Forecasting Financial Markets|
Cornerstones of Technical Analysis4
The Use of Dow Theory – Criticism and Benefits6
Moving Average Envelopes and Bollinger Bands10
The Relative Strength Index (RSI)13
Moving Average Convergence / Divergence (MACD)15
Elliot Wave Theory17
The Rule of Alternation19
Fibonacci Numbers as the Basis of the Wave Principle19
Elliot Wave Principle in Use20
“Technical analysis is a very old discipline in market analysis. Created for the most part, by pure practitioners, it has most of the time been questioned, rejected or ignored by academic circles. However, technical analysis has developed over the centuries from clear chart reading into a state where many varying toolsets are used. The used charts, trading models and analyses are very different in nature but do have a common denominator. They use pure market data as input and therefore they are classified as technical analysis.
The body of knowledge of technical analysis has grown rapidly by borrowing from other disciplines. With the growth of computer power, technicians have integrated elements from statistics, information theory, physics, time series analysis and econometrics – just to name a few. While the toolset has become more academic and sophisticated; practitioners’ intention is still driven by market returns.
Academic interest in technical analysis started in the late 1950s. Ever since the first paper on the subject was written, researchers from universities and institutions, such as central banks, have tried to prove whether technical analysis is worthwhile or whether it is just pure nonsense. For decades, the prevalent regime was the efficient market hypothesis" i.e. the idea that market prices discount available information instantly and therefore, not only technical analysis but virtually every kind of analysis is useless. This quarrel has not yet been solved, but for over 20 years there has been a growing body of evidence that technical analysis can be profitable. Whereas technicians are only interested in the question: “Does it work?”, academics prefer to ask: “Why does it work?”.”
This paper provides a brief explanation of some of the underlying theories of technical analysis and some of the most popular indicators. The paper starts with a definition of technical analysis and its basic assumptions. Then follows an overview of the Dow Theory, the first pillar of technical analysis, and its implications it the process of technical trading until now. The paper skips the topics about the process of charting stocks and the major chart patterns. It goes directly to the most popular indicators used in technical analysis – those of moving averages and oscillators. All indicators are explained in theory and in practice using the data of the Dow Jones Industrial Average index as one of the barometers of the economy. Lately, the paper presents another theory – Elliot Wave Principle as a complement of the Dow Theory and a new view of the predominant psychological influence over the stock markets.
Technical analysis is the study of market action for the purpose of forecasting of future price trends. The term market action includes the three main sources of information: price, volume and open interest (only for futures and options). Technical analysis is in its essence a set of forecasting methods used for taking trading decisions. Technical analysis is the study of how securities prices behave and how to exploit that information to make money while avoiding losses. The technical style of trading is opportunistic. The goal is to forecast the price of the security over some future time horizon in order to buy and sell the security to make a...