Theory of Stock Market Forecasting

Forecasting the stock market is every investor’s dream. The familiar adage, “Buy low, sell high,” is simple enough, but timing the lows and the highs is a challenge. Identifying the patterns in the market is the basis for all forecasting methods. Investors fortunes rise and fall with their ability to time their transactions correctly.

Technical Analysis

Most forecasting systems are built around technical analysis, which postulates that patterns in the stock market repeat themselves. If an investor can interpret the pattern correctly, then he can predict what the future direction will be. Most patterns in a bull market are also in a bear market only inverted. Traders try to identify a support level below which a stock price is unlikely to fall -- and if it does, it could fall much more. A resistance level is a higher price that is hard to penetrate. Chart followers identify head-and-shoulder formations, up trends, down trends, tops, bottoms and more. Another technique that investors follow are moving averages. By plotting moving averages of different durations -- 20-day, 50-day and 200-day, for example -- investors can identify buy and sell points.

Dow Theory

According to Dow Theory there are three trends in market movements. The Primary Tide is the long-term, underlying trend that signals a bull or bear market. Secondary Reactions are the market corrections that occur during long-term trends. Ripples are the day-to-day movements that are only significant for day traders. Primary trends establish themselves with three moves in the Dow Jones Industrial Average, each reinforcing the one before it. Both the Dow Jones Industrial Average and the Dow Jones Transportation must move together to establish a trend. In the case of a bull market in each trend both averages must close higher than the previous high. In the case of a bear market both averages must close lower than the previous low to establish a bear market.

Elliott Wave Theory

Developed by Ralph Elliott in the 1920s, this theory also proposes that the market moves in a series of predictable waves. Each trend in the market consists of five waves. In a bull market there are three impulse waves, each separated by a correction, none of which retreat to the previous low. In a bear market the trend is reversed, but following the same pattern. Within each wave there may be smaller sub-waves that fluctuate around the larger trend. Because there are so many waves and sub-waves involved, finding the core trend lines is challenging.

Candlestick Charting

Candlestick charting is an alternative way to predict stock movements. Activity is usually plotted by day or week as a figure resembling a candlestick. The ends of the “wick” tell the high and low price for the period. The ends of the “candle” tell where the stock opened and closed. The candle is solid if the stock closed down and open if it closed up for the period. Forecasters who use this method look for patterns and trends. A cursory examination of a candlestick chart can also reveal patterns in price volatility. Candlestick charting can be augmented with other technical analysis tools such as moving averages.