Beyond the Fundamentals; Technical Analysis

FIN 40500: International Finance

Fundamental analysis focuses on economic/financial theory and various economic indicators to explain market movements

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Trade Balance Approach

Monetary Approach

Interest Rate Approach

Price Level Approach

Chart Analysis Quantitative Methods

Technical analysis is not concerned with the causes of market movements. Instead, technical analysis focuses on the movements themselves. Is there information in past price movements that can be used to predict future movements?

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The forecasting equation for a technical analysis would be something like this

$/Euro: Weekly data over 3 years

Chart analysis begins with a time series plot of an asset’s price

Charts can be hourly, daily, weekly, etc.

Higher frequency data will be more detailed, but noisier

A chartist looks for patterns in the to identify resistance (upper bounds) and support levels (lower bounds)

Old Support level

New Support level

A “breakout” indicates a new pattern forming

Connect two consecutive highs to get the upper channel

A parallel line through a recent low becomes the lower support

                                                                                                                                                                                    

Bullish channels tend to have upward breakouts

                                                                                                                                                

Find the trend by connecting at least two highs

Two lows complete the triangle

“Breakout” occurs at the apex, usually with increasing volume

Ascending triangles usually have upward breakouts

                                                                                                                                                Two lows identify the “lead in” trend

The “Run”: A breakout from the lead in trend

The “Bump”: Increase in trend by more than 50%

Two lows identify the “lead in” trend

The left shoulder is the first high above the current trend

The head is the first advance past the left shoulder

The right shoulder is the first high following the reversal

The neckline connects the two shoulders and indicates lower support

What pattern do you see?

“Bump”“Run”

Fibonacci, one of the greatest mathematicians of all time discovered a sequence of numbers which are now used across many disciplines

1 Month

One Pair (Y)

Now

One Pair (M)

2 Months

Two Pair (M, Y)

3 Months

Three Pairs (M, M, Y)

Y = Young, M = Mature

Suppose that you begin with a pair of rabbits:

Rabbits take one month to mature. Once mature, they can breed offspring

Offspring come in pairs (one male and one female). A pair of offspring are born each month

The rabbits never die

Can you find the Pattern?

Each number in the Fibonacci sequence is the sum of the previous two

1+ 1 = 2

1 + 2 = 3

2 + 3 = 5 ….

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, ……

These numbers seem to appear a lot in nature…

One

White Calla Lily Euphorbia

Two

Trillium

Three

Five

Buttercups Bloodroot

Eight

Black-eyed Susan

Thirteen

(By far the most common)

Ordinary field daisies have 34 petals – a fact to be remembered when playing “she loves me, she loves me not”!

(with 34 petals, you will always finish with “she loves me not!”)

Take a pineapple…hmmm…look at the various spirals formed

Every human has 2 hands with 5 fingers on each. Each finger is made of 3 segments connected by 2 joints…don’t these numbers sound familiar?

Each section of your index finger, from the tip to the base of the wrist, is larger

than the preceding - fitting the Fibonacci numbers 2, 3, 5

and 8.By this scale, your fingernail

is 1 unit in length.

Similar ratios are seen between your hand and forearm…coincidence?

Suppose that we divide each number into the following number1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, ………

1/1 = 1 8/5 = 1.62/1 = 1 13/8 = 1.6253/2 = 1.521/13 = 1.6155/3 = 1.667 34/21 = 1.619

The ratios converge to 1.618

Now, suppose that we divide each number into the previous number1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, ………

1/1 = 1 5/8 = .6251/2 = .5 8/13= .6152/3 = .667 13/21 = .6193/5 = .6 21/34 = .617

The ratios converge to .618

AND618.1618.1 618.1618.

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Suppose that we begin with a 1X1 square

Put another 1X1 square next to it

Now, put a 2X2 underneath

Now, add a 3X3 square

Connect the corners of the squares and you get the golden spiral…look familiar??

Math is everywhere!!

Anyways, back to technical analysis. Many of the technical methods are based on PHI (.618) and powers of .618

.618

.382 = .618*.618

.236 = .618*.618*.618First, draw a trend line

Draw arcs that intersect the trend at 61.8%, 50%, and 38.2% of the high (these will indicate future supports)

Draw an initial trend line between two extreme points

At the second extreme point, draw a vertical line

Draw rays that intersect at 61.8%, 50%, and 38.2%

Once a reversal occurs, it tends to find support at Fibonacci levels!

Large price swings tend to occur on “Fibonacci times”! (times could be in days, months, years, etc)

Elliott Waves Elliot wave theory relies on cycles within cycles

Grand Super cycle Super cycle Cycle

Each cycle consists of 5 moves with the trend (1,3,5 are impulse, 2,4 are corrective) and 3 that are against the trend. A “5-3” wave

Impulse

Correction

Beginning of the next wave

Elliott Waves consist of 5 moves with the trend (1,3,5 are impulse, 2,4 are corrective) and 3 that are against the trend. A “5-3” wave cycle

Impulse (1)

Correction (2)

The 5-3 wave cycles actually oscillate around a larger “super-cycle” The super-cycle is also a 5-3 wave.

Note that the grand super cycle has two movements, the super cycle has 8 movements, the cycle has 34……Fibonacci numbers!!

Finally, the super-cycle oscillates around a “grand super-cycle”

RSI (Relative Strength Indicator)

points "down" Total points Up"" Total1

100100RSI

If “Up Points” = 0, RSI = 0

If “Down Points” = 0, RSI = 100

RSI < 30 (Oversold)

RSI > 70 (Overbought)

RSI (Relative Strength Indicator)

points "down" Total points Up"" Total1

100100RSI

Chart Interval: 15 minutes Period Length: 20 (300 minutes) Total “up” points = 7 Total “down” points = 11

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RSI

RSRSI

RS

Fast Stochastic

FS of Average Moving Period Y

Length Period X ,100*Low(X) - High(X)

Low(X)-Close(X)

Signal

FS

Period High: FS = 100

Period Low: FS = 0

Signal < 30 (Oversold)

Signal > 70 (Overbought)

May June July Aug. Sept. Oct. Nov. Dec.

.6 .3 -.1 .1 .2 .6 .2 .2

MA May June July Aug. Sept. Oct. Nov. Dec.

1 .6 .3 -.1 .1 .2 .6 .2 .2

2 .45 .1 0 .15 .4 .4 .2

3 .27 .10 .07 .3 .33 .33

4 .3 .17 .2 .275 .3

A moving average takes out the volatility by averaging several observations. For example, a MA(3) would average the current observation with the previous 2 observations.

Data

Moving Average Convergence/Divergence (MACD) The MACD indicator calculates the difference

between moving averages of two different lengths (usually, 12 periods and 26 periods)

The signal is typically a 9 period moving average of the difference

A divergence means that “something is happening”Positive to Negative = Sell SignalNegative to Positive = Buy Signal

MACD Suppose that the longer run moving average has a length equal to the number of observations – the series average

MA

Time

MA(N)

MA(10)

- To + : Buy point

+ To - : Sell point

- To + : Buy point

Punch line Technical methods are useful for short run

prediction Don’t lose sight of the fundamentals!!!