Technical Analysis

1. Technical Analysis

2. Technical Analysis • An attempt to exploit recurring and predictable patterns in stock prices • Technicians’ beliefs: • Shifts in market fundamentals can be discerned before their impact is fully reflected in prices • Market fundamentals can be perturbed by irrational factors • These presumptions are in contradiction with the weak form of the EMH

3. The Dow Theory • Originated by Charles Dow • Founder of the Dow Jones Company and editor of Wall Street Journal • Dow Theory presumes market moves in persistent bull and bear trends • Often used for market as a whole, but used for individual securities also • Types of movements defined by Dow theorists • Primary trends (bull or bear market) • Secondary trends (corrections) • Market collapses or upward surges lasting a few weeks or months • Tertiary moves (little daily fluctuations) • Meaningless random wiggles but should be studied to determine if relate to a primary trend

4. The Dow Theory Most Dow theorists do not think a new primary trend has been confirmed until pattern of ascending or descending tops occur in both industrial and transportation averages.

5. Head and Shoulders Formation • A series of reversals • Supposed to signal that a security’s price has reached a ceiling and is expected to decline in the future

6. Head and Shoulders Formation Head—a spurt of buying activity increases price to new high. Then a lull in trading decreases prices to below top of left shoulder. Confirmation (breakout)—the price falls below the neckline which is a sell signal. Left shoulder—heavy buying increases price to a peak before lull in trading pushes price downward. Right shoulder—a moderate rally increases price but not to a new level equal to the top of the head.

7. Other Patterns • Numerous patterns have been described by technicians, such as • Triangles • Pennants • Flags • Channels • Rectangles • Double tops • Triple tops • Wedge formations • Diamonds See http://www.marketscreen.com/help/chartpatterns/

8. Triangles

9. Flags Pennants

10. Rectangles

11. Wedge

12. Charting Volume of Shares Traded • Technicians argue volume measures the intensity of investor’s feelings • Volume is studied in conjunction with prices • Technicians analyze resistance and support levels along with volume

13. Support and Resistance Levels • Resistance level • Ceiling (peak) above which stock price is not expected to go • Supply of security is expected to increase • Support level • Floor (trough) below which stock price is not expected to drop • Demand of security is expected to increase

14. Support and Resistance Levels • Suppose the following occurred • Moderate surge in trading volume at Point A • Larger surge in trading volume at Point B • 3 times greater than surge at Point A • May surmise that some bullish new information caused buying pressure at Point B which overcame the previous resistance at Point A

15. Congestion Areas • Technicians are unable to offer reasons for price actions like this • Penetrating support line means sell • Penetrating resistance line means buy • Studies examining trading range breakouts find that, after deducting commissions, return was slightly larger than riskless interest rate

16. Congestion Areas Price rises through $50 resistance level—old resistance level becomes new support level. Price fluctuates in first congestion area for a while.

17. Selling Climaxes and Speculative Blowoffs • When supply and demand are out of balance (price is moving) volume is watched closely • Market is bullish when high volume is combined with a rising price • Market is bearish with high volume and falling prices • Falling prices and high volume are considered bullish if a selling climax occurs

18. Selling Climaxes and Speculative Blowoffs • If one believes the end of bear market is near and high volume occurs • Means last of bearish investors are liquidating their holdings • Clears the way for bullish investors to start bidding up price • A speculative blowoff marks the end of a bull market • High volume pushes prices to peak • Exhausts bullish speculators enthusiasm, enabling bearish market to begin • A bull dies with a bang, not a whimper

19. Other Charting Techniques • Point and figure charts • The figure has no time dimension • It traces significant upward or downward moves in stock prices • Candlestick charts • Used to summarize price data • Aid in identification of trends

20. Technical Indicators • Sentiment indicators • Flow of funds indicators • Market structure indicators

21. Sentiment indicators Trin statistic or:

22. Sentiment Indicators (cont’d) • Odd-Lot trading • Confidence Index • Put/Call ratio • Mutual fund cash position

23. Flow of Funds Indicators • Short interest – total number of shares of stock currently sold short in the market • Some technicians interpret high levels of short interest as bullish, some as bearish • Credit balances in brokerage accounts

24. Market Structure Indicators • Moving averages • Breadth • The most common measure – the spread between the number of stocks that advance and decline in price • Relative strength • The ratio of the price of the security to a price index for the industry

25. Moving Average Analysis • Moving averages are used to provide a smooth reference point for • Individual securities • Market indices • Commodity prices • Interest rates • Foreign exchange rates • Some use a 150-day (30 week) moving average • Changes each day • Most recent day is added and oldest day is dropped • Following calculation is performed • M150DAPt = (1/150)(Valuet + Valuet-1 + … Valuet-149)

26. Moving Average Analysis • Moving averages computed over short time frames follow daily prices more closely • Technicians analyze difference between daily price and moving average • If daily prices penetrate moving average line it is a signal to take action • If daily price moves down through a moving average, price fails to rise for many months • Sell signal • If daily prices are above moving average but difference is narrowing • Signals end of bull market may be near

27. Moving Average Analysis • Moving average analysts recommend buying stock if • Moving average line flattens and stock price moves up through moving average line • Price of stock falls (temporarily) below moving average line that is rising • Stock price is above moving average line, falls, turns around and rises again without penetrating moving average line

28. Moving Average Analysis • Moving average analysts recommend selling stock if • Moving average line flattens and stock price drops down through moving average line • Stock price temporarily rises above a declining moving average line • Stock price falls through moving average line and turns around only to fall again without penetrating above moving average line • Strategy is more successful if moving average is calculated over a longer time frame

29. Can Technical Analysis Work? • Self-destructing patterns • Once a useful technical rule is discovered, it ought to be invalidated once the mass of traders attempts to exploit it • A new view of technical analysis • Brown and Jennings propose a more complex framework than the EMH • They envision an economy where many investors have private information regarding the value of a stock

30. Folklore • Examples • Buy on good news, sell on bad • Buy on rumor, sell on news • Buy a stock just after a split to earn abnormal returns • Firms wholes earning decreased relative to the market … price fell in years preceding • Low priced stocks, low P/E stocks outperform high prices, high P/E stocks