Prof.

Swami Prasad Saxena

Unit 4: Investment Analysis

Lesson 1: Fundamental Analysis
An investor while investing in stock, has the primary purpose of gain. If he invests for a short
period, it is speculative; but when he holds it for a fairly long period, the anticipation is that
he would receive some return on his investment. Fundamental analysis is a method used to
evaluate the true (intrinsic) value of a stock, by examining various qualitative and quantitative
factors. This approach looks beyond short-term price changes and focuses on the company's
financial health, industry position, and economic conditions.
In the fundamental approach, various fundamentals or basic factors that affect the return and
risk of securities are examined. The purpose of analysis is to identify securities which are
perceived to be mispriced in the stock market. The assumption in this case is that the market
price (MP) of the security is different from the price justified through analysis of fundamental
factors, also called as intrinsic value (IV). It provides an opportunity for a discerning investor
to detect such discrepancy. The moment such a discrepancy is identified, the decision to invest
or disinvest is taken. The decision rule under this approach is that:
• If intrinsic value of a security is less than its market price (IV < MP): Sell the security, because
it is expected that the market will sooner or later realise its mistake and reduce its price.
• If intrinsic value of a security is higher than the market price (IV > MP): Buy the security
before the market corrects its mistake by increasing the price of security.
• If intrinsic value and market price of a security coincides (IV = MP): Hold the security.
Fundamental analysis aims to find stocks that are trading at prices different from their real
value. An investor, while using fundamental analysis tries to figure out if a stock is priced fairly,
too low, or too high. It helps him decide whether to buy, keep, or sell the stock. Fundamental
analysis involves looking at three main areas:
• Economic analysis: It includes studying broad economic indicators (economic forces in
which businesses operate), like GDP growth, inflation rates, and interest rates.
• Industry analysis: It involves analysis of industry trends (to which they belong),
competition, and growth prospects.
• Company analysis: It includes looking at the company's financial statements, management
quality, competitive position, and other essential aspects that determine the true worth of
an investment.
The analysis of three major components of fundamental analysis (Economy, Industry, and
Company) is also called as EIC Analysis. The EIC framework provides a structured approach to
analyse investment opportunities by examining economic trends, industry dynamics, and
company-specific factors. This comprehensive analysis helps investors to make informed
decisions by understanding the broader economic environment, the specific industry's
characteristics, and the company's potential within that context.
EIC analysis is crucial for investors: (i) It helps investors understand a company's true value
beyond just its stock price, (ii) Investor can spot undervalued companies with good growth
potential, and (iii) It helps investors avoid risky investments by identifying red flags in a
company's financials or market position. Thus, by using fundamental analysis, an investor can

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make smart investment decisions based on overall health and future prospects of investment
rather than just following market trends.
The process of investment analysis starts with an evaluation of economic outlook. After getting
some confidence on economic outlook, the analysis moves to identify most attractive or
potential industries that are worth for investment during the investment horizon. Once
industries are picked up, the analysis moves to examine the outlook of firms in the selected
industries for picking potential stocks.
Types of Fundamental Analysis
Fundamental analysis can be divided into two main categories: (i) Qualitative analysis, and (ii)
Quantitative analysis. The purpose of qualitative analysis is to understand a company's strategic
direction and long-term potential and identify potential risks and opportunities that may not
be apparent from financial data alone. It involves evaluating non-numerical factors that can
impact a company's future prospects, and examines factors like management quality,
competitive advantages, and industry trends. Key factors in qualitative analysis are analysis of
the fundamental of macroeconomy (macroeconomic indicators and government policies),
industry analysis (understanding the industry's growth prospects, competitive landscape, and
regulatory environment), competitive advantage (determining if the company has a sustainable
edge over its competitors, such as brand recognition, patents etc.), management quality
(assessing the experience, integrity, and vision of a company's leadership, business model
(evaluating company's revenue streams, competitive advantages, and growth potential, and
corporate governance (assessing the company's ethical practices and accountability).
Quantitative analysis aims to assess a company's financial stability, profitability, and efficiency,
and determines if a company's stock is undervalued or overvalued. It involves analysing
numerical data and financial metrics through financial statement analysis and ratios analysis.
The analysis of financial statements involves analysing trends in revenue, expenses, and profits,
evaluating a company's assets and liabilities, and assessing cash flow generation, while ratios
analysis assesses company's financial health through profitability ratios (e.g., profit margin,
return on equity), liquidity ratios (e.g., current ratio, quick ratio), solvency ratios (e.g., debt-
to-equity ratio), and valuation ratios (e.g., price-to-earnings ratio).
In brief, qualitative analysis helps investor understand why those numbers are what they are,
and what they mean for the future of the company, and quantitative analysis tells what the
numbers are expected to affect performance of the company. Both quantitative and qualitative
analysis are essential for a comprehensive understanding of a company. Thus, by combining
both approaches, investors can make more informed and well-rounded investment decisions.
Detailed description of various components of fundamental analysis is as follows.
A. Economy Analysis
Economy analysis is crucial because the overall state of the economy can significantly impact a
company's performance. The significance of the economic indicators is primarily to try and
form a strategy for making investments. It involves studying the overall health and direction of
the economy. Investors primarily look at macroeconomic factors, such as GDP growth,
inflation, interest rates, unemployment, and consumer spending to understand the broader
economic environment that companies operate in. Further, a look into the monetary, fiscal,
and demographic factors will give a basic idea into the trends in the economy.

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The critical issue before investors is to assess the future of economic activity so that they can
take an informed investment decision. It is possible by forecasting a few widely used economic
measures.
Prominent economic measures considered in economy analysis
• Economic and political stability: A stable political environment is necessary for steady and
balanced growth as it ensures stability in government’s economic policies. The stable long-
term economic policies help boost investors’ confidence, economic and industrial growth.
• Gross domestic product: It measures the overall size and health of the economy. GDP
growth rate is relevant for investment for two reasons: (i) a good GDP growth means
continuous income for individuals and hence surplus money can be deployed for
investments, and (ii) corporate growth is directly influenced by the GDP growth.
• Inflation: Inflation can erode a company's profits if it cannot raise prices on its products or
services to offset rising costs. Inflation in general is not bad if it comes along with the growth
of the economy. When the economy is expanding fast, it is natural that money supply also
increases along with disposable personal income of individuals and thus cause an increase
in prices. Under this condition, stock market is favourably affected on account of increase
in profitability of firms.
• Interest rates: Interest rates affect borrowing costs for companies. An increase in interest
rate affects the value of stock as well as other securities in two ways: (i) it affects adversely
the profitability of firms because of higher outflow on interest cost, and (ii) it also increases
the expected rate of return of investors, so adversely effects the value of securities.
• Foreign exchange rate and Forex reserve: Exchange rate affects balance of trade, balance
of payment and foreign exchange reserves position. A large size of foreign exchanges
reserves is an indicator of the strength of economy and the value of domestic currency on
external account.
• Government policies: Government has two broad classes of macroeconomic tools that
affect the demand and supply of goods and services in the economy. Demand-side policy
focuses on government spending, tax levels, and monetary policy, and supply-side policy
is concerned concerns with enhancing the productive capacity of the economy. These
policies primarily include fiscal policy and monetary policy. Fiscal policy refers to the
government’s spending and tax action and is part of demand-side management. It is the
most direct way to influence the economy. Monetary policy, in the form of changing CRR
and SLR is also demand-side management of economy.
• Government budget: The government budget provides detailed information on each of
government spending and revenues. The deficit is essentially the excess of government
spending on revenues. Budget deficit though often incurred for creating infrastructural
facilities in the economy tends to create inflationary pressure. Due to this there is a strong
public opinion against the government's creation of deficit without expanding the revenue.
The government spending generates substantial demand for goods and services produced
by such industries. The government expenditure is also great stimulant of the economy by
creating employment and generating effective demand. In view of the significance of
government expenditure and deficit on the economy, an investor has to evaluate these
carefully to assure their impact on his investment.
• Savings and investment: The capital market is a channel through which the savings of
households are made available to corporate for investment. Therefore, the trends in saving

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and investment are significant in studying their impact on capital market. A rising trend in
investment points to the fact, that economy is on upswings with additional employment
and income generation. Under such simulation, the share prices are likely to go up,
particularly due to demand for this type of financial assets. Moreover, the pattern of
distribution of savings over the various assets like bank deposits, bullion, stocks etc. will
give an idea of-relative preference of the investor to various types of assets.
• Consumer confidence: Consumer confidence index is one of the strong short-term
economic indicators used by the investors to assess whether there is any change of direction
in the economy. It indicates how optimistic consumers are about the economy, leading to
higher consumer spending, and benefits to most businesses.
Techniques of economy analysis
To perform economy analysis, it is essential to forecast economic performance for short,
medium and long period, with the help of some of the economic factors. The major techniques
used for this purpose include: (i) survey of experts’ opinion, (ii) analysis of trends of
macroeconomic indicators, (iii) analysis of trends in money supply and stock price, and (iv)
economic modelling. Investors need not necessarily make their own economic forecasts, but
they must be able to understand published information to find out the possible impact of
macroeconomic factors on stock price movements.
Steps involved in economy analysis
• Identify Trends: Investors look for major economic trends that might favour certain
industries or companies. For example, a growing economy might be good news for
consumer discretionary stocks.
• Assess Risk: Economic analysis helps assess the overall risk level of an investment. Investing
in a company during a recession, for example, might be considered riskier than investing
during a period of economic growth.
• Make Forecasts: Investors use economic data to make forecasts about future economic
conditions, which can help them predict how well a company might perform.
B. Industry Analysis
Industry analysis is a crucial part of fundamental analysis. This focuses on the specific industry;
a company belongs to. Investors analyse industry trends, competition, growth potential, and
the industry's overall life cycle to evaluate the intrinsic value of a company and make informed
investment decisions. Some of the more useful bases for classifying industries from the
investment decision point of view are as follows.
• Growth industry: This is the industry, which is expected to grow persistently, and its growth
is likely to exceed the average growth of the economy.
• Cyclical industry: In this category of the industry, the firms included are those which move
closely with the rate of industrial growth of the economy and fluctuate cyclically as the
economy fluctuates.
• Defensive industry: It is a grouping that includes firms which move steadily with the
economy and decline less than the average decline of the economy in a cyclical downturn.
• Declining industry: This is that category of firms, which either generally decline absolutely
or grow less than the average growth of the economy.

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Why industry analysis matters?

• Identify growth opportunities: Some industries are naturally positioned for growth due to
factors like technological advancements, changing consumer preferences, or demographic
shifts. Industry analysis helps pinpoint these areas.
• Assess risks: Industries can be susceptible to various risks, such as regulatory changes,
economic downturns, or intense competition. Understanding these risks helps in making
informed investment decisions.
• Compare companies: By analysing the industry, you can better understand how a specific
company performs relative to its competitors. This helps in identifying companies with a
competitive edge.
• Diversification: Industry analysis helps in diversifying a portfolio across different sectors,
reducing the overall risk.
• Informed decision-making: Ultimately, industry analysis provides a framework for making
informed investment decisions, increasing the chances of achieving your financial goals.
Key components of industry analysis
• Industry overview: It includes: (i) understanding of the current size of the industry and its
historical and projected growth rates, (ii) analyse industry's structure, including the number
of competitors, their market share, and the level of concentration, and (iii) identify key
trends affecting the industry, such as technological advancements, changing consumer
preferences, and regulatory changes.
• Demand supply gap: The gap between demand-supply of a product is a fair indicator of
short term and long-term profitability of the firm in the industry. Excess capacity (excess of
supply over demand) tends to reduce profitability of an industry through the decline in the
unit price realization, and inadequate capacity (excess of demand over supply) tends to
improve the profitability through higher price realization.
• Competitive landscape: It comprises of the analyse of industry's competitive intensity using
Porter's Five Forces framework, that includes:
o Threat of new entrants – How easy or difficult is it for new companies to enter the
industry?
o Bargaining power of suppliers – How much power do suppliers have to influence prices
and availability of inputs?
o Bargaining power of buyers – How much power do buyers have to negotiate prices?
o Threat of substitute products or services – Are there other products or services that can
satisfy the same customer need?
o Rivalry among existing competitors: How intense is the competition among existing
players in the industry?
• Competitive advantages: Identify the key factors that give companies a competitive edge,
such as cost leadership, differentiation, or niche market focus.
• Key success factors: Determine the critical factors that companies need to excel at to succeed
in the industry. These could include factors like innovation, operational efficiency, customer
service, or brand recognition.
• Industry life cycle: Identify the stage of the industry's life cycle (introduction, growth,
maturity, or decline). This will provide insights into the industry's growth potential and
competitive dynamics.

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• Policies, regulations and economic factors: It includes regulations and economic factors
affecting industry performance.
o Economic Policies: Identify government policies, such as tax breaks, exemptions etc.
that are available for export-oriented units that may impact corporate performance.
o Regulations: Understand the regulatory environment in which the industry operates,
including industry-specific and environment or pollution related regulations that may
impact companies.
o Economic factors: Consider macroeconomic factors that may affect the industry, such
as GDP growth, inflation, interest rates, labour force, and consumer spending.
Steps involved in industry analysis
• Define the industry: Clearly define the boundaries of the industry you are analysing. This
will help you focus your research and analysis.
• Gather information: Collect relevant data and information pertaining to market size and
growth rate, key players and their market share, industry trends (such as, technological
advancements, regulatory changes), competitive landscape (such as, level of competition,
barriers to entry) , economic factors (such as, impact of economic cycles on the industry)
from various sources, such as industry reports, company filings, market research reports,
and news articles.
• Analyse the data: Use the components of industry analysis to analyse the collected data
using Porter's five forces model, PESTLE analysis technique (political, economic, social,
technological, legal and environmental factors of the industry), and evaluate SWOT
(strengths, weaknesses, opportunities, and threats for the industry). This will help you
understand the industry's dynamics, competitive landscape, and key success factors.
• Identify opportunities and threats: Based on your analysis, identify the opportunities and
threats facing companies in the industry.
• Assess industry attractiveness: Evaluate the overall attractiveness of the industry based on
your analysis. Consider factors like growth potential, profitability, and competitive
intensity.
• Draw conclusions: Summarize your findings and draw conclusions about the industry's
prospects and its potential impact on the companies you are analysing.
C. Company Analysis
The key objective of investors is to maximise returns. For this purpose, investors normally apply
a simple and common-sense decision rule. i.e., (i) Buy the share at a low price, and (ii) Sell the
share at a high price. But, to operationalize the decision, investors must try to explore answer
to two prominent questions: (i) Whether the price of a company’s share is high or low? and
(ii) Which benchmark to use to compare the price of the share? To get answers to these
questions, investors need to conduct company analysis.
Basically, company analysis is the process of evaluating a company’s financial and operational
performance to determine its strengths, weaknesses, opportunities, and threats. Company
analysis is also referred as security analysis in which stock picking activity is done. Different
analysts use quantitative and qualitative methodologies to conduct company analysis.
Quantitative analysis is related to information that can be shown in numbers and amounts.,

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while qualitative analysis is concerned with the nature or standard of something, rather than
to its quantity.
Key aspects of company analysis
The key qualitative factors analysts always consider for company analysis are:
• Business model: The first and foremost thing an investor should do before starting any study
is to understand what the firm performs to generate income. A business model specifies the
company's revenue generation strategy, products and services, and target market to retain
profitability. Companies must constantly update, develop, and be ready to withstand any
technological disruption, as well as implement efficient marketing and commercial strategies
for their smooth operation, or they will incur losses and finally be wiped out of the market.
• Competitive advantage: Typically, investors should prefer to invest in companies that have
developed competitive advantages for themselves in terms of cost advantage, quality,
brand, distribution network, and so on. This assists a company in creating an economic
moat around the business, allowing it to keep competitors at bay while enjoying longevity,
growth, profits, and market share dominance.
• Management: Sound management with high credibility always works for the benefit of the
company and its people while also creating profit for the shareholders. As a result, it is
always in the best interests of the shareholders to be identified with trustworthy and
competent management rather than with management whose reputation is questioned.
The investors should consider variables such as management credentials, integrity,
transparency, the viability of objectives and goals, past execution skills, competitiveness,
and length of tenure, among others.
• Corporate Governance: This is the set of rules, policies, and processes that command-and-
control enterprises while also balancing the interests of management, directors, and
stakeholders. Investors should put their money into companies that are conducted ethically,
fairly, honestly, and efficiently, and whose management respects the rights and interests of
its shareholders. The investors should make sure that communications on the part of
company are clear, transparent, and intelligible. They should avoid companies that do not
engage in such procedures or are under the scrutiny of SEBI or the government because of
any misappropriation.
• Industry Trends: This involves understanding the trends in the industry in which the
company operates, including technological advancements, regulatory changes, and
customer behaviour. An investor should consider a company's customer base, market share,
industry growth, competition, regulation, and business cycles. Learning how the industry
works will give an investor a deeper understanding of a company's financial health.
• Stakeholder Satisfaction: Employees, managers, customers, suppliers, investors, and other
stakeholders should all have positive views on the company and its prospects. Without
that, a company's brand equity and image can suffer, which can lead to fewer sales, lower
profits, and flagging share prices.
The quantitative analysis primarily focuses on financial performance analysed through ratio
analysis. The widely used financial ratios are categorised as: profitability ratio, liquidity ratios,
solvency ratios, efficiency ratios, and valuation ratios. The formulae used for analysing
company’s performance on identified parameters are given below.

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A. Profitability Ratios
Gross Profit Operating Profit
Gross Profit Margin = Operating Profit Margin =
Sales Sales
Net Profit Profit after Tax
Net Profit Margin = Return on Total Assets =
Sales Average Total Assets
Profit after Tax PAT + Interest (1 − Tax)
Return on Equity = Return on Capital Employed =
Equity Funds Total Capital Employed
Higher margins and returns generally indicate a more profitable and efficient business.
B. Liquidity Ratios
Current Assets Cash + Marketable Sec. + Receivables
Current Ratio = Liquid Ratio =
Current Liabilities Current Liabilities
Higher liquidity ratios suggests that company has enough liquidity to cover short-term
liabilities.
C. Solvency Ratios
Debt Debt
Debt to Equity Ratio = Debt to Assets Ratio =
Equity Funds Total Assets
EBIT EAT − Pref. Dividend
Interest Coverage Ratio = Cover for Equity Dividend =
Interest Equity Dividend
Solvency ratios indicate company's ability to meet its long-term debt obligations. Lower debt
ratios and higher interest coverage ratios generally indicate a more financially stable company.
D. Efficiency Ratios
CoGS CoGS
Asset Turnover Ratio = Inventory Turnover Ratio =
Total Assets Average Inventory
CoGS CoGS
WC Turnover Ratio = Receivables Turnover Ratio =
Working Cap. Avg. Accounts Receivables
Efficiency ratios measure how effectively a company manages its assets to generate sales.
Higher turnover ratios suggest that company is using its assets more efficiently.
E. Valuation Ratios
Market Price per Share Market Price per Share
PE Ratio = Price to Book Value Ratio =
Earning per Share Book Value per Share
Earning per Share Dividend per Share
Earning Yield = Dividend Yield =
Mkt. Price per Share Mkt. Price per Share
Eq. Capital + Res. Highest Price + Lowest Price
BV per Share = Price Volatility =
No. of Eq. Shares Lowest Price of Shares
Equity Dividend
Dividend Payout =
Equity Earning
Higher valuation ratios may indicate that the stock is overvalued. Higher volatility indicates
high investment risk.

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Fundamental analysts forecast future performance by analysing historical trends, growth rates,
industry dynamics, management strategies, and market conditions. It projects future earnings,
cash flows, and revenue based on past performance and expected changes in the business
environment. It also incorporates qualitative factors by assessing a company’s brand value,
market perception, customer loyalty, competitive positioning, and innovation. These factors
contribute to the company’s competitive edge and long-term sustainability, influencing its
intrinsic value.
In companies with limited historical data, fundamental analysis relies on assessing management
quality, the uniqueness of the business model, market potential, innovation, and future growth
prospects. It also involves benchmarking against other established companies in the industry.
By examining a company’s financial health, debt levels, and management strength,
fundamental analysis helps assess the risks associated with an investment. Understanding these
risks is essential in managing a portfolio effectively.
Evaluating the fundamental aspects assists in identifying undervalued stocks, selecting robust
performers, managing risks, and diversifying portfolios. Even for a short-term gain or aiming
for long-term wealth accumulation, a comprehensive understanding of a company’s
fundamentals is the basis for building successful investment strategies.

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Lesson 2: Technical Analysis – Theoretical Framework

Prominent theories of technical analysis are (i) Dow theory, (ii) Elliott Wave theory, (iii) Theory
of Contrary Opinion, and (iv) Odd Lot theory. These theories primarily consider changes in
securities prices, time taken in trend reversal, volume of transactions due to price changes, and
width of price changes (i.e., whether a change in trend spreads across most sectors and
industries or is concentrated in few securities only).
Dow Theory
Dow theory is a foundational concept in technical analysis, developed by Charles Dow in the
late 19th and early 20th centuries. It provides a framework for understanding and interpreting
market movements, aiming to identify primary trends and potential reversals.
Key principles of Dow theory
1. Market discounts everything: This means all known information, including economic news,
political events, and company-specific factors, is already reflected in market prices.
Therefore, price action is the primary indicator to analyse trends
2. Market trend is of three types.
• Primary trend is major, long-term trend, lasting from months to years. It can be bullish
(uptrend) or bearish (downtrend).
• Secondary trends are intermediate-term corrections within the primary trend, typically
lasting from a few weeks to several months. They usually retrace a portion of the
previous primary trend's move.
• Minor trends are short-term fluctuations, lasting from few days to weeks, and are
considered less significant in identifying the overall market direction.
3. Primary trends have three phases.
• Accumulation phase – when informed investors start buying when the market sentiment
is still bearish.
• Public participation or mark-up phase – when trend becomes more evident, more
investors enter the market, leading to significant price increases.
• Distribution phase – when informed investors begin selling their holdings as the market
reaches its peak and sentiment becomes overly bullish.

4. Indices must confirm each other: Dow emphasized the importance of confirmation between
different market indices, particularly the Dow Jones Industrial Average (DJIA) and the Dow
Jones Transportation Average (DJTA). A valid primary trend is believed to be in place only
when both indices confirm each other by moving in the same direction.

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5. Volume must confirm the trend: Trading volume should increase in the direction of the
primary trend. For example, in an uptrend, volume should rise as prices go up, indicating
strong buying pressure. Conversely, volume should decrease during secondary corrections.
6. A trend persists until a clear reversal occurs: This principle suggests that a trend will likely
continue until there is definitive evidence that it has reversed. It is important not to confuse
secondary corrections with the start of a new primary trend.
Applications of Dow Theory in Trading
1. Identifying market trends: The Dow Theory helps traders understand the overall direction
of the market by analysing the relationship between price movements and volume.
2. Determining entry and exit points: By identifying primary trends and potential reversals,
traders can use the Dow Theory to make informed decisions about when to enter and exit
trades.
3. Confirming trading signals: The principle of index confirmation can be used to validate
trading signals generated by other technical analysis tools.
4. Risk management: Understanding market trends can help traders adjust their risk exposure
and make more informed decisions about stop-loss levels and position sizing.
5. Long-term investing: The theory can be useful particularly for long-term investors in
identifying primary trends and making strategic investment decisions.
Double Bottom and Top Formation
Dow Theory largely rests on analysing trendlines, troughs and peaks, support and resistance,
and other market patterns and formations. Dow theory helps traders identify and confirm
trends and pick near-accurate entry and exit points and stop losses. A double top and double
bottom are recognized as reversal patterns in Dow Jones trading. A double bottom (which
resemble the letter ‘W’) takes place when a stock’s price reaches a modest low and promptly
bounces back with a rapid recovery, perceived as a bullish signal. It indicates potential buying
opportunities for investors. The case of double bottom is shown below.

Just like a double bottom, the double top (which resemble the letter ‘M’) also hints at a trend
reversal after an uptrend. It is perceived as a bearish signal, indicating potential opportunities
to sell the securities. The case of double top is shown below.

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After the price rebound, the stock sustains trading at an elevated level (in relation to the initial
low) for a minimum of two weeks, with well-distributed intervals. Following this period, the
stock attempts to return to the previously established low. If the stock successfully holds its
ground, experiences another rebound, then a double bottom pattern emerges. Once a pattern
is identified, say a double top or bottom, investors are expected to confirm the trend by the
markets using statistical tools and technical indicators.
Limitations of the Dow Theory
1. Lagging indicator: Dow theory signals are often lagging, meaning they confirm a trend after
it has already been established. This can result in missed opportunities or entering a trend
late.
2. Subjectivity: Interpreting Dow theory principles can be subjective, leading to different
conclusions among analysts.
3. Focus on price and volume: The theory primarily focuses on price and volume, potentially
overlooking other important market factors.
4. Not always applicable: The theory may not be as effective in all market conditions or with
all types of financial instruments.

Despite its limitations, the Dow Theory remains a fundamental concept in technical analysis
and provides a valuable framework for understanding market behaviour. Many modern
technical analysis tools and strategies are built upon the principles of the Dow Theory.

Elliott Wave Theory

The Elliott Wave theory, developed by Ralph Nelson Elliott, is based on the idea that financial
markets move in predictable patterns. These patterns, called waves, are thought to reflect the
collective psychology of investors.
Key Concepts of Elliott Wave Theory
• Impulse waves: These waves move in the direction of the main trend and consist of five
sub-waves, labelled 1, 2, 3, 4, and 5.
• Corrective waves: These waves move against the main trend and consist of three sub-waves,
labelled A, B, and C.
• Fractal nature: Wave patterns repeat themselves on different time scales. A five-wave
impulse pattern on a daily chart, for example, will also contain smaller five-wave impulse
patterns on hourly charts.

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• Fibonacci ratios: Elliott Wave theory uses Fibonacci ratios to predict the potential length
and duration of waves. Common retracement levels include 38.2%, 50%, and 61.8%,
while extension levels include 161.8%.
Following figure showing movement in the direction of the trend is unfolding in 5 waves
(called motive wave) while any correction against the trend is in three waves (called
corrective wave). The movement in the direction of the trend is labelled as 1, 2, 3, 4, and
5. The three-wave correction is labelled as a, b, and c. These patterns can be seen in long
term as well as short term charts.
Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves
are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece,
does, in fact, look like the big piece. This information (about smaller patterns fitting into
bigger patterns), coupled with the Fibonacci relationships between the waves, offers the
investor a level of anticipation or prediction when searching for and identifying trading
opportunities with solid reward-risk ratios.

In Elliott’s model, market prices alternate between an impulsive, or motive phase, and a
corrective phase on all time scales of trend. Impulses are always subdivided into a set of 5
lower-degree waves, alternating again between motive and corrective character, so that waves
1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3.
In the figure, waves 1, 3 and 5 are motive waves and they are subdivided into 5 smaller degree
impulses labelled as ((i)), ((ii)), ((iii)), ((iv)), and ((v)). Waves 2 and 4 are corrective waves and
they are subdivided into 3 smaller degree waves labelled as ((a)), ((b)), and ((c)). The 5 waves
move in waves 1, 2, 3, 4, and 5 make up a larger degree motive wave (1).
Corrective waves subdivide into 3 smaller-degree waves, denoted as ABC. Corrective waves
start with a five-wave counter-trend impulse (wave A), a retrace (wave B), and another impulse
(wave C). The 3 waves A, B, and C make up a larger degree corrective wave (2)
In a bear market the dominant trend is downward, so the pattern is reversed—five waves
down and three up

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Rules and Guidelines

There are specific rules and guidelines that help identify and interpret Elliott Wave patterns.
Some of the core rules include:
• Wave 2 cannot retrace more than 100% of Wave 1.
• Wave 3 cannot be the shortest of the impulse waves (1, 3, and 5).
• Wave 4 cannot overlap with the price territory of Wave 1.
Applications of Elliott Wave Theory
• To identify potential entry and exit points: By recognizing wave patterns, traders can
anticipate where a trend is likely to begin or end.
• To forecast price movements: Fibonacci ratios can help estimate the potential price targets
for different waves.
• To understand market psychology: The theory suggests that wave patterns reflect the shifts
in investor sentiment between optimism and pessimism.
Limitations of Elliott Wave Theory
• Subjectivity: Interpreting Elliott Wave patterns can be subjective, and different analysts may
come to different conclusions.
• Not always accurate: Like all forms of technical analysis, Elliott Wave theory is not
foolproof and should be used in conjunction with other tools and indicators.
• Time-consuming: Accurately identifying wave patterns can be time-consuming and requires
practice.
Elliott Wave theory is a complex but potentially useful tool for technical analysis. It can help
traders understand market cycles and forecast potential price movements, but it's important to
be aware of its limitations and use it as part of a broader trading strategy.
Theory of Contrary Opinion
The theory of contrary opinion, also known as contrarian investing, suggests that investors
should do the opposite of what the majority of investors are doing. This is based on the idea
that when everyone is bullish (expecting prices to go up), there are few buyers left to push
prices higher. Conversely, when everyone is bearish (expecting prices to go down), there are
few sellers left to push prices lower.
Key Concepts of the Theory of Contrary Opinion
• Market sentiment: Contrary opinion heavily relies on understanding the prevailing market
sentiment, whether it is bullish or bearish.
• Crowd psychology: The theory is based on the idea that the majority of investors are often
wrong, especially at market extremes.
• Identifying extremes: This theory aims to identify when market sentiment has reached an
extreme, suggesting a potential reversal.
Operation of the Theory
1. Assess market sentiment: Technical analysts use various tools and indicators to gauge the
overall sentiment of the market. These can include:
• Sentiment surveys: Surveys that ask investors whether they are bullish or bearish.
• Put/ call ratio: Compares the volume of put options (bearish) to call options (bullish).
• Volatility indices (VIX): Measures market expectations of future volatility, often seen as
a "fear gauge."

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• Advance/ decline line: Tracks the number of stocks rising versus falling.
• News and social media sentiment: Analysing the tone of financial news and social media
discussions.
2. Identify extremes in sentiment: The theory suggests that when these indicators reach
extreme levels (e.g., very high bullish sentiment or very high bearish sentiment), it could
signal an opportunity to take a contrarian position.
3. Take the opposite position: A contrarian investor would then take a position opposite to
the prevailing sentiment. For example:
• If bullish sentiment is extremely high, a contrarian might sell or short stocks, expecting
a market downturn.
• If bearish sentiment is extremely high, a contrarian might buy stocks, expecting a market
rally.
Key Considerations
• Not a timing tool: The theory of contrary opinion is not a precise timing tool. Extreme
sentiment can persist for extended periods.
• Confirmation is key: It's often wise to look for confirmation from other technical indicators
or fundamental analysis before acting on a contrarian signal.
• Risk management: As with any trading strategy, proper risk management is crucial when
using contrary opinion.
• Not always right: The majority is not always wrong, and blindly going against the crowd
can be risky.

In nutshell, this theory analysis is a strategy that involves identifying when market sentiment
has reached an extreme and then taking a position that goes against the prevailing opinion. It
is based on the idea that the majority can be wrong at market turning points.

Odd Lot theory

The odd lot theory, a technical analysis hypothesis, assumes that small individual investors are
often incorrect in their market timing and investment decisions. They are more likely to
generate odd-lot sales (stock order less than 100 shares). Therefore, if odd lot sales are up and
small investors are selling a stock, it is probably a good time to buy. Similarly, when odd-lot
purchases are up, it may indicate a good time to sell.
Assumptions
• Professional investors and traders tend to trade in normal lot sizes (multiples of 100 shares)
to improve pricing efficiency in their orders.
• Small investors, who often trade in odd lots, are less informed and more prone to
emotional decision-making compared to institutional investors.
Operation of the Theory
Theory suggests that traders should act contrary to the trading patterns of odd lot traders.,
meaning that:
• When there's an increase in odd lot sales by small investors (Bullish Signal), it might be a
good time to buy.
• Conversely, if there's an increase in odd lot purchases by small investors (Bearish Signal), it
is potentially good time to sale the stock.

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Limitations and Current Relevance:

• Decreased Validity: Over time, the Odd Lot Theory has lost much of its relevance and is
not widely used today. Several factors contribute to this:
o Increased Information Access: Small investors now have greater access to information
and analytical tools, potentially making their decisions more informed.
o Rise of Mutual Funds and ETFs: Individual investors increasingly invest through mutual
funds and ETFs, where trading is done in round lots by institutional managers.
o Market Efficiency: Modern markets are more efficient, and odd lot orders are processed
just as efficiently as round lot orders.
• Historical Context: The theory was more popular in the mid-20th century before the
widespread availability of information technology and changes in market structure.
In conclusion, while the Odd Lot Theory is an interesting piece of financial history, it is not
considered a reliable indicator for market analysis in today's environment.

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Lesson 3: Technical Analysis – Charts and Indicators

Unlike fundamental analysis, which focuses on a company’s financial health and intrinsic value,
technical analysis concentrates primarily on past price movements, trading volumes, and
market behaviour to forecast future price movements. Technical analysis involves evaluating
securities by analysing statistical trends and patterns in historical market data. It uses price and
volume data in decision making. The data is often graphically displayed in the form of charts.
These charts are analysed using various indicators to identify investment opportunities.
Technical analysis is based on three logics: (i) supply and demand of securities determine prices,
(ii) changes in supply and demand – both in price level and volume – can cause changes in
prices, (iii) past price action can be used to project potential future prices with charts and other
technical tools. Although technical analysis is commonly used for short-term trading or tactical
asset allocation decisions, analysing long-term charts can assist in making long-term investment
decisions or strategic asset allocation decisions.
Assumptions of Technical Analysis
• The market discounts everything: A core assumption of technical analysis is that the price
already reflects all known factors impacting a financial instrument. i.e. at any point in time,
a stock’s price already reflects its fundamentals – balance sheet, income statement, cash flow
statement, as well as broad economic factors and market psychology.
• Prices move in trends and countertrends: It means, prices follow trends – upward,
downward, sideways or a combination of these. Once a trend is identified, we can expect
future price movements to follow the trend rather than go against it.
• Price action is repetitive, and certain patterns tend to reoccur: Technical analysis assumes
that due to market psychology, price movements repeat. These repetitions in price
movements can be charted, and patterns that are likely to repeat can be identified.
• Present trends are influenced by the past trends and the projection of future trends is
possible by an analysis of past price trends.
• Stock prices (except minor variations) tend to move in trends which continue to persist for
an appreciable length of time.
• Changes in trends in stock prices are caused by a shift in the demand and supply factors.
The timing and reasons of shift in demand and supply can be detected through charts
showing market action.
• The patterns projected by technical charts can be used for forecasting future trends and
patterns.
Tools of Technical Analysis
The primary tools used in technical analysis are charts and indicators.
Charts
Charts are graphical displays of price and volume data, while indicators are approaches to
analysing the charts. Investors normally use combination of both charts and indicators to obtain
best results. For the purposes of technical analysis, charts can be of different types, such as: (i)
Line chart, (ii) Bar chart, (iii) Point and figure chart, and (iv) Candlestick chart.
Line Chart: Line chart represents any variable over a set period of time. The line is formed by
connecting value of represented variable over the time frame. Line charts do not provide visual

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information of the trading range for the individual points such as the high, low and opening
prices and closing price. They depict any variable like volume of a security, index number,
price etc.

Line Chart

Above line chart shows that the price of the stock during the first upward movement of the
price is higher than the second high. Line charts are useful in trend analysis (upward, downward,
or sideways trends), support and resistance (indicated by peaks and troughs), and comparing
performance of multiple assets on the same graph.
Bar Chart: This is a popular technique of showing the price variation and volume on a particular
day. The chart is made up of a series of vertical lines that represent each data point. This
vertical line represents the high and low for the trading period, along with the closing price.
The close and open are represented on the vertical line by a horizontal dash. If the closing price
is higher than the opening price, the bar is usually coloured green or unshaded (indicating a
bullish period), and if the closing price is lower than the opening price, the bar is usually
coloured red or shaded (indicating a bearish period).

Bar Chart

Bar charts are helpful in trend identification (upward, downward, or sideways trends), volatility
analysis or range of price movements (represented by height of the bars), and patterns
recognition (like head and shoulders, double tops, or flags) for decision-making.
Point and Figure Chart: The Point and Figure (P&F) chart is not well known or used by the
average investor, but it has had a long history of use dating back to the first technical traders.

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This type of chart reflects price movements and is not as concerned about time and volume in
the formulation of the points. In order to prepare this type of graph, the analyst has to decide
as to what is a significant price change. It uses a chart with "X"s and "O"s for predicting financial
asset prices. The "X"s are used to indicate rising prices and "O"s to indicate falling prices.
Traders often use P&F charts to identify breakout levels, support and resistance zones, and to
determine potential price targets. P&F chart filters out minor price fluctuations or "noise” and
doesn't include time as a factor.

Point and Figure Chart

Candlestick Chart: Similar to the bar chart, the candlestick also has a thin vertical line showing
the period's trading range. Candlesticks rely heavily on the use of colours to explain what has
happened during the trading period. There are two colour constructs for days up and one for
days that the price falls. When the price of the stock is up and closes above the opening trade,
the candlestick will usually be white or clear. If the stock has traded down for the period, then
the candlestick will usually be red or black. If the stock's price has closed above the previous
day's close but below the day's open, the candlestick will be black or filled with the colour that
is used to indicate an up day.

Candlestick Chart

Candlestick charts are valued for their visual clarity and for highlighting price patterns. Traders
use various patterns of candlestick, like Doji, Hammer, and Shooting Star to predict future price
movements. Doji is very small body candlestick, where the opening and closing prices are
nearly equal. It looks like a plus sign (+) or a cross. It represents market indecision—neither

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buyers nor sellers have full control. It often precedes a potential reversal in the trend, but the
direction depends on the context (e.g., the surrounding candlesticks).
Hammer is a bullish reversal pattern that appears after a downtrend. It has a small body near
the top of the range, with a long lower wick (at least twice the length of the body) and little
to no upper wick. It indicates that sellers pushed prices lower during the session, but buyers
regained control and drove prices back up. This signals a potential price reversal upward.
Shooting star is a bearish reversal pattern that appears after an uptrend. It is opposite of the
Hammer; it has a small body near the bottom of the range, with a long upper wick and little
to no lower wick. It shows that buyers pushed prices higher during the session, but sellers
regained control and drove prices back down. This signals a potential price reversal downward.
Support and Resistance Levels
Support and resistance levels are key concepts in technical analysis. These provide insight into
potential price movements and market behaviour, and guide traders in making buy or sell
decisions. When prices break through these levels, they may indicate a continuation of the
trend or a reversal.
Support is the price level at which demand is thought to be strong enough to prevent the price
from declining further. The logic dictates that as the price declines towards support and gets
cheaper, buyers become more inclined to buy, and sellers become less inclined to sell.
Resistance is the price level at which selling is thought to be strong enough to prevent the price
from rising further. The logic dictates that as the price advances towards resistance, sellers
become more inclined to sell, and buyers become less inclined to buy.

Chart Patterns
Chart patterns are a cornerstone of technical analysis, providing visual cues about potential
future price movements based on historical trends. These patterns emerge in price charts and
help traders make informed decisions. Following chart patterns help traders in analysing
security price movements.

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Reversal Patterns: The reversal patterns are those which indicate a reversal of existing trend. It
can further be classified as bullish patterns or bearish patterns, represented by head-and-
shoulders, inverted head-and-shoulders, and double tops and bottoms.
• Head and Shoulders: The head-and-shoulders top signals to chart users that a security's price
is likely to make a downward move, especially after it breaks below the neckline of the
pattern. Due to this pattern forming mostly at the peaks of upward trends, it is considered
to be a trend-reversal pattern, as the security heads down after the pattern's completion.
Head and Shoulders

• Inverted Head and Shoulders: The inverted head-and-shoulders pattern is the exact
opposite of the head-and-shoulders top, as it signals that the security is set to make an
upward move. Often coming at the end of a downtrend, the inverse head and shoulders is
considered to be a reversal pattern, as the security typically heads higher after the
completion of the pattern.
Inverted Head and Shoulders

• Double Tops and Double Bottoms: These two reversal patterns illustrate a security's attempt
to continue an existing trend. Upon several attempts to move higher, the trend is reversed,
and a new trend begins. These chart patterns formed will often resemble what looks like a
"W" (for a double bottom) or an "M" (double top).
Double Tops and Double Bottoms

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Following figure (right side) shows price trend, first trough, peak, second trough advance
from trough, resistance break, resistance turned support, and price target. The double-top
pattern is found at the peaks of an upward trend and is a clear signal that the preceding
upward trend is weakening and that buyers are losing interest.
Double Tops and Double Bottoms

Upon completion of this pattern, the trend is considered to be reversed, and the security is
expected to move lower. A double bottom appears when a share hits a low, comes higher,
again pulls back. A double bottom appears at the end of a bearish trend and indicates the
start of the bullish trend.
Continuation Patterns: The continuation patterns suggest that there is only a pause in the
market and the old trend will continue again after the pause. These are represented by triangles,
and flags.
• Triangles: A triangle is formed when each succeeding peak is lower than the previous peak
or each succeeding bottom is higher than the previous bottom. The series of peaks and
bottoms are joined by a line which converges and form a shape of triangle. Triangles can
be symmetric, ascending or descending.

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• Flags: A flag pattern appears when a bully rally or a bear phase is interrupted by a
consolidation pattern appearing as a rectangle or a parallelogram. As the flag formation
indicates a pause before continuation of earlier trend, the prices move in the same direction
after the flag as before.

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• Gaps: Gaps occur when a price opens much higher (gap higher) or lower (gap lower) than
the previous day’s close. Once a gap occurs, the new price represents an important price
level. Gaps higher create support that should allow the stock to move higher and gaps
lower create resistance that should pressure the stock lower. Until the gap is violated, we
should assume the trend will continue in the gap’s direction. Gaps can be breakaway,
runaway, and exhaustion. These can also take form of rounding bottom, and cup with
handle.

Breakaway gaps: Breakaway gaps occur when the price action is breaking out of their
trading range or congestion area. A congestion area is just a price range in which the market
has traded for some period of time, usually a few weeks or so. To break out of these areas
requires market enthusiasm and, either many more buyers than sellers for upside breakouts
or more sellers than buyers for downside breakouts.

Runaway gaps: Runaway gaps are also called measuring gaps and are best described as gaps
that are caused by increased interest in the stock. For runaway gaps to the upside, it usually
represents traders who did not get in during the initial move of the up-trend and while
waiting for a retracement in price, decided it was not going to happen. Increased buying
interest happens all of a sudden, and the price gaps above the previous day's close. This
type of runaway gap represents an almost panic state in traders.

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Exhaustion gaps: Exhaustion gaps are those that happen near the end of a good up- or
downtrend. They are many times the first signal of the end of that move. They are identified
by high volume and large price difference between the previous day's close and the new
opening price. They can easily be mistaken for runaway gaps if one does not notice the
exceptionally high volume.

Rounding bottom: Rounding bottom is a long-term reversal pattern that is best suited for
weekly charts. It is also referred to as a saucer bottom and represents a long consolidation
period that turns from a bearish bias to a bullish bias.

Cup with Handle: Cup with Handle is a bullish continuation pattern that marks a
consolidation period followed by a breakout. As its name implies, there are two parts to
the pattern: the cup and the handle. The cup forms after an advance and looks like a bowl
or rounding bottom. As the cup is completed, a trading range develops on the right-hand
side and the handle is formed. A subsequent breakout from the handle's trading range
signals a continuation of the prior advance.

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Indicators
Indicators analysis is a mathematical examination of price and volume information over a given
period. The basic objective of indicators analysis is to predict where and in which direction the
price may move in near future. It attempts to establish a mathematical relationship of current
price past prices. The main methods of indicators analysis are moving averages and relative
strength index.
Moving Averages: Moving average refers to average level of closing prices, calculated on
regular basis. A sequence of averages is calculated by calculating averages on daily basis. Simple
moving averages take following form.

Relative Strength Index: The concept of relative strength index (RSI) was developed by J.
Welles wilder. It is a popular momentum oscillator used in technical analysis to measure the
speed and magnitude of price movements. It helps traders identify overbought or oversold
conditions in the market. Following is the formula to calculate RSI.
100
RSI = 100 −
(1 + RS)
Here: RS is Relative Strength, calculated as Average of X days' closing gains ÷ Average of X
days' closing losses.

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RSI compares the strength of recent price gains to recent price losses over a specified period
(commonly 14 days). It is displayed as a line graph below the price chart, offering visual cues
about market momentum. RSI oscillates between 0 and 100, providing an indicator of
market momentum. An RSI above 70 suggests an overbought condition, and an RSI below
30 suggests an oversold condition.

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