strong signal if it appears in a bull trend.
Cycles
Cycles are recurring interval of time, within which various regularly repetitive events are completed.
Most phases of technical analysis depend to some extent on time considerations. Cyclic analysis holds that time cycles are the determining factor in bull and bear markets. Not only is time the dominant factor, but all other technical tools can be improved by incorporating cycles. Moving averages and oscillators can be optimized by tying them to dominant cycles. Trendline analysis can be more precise with cyclic analysis by determining which are valid trendlines and which are not. Price pattern analysis can be enhanced if combined with cyclical peaks and troughs. Cycle bottoms are called troughs and the tops referred to as crests, cycle lengths are preferably measured from low to low.
The three qualities of a cycle are amplitude, period, and phase. Amplitude measures the height of the wave. The period of a wave is the time between troughs. And the phase is a measure of the time location of wave trough. Because there are several different cycles occurring at the same time, phasing allows the cyclic analyst to study the relationships between the different cycle lengths.Phasing is also used to identify the date of the last cycle low. Once the amplitude, period, and phase of a cycle are known, the cycle can theoretically be extrapolated into the future. Assuming the cycle remains fairly constant, it can then be used to estimate future peaks and troughs. That is the basis of the cyclic approach in its simplest form.
Cyclic Principles
There are six most important principles of cycles: Summation, Harmonicity, Synchronicity, Proportionality, Variation and Nominality. The principle of summation holds that all price movement is the simple addition of all active cycles. Cycle theory holds that all price patterns are formed by the interaction of two or more different cycles. The principle of summation gives us an important insight into the rationale of cyclic forecasting. The principle of Harmonicity simply means that neighboring waves are usually related by a small, whole number. That number is usually two. The principle of synchronicity refers to the strong tendency for waves of differing lengths to bottom at about the same time. It is also means that similar cycle lengths of different markets will tend to turn together. The principle of proportionality describes the relationship between cycle period and amplitude. Cycles with longer periods (lengths) should have proportionally wider amplitudes. The principle of variation is a recognition of the fact that all of the other cyclic principles already mentioned - summation, harmonicity, synchronicity, and proportionality - are just strong tendencies and not hare and fast rules; some “variation” can and usually does occur in the real world. The principle of Nominality is based on the premise that, despite the differences that exist in the various markets and allowing for some variation in the implementing of cyclic principles, there seems to be a nominal set of harmonically related cycles that affect all markets. An that nominal model of cycle lengths can be used as a starting point in the analysis of any market.
Dominant Cycles.
There are many different cycles affecting the financial markets. The only ones of real value for forecasting purposes are the dominant cycles. Dominant cycles are those that consistently affect prices and that can be clearly identified. All technical analysis should begin with the long term picture, gradually working toward the shorter term. That principles holds true in the study of cycles. The proper procedure is to begin the analysis with a study of long term dominant cycles, which can span several years; then work toward the intermediate, which can be several weeks to several months; finally, the very short term cycles, from several hours to several days, can be used for timing of entry and exit points and to help confirm the turning points of the longer cycles. As a general rule, long term and seasonal cycles determine the major trend of a market. For trading purposes, the weekly primary cycle is the most useful.The trend of each cycle is determined by the direction of its next longer cycle. Once the trend of a longer cycle is established, the trend of the next shorter cycle is known.
LEFT AND RIGHT TRANSLATION The concept of translation may very well be the most useful aspect of cycle analysis. Left and right translation refers to the shifting of the cycle peaks either to the left or the rights of ideal cycle midpoint. For example, a 20 day trading cycle is measured from low to low. The ideal peak should occur 10 days into the cycle or at the halfway point. That would allow for a 10 day advance followed by a 10 day declines. Ideal cycle peaks, however, rarely occur. Most variations in cycles occur at the peaks or crests and not at the troughs. That's why cycle troughs are considered more reliable and used to measure cycle lengths. Cycle crests act differently depending on the trend of the next longer cycle. If the trend is up, the cycle crest shifts to the right of the ideal midpoint, causing right translation. If the longer trend is down, the cycle crest shifts to the left of the mid point, causing left translation. Therefore right translation is bullish and left translation is bearish. In bull trend prices spend more time going up rather than down. In bear trend prices spend more time going down that up.

Dow Theory
Charles Dow & Edward Jones founded Dow Jones & Company in 1882. Technical Analysis has its origin in theories published by Dow in series of editorials he wrote for the Wall Street Journal. Dow Theory still holds good in age of sophisticated computer technology. Dow created two separate index that would provide good indication of health of economy, Industrial Index and Stock Rail index. Dow relied on closing prices and did not considerintraday penetrations valid.
There are six basic tenants of Dow Theory. They are :-
  1.  Averages Discount Everything - Sum and tendency of the stock exchange represent the sum of all stock markets knowledge of the past, immediate and remote, applied to the discounting of the future. Markets cannot anticipate only natural calamities, but even those are discounted quickly as and when they occur.

  2. Market has Three Trends - Dow defined uptrend as a situation in which each successive rally closes higher than the previous rally high and each successive rally low also closes higher than the previous rally low. In other words uptrend has higher tops and higher bottoms. Opposite situation of lower tops and lower bottoms defines a downtrend. Dow believed that laws of action and reaction apply to markets just as they do to the physical universe. Dow considered trend to have three parts; primary, secondary and minor, which he compare to tide, waves and ripples of the sea. An observer can determine the direction of tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one the tide is flowing in. When the high point of each successive waves recedes, the tide is ebbing.
  3. Major Trends have three Phases - Accumulation, Participation & Distribution are the key phases in major trends. In the accumulation phase the informed insiders know that in the current downtrend, markets have fully discounted the bad news, they accumulate at discounted prices. Public participation phase starts when prices are rising rapidly and now even the business & economic news is improving. Distribution phase starts when all the media carries bullish headlines, there is speculative buying on huge volumes. During this last phase the same informed investor who began accumulating near the bear market bottom, begins to distribute before anyone else starts selling.
  4. Averages must confirm each other -  Dow while referring to Industrial and Rail averages meant that no important Bull or Bear market signal could take place unless both averages gave the same signal thus confirming each other.

  5. Volume must confirm the Trend - Volume is secondary but important factor in confirming price signals according to Dow. Volume should expand in the direction of the major trend. Volume should increase as prices move higher in uptrend. Similarly volume should also increase as prices move lower in downtrend.

  6. Trend is intact till proven otherwise - It relates to physical law of market movement, which states that an object in motion tends to continue in motion, until some external force causes it to change direction. There are many trend reversal signals now, like support/resistances, price patterns, trend lines, moving averages. Some indicators can also provide warnings of loss of momentum.

 

Elliot Wave Theory

Elliott Wave Theory interprets market actions in terms of recurrent price structures. Basically, Market cycles are composed of two major types of Wave : Impulse Wave and Corrective Wave. For every impulse wave, it can be sub-divided into 5 - wave structure (1-2-3-4-5), while for corrective wave, it can be sub-divided into 3 - wave structures (a-b-c). 



 

Waves within Wave An important feature of Elliott Wave is that they are fractal in nature. 'Fractal' means market structure are built from similar patterns on a larger or smaller scales. Therefore, we can count the wave on a long-term yearly market chart as well as short-term hourly market chart. 


Rules for Wave Count

Based on the market pattern, we can identify ' where we are' in term of wave count. Nevertheless, as the market pattern is relatively simplistic, there are several rules for valid counts: 
  1. Wave 2 should not break below the beginning of Wave 1;
  2. Wave 3 should not be the shortest wave among Wave 1, 3 and 5;
  3. Wave 4 should not overlap with Wave 1, except for wave 1, 5, a or c of a higher degree.
  4. Rule of Alternation : Wave 2 and 4 should unfold in two different wave forms.
Wave forms in Impulse Wave
There are three major types of wave form in Impulse Wave: 
(a) Extended Wave

Among Wave 1, 3 and 5, only one should unfolded into extended wave. 'Extension' means the wave is elongated in nature and sub-waves are conspicuous in relation to waves of higher degree. 
(b) Diagonal Triangle at Wave 5

Sometimes, the momentum at Wave 5 is so weak that the 2nd and 4th sub-waves overlap with each other and evolved into diagonal triangle. 

(c) 5th Wave Failure

In some other circumstances, the Wave 5 is so weak than it even cannot surpass the top of the wave 3, causing a double top at the end of the trend. 


Wave Forms in Corrective Wave
Corrective Wave forms are rather complicated, but basically we can categorize them into six major wave forms:  
  1. Zig-Zag : abc pattern composed of 5-3-5 sub-wave structure.
  2. Flat : abc pattern composed of 3-3-5 sub-wave structure, with b equals a.
  3. Irregular : abc pattern composed of 3-3-5 sub-wave structure, with b longer than a.
  4. Horizontal Triangle : 5-wave triangular pattern composed of 3-3-3-3-3 sub-wave structure.
  5. Double Three : abcxabc pattern composed of any two from above, linked by x wave.
  6. Triple Three : abcxabcxabc pattern composed of any three from above, linked by two x waves.


The attractiveness of Elliott Wave Analysis is : Three impulse wave forms and six corrective wave forms are conclusive. All we have to do is to identify which wave form is going to unfold in order to predict future market actions, however knowledge of market historical wave patterns and experiences in wave count are of paramount importance.
Fibonacci Tools

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 sequence occurs by adding the previous two numbers (i.e. 1+1=2, 2+3=5) The main ratio used is .618, this is found by dividing one Fibonacci number into the next in sequence Fibonacci number (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. There are many Fibonacci tools used by traders, they include:

Fibonacci Retracements

Arguably the most heavily used Fibonacci tool is the Fibonacci Retracement. To calculate the Fibonacci Retracement levels, a significant low to a significant high should be found. From there, prices should retrace the initial difference (low to high or high to low) by a ratio of the Fibonacci sequence, generally the 23.6%, 38.2%, 50%, 61.8%, or the 76.4% retracement.



Note that a trendline was drawn from a significant low (beginning of trend) to a significant high (end of trend). The chart below shows that Fibonacci Retracements can be used to retrace downtrend moves as well: fibonacci retracements act as support and resistance.  Notice after the bottom that price rallied to the 23.6% retracement level and then was promptly rejected downwards. After breaking resistance a few months later, the 23.6% retracement became support. Price rallied up to the 50% retracement level, where it ran up against resistance. Price continued to fluctuate between the 38.2% retracement level (acting as support) and the 50% retracement level (acting as resistance).

Fibonacci Arcs
Fibonacci Arcs are percentage arcs based on the distance between major price highs and price lows. Therefore, with a major high, major low distance of 100 units, the 31.8% Fibonacci Arc would be a 31.8 unit semi-circle.


After the significant bear market, the rally was stopped by the 50% arc; the 50% arc retracement acted as resistance, 38.2% arc than gave support, bouncing between the 50% arc and the 38.2% arc for many months. After price broke through the resistance arc at 50%, price moved up to the next significant Fibonacci ratio, 61.8%, where it found a new resistance level. The prior resistance level at 50%, after being broken, became a new support level. The next Fibonacci arc was at 100%, where price met resistance.

Fibonacci Fans

Fibonacci Fans use Fibonacci ratios based on time and price to construct support and resistance trendlines; also, Fibonacci Fans are used to measure the speed of a trend's movement, higher or lower. If prices move below a Fibonacci Fan trendline, then price is usually expected to fall further until the next Fibonacci Fan trendline level; therefore, Fibonacci Fan trendlines are expected to serve as support 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 pierced, then the next Fibonacci Fan trendline higher is expected to act as resistance. The Fibonacci ratio is also used to predict areas of time in which price could change course.


Fibonacci Time Extensions


Fibonacci Time Extensions are used to predict periods of price change (i.e. lows or highs). For example, after a downtrend, a reversal would be expected at a significant Fibonacci Time Extension line. Similarly, after an uptrend, a reversal warning could occur if a Fibonacci Time Extension was soon approaching. The Fibonacci Time Extension tool is created by locating a significant high (low) and finding a significant retracement or extension low (high).



Fibonacci Tools are very popular, possibly the very reason that they appear to work. Whether or not a trader believes Fibonacci ratios work beyond nature and into the financial markets, traders should be aware of Fibonacci Retracements (most often used) and the other Fibonacci Tools. Because there are many traders out there who do believe that the Fibonacci ratios apply to the financial markets, that means there are real supply and demand forces working on the markets at these important Fibonacci junctures. This is important because, after all, supply and demand is the concept that moves the markets.

Moving Averages
Moving averages are one of the most popular and easy to use tools available to the technical analyst. They smooth a data series and 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.

The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are described in more detail below.


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. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.

The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curving 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:


Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will be subtracted and the moving average will continue to move over time. In this example , using closing prices , day 10 is the first day possible to calculate a 10-day simple moving average. As the calculation continues, the newest day is added and the oldest day is subtracted. The 10-day SMA for day 11 is calculated by adding the prices of day 2 through day 11 and dividing by 10. The averaging process then moves on to the next day where the 10-day SMA for day 12 is calculated by adding the prices of day 3 through day 12 and dividing by 10.The chart above is a plot that contains the data sequence in the table. The simple moving average begins on day 10 and continues.
This simple illustration highlights the fact that all moving averages are lagging indicators and will always be "behind" the price. The price is trending down, but the simple moving average, which is based on the previous 10 days of data, remains above the price. If the price were rising, the SMA would most likely be below. Because moving averages are lagging indicators, they fit in the category of trend following indicators. When prices are trending, moving averages work well. However, when prices are not trending, moving averages can give misleading signals.

Exponential Moving Average Calculation

Exponential Moving Averages can be specified in two ways - as a percent-based EMA or as a period-based EMA. A percent-based EMA has a percentage as its single parameter while a period-based EMA has a parameter that represents the duration of the EMA.

The formula for an exponential moving average is:

EMA(current) = ( (Price(current) - EMA(prev) ) x Multiplier) + EMA(prev)

For a percentage-based EMA, "Multiplier" is equal to the EMA's specified percentage.
For a period-based EMA, "Multiplier" is equal to 2 / (1 + N) where N is the specified number of periods.

For example, a 10-period EMA's Multiplier is calculated like this:

(2 / (Time periods +1) ) = (2 / (10+1) ) = 0.1818 (18.18%)

This means that a 10-period EMA is equivalent to an 18.18% EMA.

Note: StockCharts.com only support period-based EMA's.

Below is a table with the results of an exponential moving average calculation for Eastman Kodak. For the first period's exponential moving average, the simple moving average was used as the previous period's exponential moving average (yellow highlight for the 10th period). From period 11 onward, the previous period's EMA was used. The calculation in period 11 breaks down as follows:

  1. (C - P) = (61.33 - 63.682) = -2.352
  2. (C - P) x K = -2.352 x .181818 = -0.4276
  3. ((C - P) x K) + P = -0.4276 + 63.682 = 63.25



*The 10-period simple moving average is used for the first calculation only. After that the previous period's EMA is used.

Note that, in theory, every previous closing price in the data set is used in the calculation of each EMA that makes up the EMA line. While the impact of older data points diminishes over time, it never fully disappears. This is true regardless of the EMA's specified period. The effects of older data diminish rapidly for shorter EMAs than for longer ones but, again, they never completely disappear.

Simple Versus Exponential

From afar, it would appear that the difference between an exponential moving average and a simple moving average is minimal. For this example, which uses only 20 trading days, the difference is minimal, but a difference nonetheless. The exponential moving average is consistently closer to the actual price. On average, the EMA is 3/8 of a point closer to the actual price than the SMA.

Which moving average you use will depend on your trading and investing style and preferences. The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks. 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 addition, much will depend on the individual security in question. Moving average type and length of time will depend greatly on the individual security and how it has reacted in the past.

The initial thought for some is that greater sensitivity and quicker signals are bound to be beneficial. This is not always true and brings up a great dilemma for the technical analyst: the trade off between sensitivity and reliability. The more sensitive an indicator is, the more signals that will be given. These signals may prove timely, but with increased sensitivity comes an increase in false signals. The less sensitive an indicator is, the fewer signals that will be given. However, less sensitivity leads to fewer and more reliable signals. Sometimes these signals can be late as well.

For moving averages, the same dilemma applies. Shorter moving averages will be more sensitive and generate more signals. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability.

When to Use MA

Moving averages smooth out a data series and make it easier to identify the direction of the trend. Because past price data is used to form moving averages, they are considered lagging, or trend following, indicators. Moving averages will not predict a change in trend, but rather follow behind the current trend. Therefore, they are best suited for trend identification and trend following purposes, not for prediction.

Because moving averages follow the trend, they work best when a security is trending and are 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. This process does not have to be a scientific examination. Usually, a simple visual assessment of the price chart can determine if a security exhibits characteristics of trend. In its simplest form, a security's price can be doing only one of three things: trending up, trending down or trading in a range. An uptrend is established when a security forms a series of higher highs and higher lows. 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 range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.

Once a security has been deemed to have enough characteristics of trend, the next task will be to select the number of moving average periods and type of moving average. The number of periods used in a moving average will vary according to the security's volatility, trendiness and personal preferences. The more volatility there is, the more smoothing that will be required and hence the longer the moving average. Stocks that do not exhibit strong characteristics of trend may also require longer moving averages. There is no one set length, 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 trends 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. Trial and error is usually the best means for finding the best length. Examine how the moving average fits with the price data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If the moving average is slow to react, shorten the moving average to increase its sensitivity. In addition, you may want to try using both simple and exponential moving averages. Exponential moving averages are usually best for short-term situations that require a responsive moving average. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity.


Uses for Moving Averages

There are many uses for moving averages, but two basic uses stand out:-

Trend identification/confirmation

The first trend identification technique uses the direction of the moving average to determine the trend. If the moving average is rising, the trend is considered up. 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 moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.


The second technique for trend identification is price location. The location of the price relative to the moving average can be used to determine the basic trend. If the price is above the moving average, the trend is considered up. If the price is below the moving average, the trend is considered down.

The third technique for trend identification is based on the location of the shorter moving average relative to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up. If the shorter moving average is below the longer moving average, the trend is considered down.

Support and Resistance level identification/confirmation

Another use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets.

ConclusionsMoving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. However, traders and investors should learn to identify securities that are suitable for analysis with moving averages and how this analysis should be applied. Usually, an assessment can be made with a visual examination of the price chart, but sometimes it will require a more detailed approach. 

The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages will help ensure that a trader is in line with the current trend. However, markets, stocks and securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to get out at the top and in at the bottom using moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.