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Technical AnalysisTechnical 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

Technical Analysis


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


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.


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


Head and Shoulders Formation

Left shoulder—heavy buying

increases price to a peak before lull in trading pushes price downward.

Head—a spurt of buying activity

increases price to new high. Then a

lull in trading decreases prices to below top of left shoulder.

Right shoulder—a moderate rally increases price

but not to a new level equal to the top of the head.

Confirmation (breakout)—the price falls below

the neckline which is a sell

signal.


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/


Triangles


Flags Pennants


Rectangles


Wedge


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


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


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


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


Congestion Areas

Price fluctuates in first congestion area for a while.

Price rises through $50 resistance level—old resistance level

becomes new support level.


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


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


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

Other Charting Techniques


Sentiment indicators Flow of funds indicators Market structure indicators

Technical Indicators


Trin statistic

Sentiment indicators

or:

Number advancing/Number decliningTrin=

Volume advancing/Volume declining

Volume declining/Number decliningTrin=

Volume advancing/Number advancing


Odd-Lot trading Confidence Index Put/Call ratio Mutual fund cash position

Sentiment Indicators (cont’d)


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

Flow of Funds 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

Market Structure Indicators


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)



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



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



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


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

Can Technical Analysis Work?


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

comm 324 --- w. suo slide 1. comm 324 --- w. suo slide 2 an attempt to exploit recurring and...

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