Technical Analysis of Stocks
Investing in Stock Markets — Detailed Study Notes
1. Meaning and Basic Assumptions
Technical analysis is the study of historical price movements and trading volume to forecast future price
behaviour of securities. Unlike fundamental analysis, it does not concern itself with a company's
intrinsic value; instead, it assumes that all relevant information is already reflected in the price, and that
prices move in identifiable trends that tend to repeat because market psychology repeats.
Technical analysis rests on three core assumptions, often attributed to the Dow Theory: (i) the market
discounts everything, meaning all known information is already priced in; (ii) prices move in trends, and
a trend in motion is more likely to continue than reverse; and (iii) history tends to repeat itself, largely
because of the recurring nature of investor psychology in the face of fear and greed.
Exam Tip: The three core assumptions of technical analysis are a common short-answer question —
memorise them precisely.
2. Dow Theory
Dow Theory, developed by Charles Dow, is considered the foundation of modern technical analysis. It
identifies three types of trends operating simultaneously: the primary trend (long-term, lasting a year or
more), the secondary trend (intermediate corrections lasting weeks to months that move against the
primary trend), and minor trends (short-term daily fluctuations considered market "noise").
The theory also states that a trend remains in effect until a clear reversal signal appears, and that
trading volume should confirm the price trend — rising volume on advances and declining volume on
corrections strengthens confidence in an ongoing uptrend.
3. Chart Types
• Line Chart: connects closing prices over time; simplest form, useful for spotting the broad trend.
• Bar Chart (OHLC): shows Open, High, Low, and Close for each period as a single vertical bar with
side ticks.
• Candlestick Chart: displays the same OHLC data as a "candle" body (open-close range) with wicks
(high-low range); the most widely used chart in modern trading due to its visual clarity on market
sentiment.
• Point and Figure Chart: plots only significant price movements using X's and O's, ignoring time and
minor fluctuations.
4. Trend, Support, and Resistance
A trend is the general direction in which a security's price is moving — uptrend (higher highs and higher
lows), downtrend (lower highs and lower lows), or sideways/range-bound. Support is a price level at
which buying interest is historically strong enough to prevent the price from falling further, while
resistance is a price level at which selling interest tends to cap further upward movement. When a
resistance level is decisively broken, it often becomes a new support level, and vice versa — a concept
known as role reversal.
Exam Tip: A well-drawn diagram of an uptrend/downtrend with support and resistance lines labelled is a
good way to score full marks in diagram-based questions.
5. Chart Patterns
5.1 Reversal Patterns
• Head and Shoulders: a peak (left shoulder), a higher peak (head), and another lower peak (right
shoulder), signalling a bearish reversal at the top of an uptrend; the inverse pattern signals a bullish
reversal at the bottom of a downtrend.
• Double Top / Double Bottom: two consecutive peaks or troughs at roughly the same price level,
indicating the prevailing trend is losing strength and may reverse.
5.2 Continuation Patterns
• Flags and Pennants: brief consolidation patterns that occur after a sharp price move, typically
resolving in the direction of the prior trend.
• Triangles (ascending, descending, symmetrical): periods of converging price consolidation that
usually break out in the direction of the dominant trend.
6. Technical Indicators
Indicator Category Purpose
Moving Average (SMA/EMA) Trend-following Smooths price data to reveal the underlying trend direction
MACD Trend/Momentum Shows relationship between two moving averages to signal momentum
RSI (Relative Strength Index) Momentum/Oscillator Measures speed of price change; identifies overbought (>70) and overs
Bollinger Bands Volatility Bands around a moving average that widen/narrow with volatility
On-Balance Volume (OBV) Volume Uses volume flow to confirm or question price trends
Stochastic Oscillator Momentum Compares closing price to its price range over a set period
Exam Tip: RSI thresholds (above 70 = overbought, below 30 = oversold) are frequently tested
numerically — know them cold.
7. Moving Averages in Detail
A Simple Moving Average (SMA) is the arithmetic mean of closing prices over a specified number of
periods (e.g., a 50-day or 200-day SMA), recalculated as each new period closes. An Exponential
Moving Average (EMA) gives greater weight to recent prices, making it more responsive to new
information than the SMA. A widely watched signal is the "Golden Cross," where a shorter-term moving
average crosses above a longer-term moving average (e.g., 50-day crossing above 200-day),
considered bullish; the opposite, a "Death Cross," is considered bearish.
8. Strengths and Limitations
• Strength: useful for timing entry and exit points, especially for short-term traders.
• Strength: applicable across any liquid, traded asset class, since it relies only on price/volume data.
• Limitation: can produce false signals, especially in choppy or low-volume markets.
• Limitation: is inherently backward-looking, relying on historical patterns that may not repeat.
• Limitation: does not consider the underlying business quality or intrinsic value of the security.