Technical indicators Ι Dow Theory assumptions Ι Factors Affecting the risk

Explanation of technical indicators

A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security.

Price data can be any combination of the open, high, low or closing price over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest in their formulae. The price data is entered into the formula and a data point is produced.

If a technical indicator is constructed using the average of the closing prices, then the average of the 3 closing prices is one data point ((41+43+43)/3=42.33). However, one data point does not offer much information. A series of data points over a period of time is required to enable analysis.

 Technical indicators measure money flow, trends, volatility and momentum etc. They are used for two main purposes: to confirm price movement and the quality of chart patterns, and to form buy and sell signals. A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulae and are relatively easy to understand.

Explanation of Dow Theory and its assumptions

Dow Theory

The Dow Theory was originated by Charles Dow. He was the founder of the Dow Jones Company and editor of the Wall Street Journal. The Dow Theory presumes that the market moves in persistent bull and bear trends. Dow Theory was originally used for the market as a whole, but it is now used for individual securities as well.

The Dow Theory comprises the following assumptions:

  1. The averages discount everything: An individual stock’s price reflects everything that is known about security. As new information arrives, market participants quickly disseminate the information and the price adjusts accordingly.
  1. The market is comprised of three trends: At any given time in the stock market, three forces are in effect: the Primary trend, Secondary trends, and Minor trends.
  1. The volume confirms the trend: Volume is only used to confirm uncertain situations. Volume should expand in the direction of the primary trend.
  1. A trend remains intact until it gives a definite reversal signal: An up-trend is defined by a series of higher-highs and higher-lows. In order for an up-trend to reverse, prices must have at least one lower high and one lower low.

Explanation of factors affecting the risk

  • Business risk: This is the possibility that the company holding your money will not pay the interest or dividend due, or the principal amount when your bond matures. This may be caused by a variety of factors like heightened competition, the emergence of new technologies, and the development of substitute products.
  • Inflation risk: Inflation risk is the chance that the purchasing power of the invested rupees will decline. This is the risk that the rupee you get when you sell your asset will buy less than the rupee you originally invested in the asset.
  • Interest rate risk: The variability in a security’s return resulting from changes in the level of interest rates is referred to as interest rate risk. This is the possibility that a fixed debt instrument, such as a bond, will decline in value due to a rise in interest rates.
  • Market risk: Market risk is the variability in a security’s returns resulting from fluctuations in the aggregate market. This is the risk that the unit price or value of your investment will decrease because of a decline in the market. The market tends to move in cycles.

Also read about Financial Derivatives & Financial Intermediaries

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