investment theory - technical analysis
DESCRIPTION
ShareTRANSCRIPT
Copyright © 1996 – 2006 Investment Analytics Slide: 1
Technical Analysis
Copyright 1996-2006 Investment Analytics
Copyright © 1996 – 2006 Investment Analytics Slide: 2
Technical Analysis
Technical Analysis:Study of past market action to forecast pricesLooks for patterns in historical data
Copyright © 1996 – 2006 Investment Analytics Slide: 3
Technical Analysis Tools
ChartingGann Elliot WaveCycle TheoryOscillators & IndicatorsJapanese CandlesticksMarket ProfileComputerized Trading Systems
Copyright © 1996 – 2006 Investment Analytics Slide: 4
Classical Charting
Trend LinesSupport/ResistanceContinuation PatternsReversal PatternsGaps & SpikesMoving Averages
Copyright © 1996 – 2006 Investment Analytics Slide: 5
Trends
Trend Direction
• Uptrend: Downtrend: higher highs, higher lows lower lows, lower highs
Trend timeframe:• 3 Trends: (e.g. weekly, daily, hourly)
Main technical analysis tools:• Trend Lines• Moving Averages
Copyright © 1996 – 2006 Investment Analytics Slide: 6
Trendlines
Drawing Trendlines:• Connect highs to highs, lows to lows• Draw through congestion areas• Ignore ‘tails’ or ‘spikes’
Trends are stronger . . . . • The longer the trendline• The more contacts between prices and the trendline• When volume expands in the direction of the trend
Copyright © 1996 – 2006 Investment Analytics Slide: 7
Trendline Examples
62
64
66
68
70
72
74
`
Rising Volume
BA
Trend B is more significant than trend A . . .1. More contact points2. Longer trendline3. Rising volume
Copyright © 1996 – 2006 Investment Analytics Slide: 8
Trading Rules for (UP)TrendsTrade only in the direction of the trend
• Ignore all signals to short a bull market
Wait for a pullback to the trendline to get long• Wait! If no pullback - forget it!
Use a trailing stop to get aboard the trend:• As pullback nears trendline, place an order to buy on a stop
one tick above previous day’s high
Set protective stop• Once you are long the market• Place a stop loss order just below the trendline• Move your stop up as trend progresses
Copyright © 1996 – 2006 Investment Analytics Slide: 9
Trading Rule Illustrated
62
64
66
68
70
72
74
`
1. Pullback approaches trendline at point A2. Order to buy on a stop, 1 tick above high at A3. Get stopped in at next day’s open - point B4. Place an order to sell on a stop at level C
A
B
C
Copyright © 1996 – 2006 Investment Analytics Slide: 10
Trendlines Breaks
Trendlines provide support & resistanceSteep trendlines (over 45 degrees) precede sharp breaksA pullback to the trendline after a break is often a good shorting opportunity
Copyright © 1996 – 2006 Investment Analytics Slide: 11
Trading Trendline Breaks
300.0
310.0
320.0
330.0
340.0
350.0
360.0
370.0
380.0
390.0
400.0
11/2
5/88
12/1
6/88
01/0
6/89
01/2
7/89
02/1
7/89
03/1
0/89
03/3
1/89
04/2
1/89
05/1
2/89
06/0
2/89
06/2
3/89
07/1
4/89
08/0
4/89
08/2
5/89
09/1
5/89
10/0
6/89
10/2
7/89
11/1
7/89
12/0
8/89
12/2
9/89
01/1
9/90
02/0
9/90
03/0
2/90
03/2
3/90
04/1
3/90
05/0
4/90
05/2
5/90
06/1
5/90
07/0
6/90
07/2
7/90
08/1
7/90
09/0
7/90
09/2
8/90
10/1
9/90
S&P 500 Futures
Buying Opportunity
Buying Opportunity
Selling Opportunity
Copyright © 1996 – 2006 Investment Analytics Slide: 12
Channel Lines
A line running parallel to the trendlineDrawn through tops of rallies(bottoms of declines)Marks maximum power of bulls (bears)The wider the channel the stronger the trendTrading Rules:
• Go long in lower quarter of channel• Take profits in upper quarter
Copyright © 1996 – 2006 Investment Analytics Slide: 13
Channel Lines
300.0
310.0
320.0
330.0
340.0
350.0
360.0
370.0
380.0
390.0
400.0
11/2
5/88
12/1
6/88
01/0
6/89
01/2
7/89
02/1
7/89
03/1
0/89
03/3
1/89
04/2
1/89
05/1
2/89
06/0
2/89
06/2
3/89
07/1
4/89
08/0
4/89
08/2
5/89
09/1
5/89
10/0
6/89
10/2
7/89
11/1
7/89
12/0
8/89
12/2
9/89
01/1
9/90
02/0
9/90
03/0
2/90
03/2
3/90
04/1
3/90
05/0
4/90
05/2
5/90
06/1
5/90
07/0
6/90
07/2
7/90
08/1
7/90
09/0
7/90
09/2
8/90
10/1
9/90
S&P 500 Futures
Buying Opportunity
Buying Opportunity
Selling Opportunity
Take Profits
Copyright © 1996 – 2006 Investment Analytics Slide: 14
Moving AverageShows the average price during a given time window
• E.g. a 5-day MA shows the average price over the last 5 days• 20-day MA shows the average price over the last 20 days
Averages the price series to smooth out effect of extreme highs or lowsReveals underlying trend
• Longer MA’s show longer term trend• Shorter MA’s react more quickly to recent prices
Copyright © 1996 – 2006 Investment Analytics Slide: 15
Moving Average Example
94
94.2
94.4
94.6
94.8
95
95.2
95.4
95.6
95.8
08/0
7/92
08/2
1/92
09/0
4/92
09/1
8/92
10/0
2/92
10/1
6/92
10/3
0/92
11/1
3/92
11/2
7/92
12/1
1/92
12/2
5/92
01/0
8/93
01/2
2/93
02/0
5/93
02/1
9/93
03/0
5/93
03/1
9/93
04/0
2/93
04/1
6/93
04/3
0/93
05/1
4/93
05/2
8/93
06/1
1/93
06/2
5/93
3 per. Mov. Avg.
Eurodollars
Formula:MN(t) = (X(t)+X(t-1)+...+X(t-N+1))/N
Copyright © 1996 – 2006 Investment Analytics Slide: 16
Moving Average Formula
Formula: MA = P1 + P2 + . . . + PNN
Example:• Time Price 3-Day MA
t1 17 N/At2 16 N/At3 19 (17+16+19)/3 = 17.3t4 22 (16+19+22)/3 = 19.0
Copyright © 1996 – 2006 Investment Analytics Slide: 17
Using Moving Averages in TradingAs Trend Indicators
• Trend direction indicated by the slope of the MA • Short, medium, or long term trend• Similar trading rules as for trendlines
– trade with the MA trend– buy on pullbacks to moving average
Copyright © 1996 – 2006 Investment Analytics Slide: 18
Donchian’s MA Crossover SystemMethod
• Plot short and long term MA on same chart• Example: 9 day MA and 21 day MA
Trading Signals• Buy when short MA crosses above long MA• Sell when short MA crosses below long MA
When to use:• Works well in trending markets• Loses money in whipsaw markets
Optimization• You can find the ‘optimal’ short and long MA
Copyright © 1996 – 2006 Investment Analytics Slide: 19
Example: Moving Average Crossover
65
70
75
80
85
90
95
100
105
9 Day MA
21 Day MA
BUY
SELL
BUY
Copyright © 1996 – 2006 Investment Analytics Slide: 20
Example: Moving Average Crossover
94
94.2
94.4
94.6
94.8
95
95.2
95.4
95.6
95.8
08/0
7/92
08/2
1/92
09/0
4/92
09/1
8/92
10/0
2/92
10/1
6/92
10/3
0/92
11/1
3/92
11/2
7/92
12/1
1/92
12/2
5/92
01/0
8/93
01/2
2/93
02/0
5/93
02/1
9/93
03/0
5/93
03/1
9/93
04/0
2/93
04/1
6/93
04/3
0/93
05/1
4/93
05/2
8/93
06/1
1/93
06/2
5/93
3 per. Mov. Avg.6 per Mov. Avg
Eurodollars
SellSell
Buy
Copyright © 1996 – 2006 Investment Analytics Slide: 21
Whipsaw Market
440
460
480
500
520
540
560
580
10/0
5/84
10/2
6/84
11/1
6/84
12/0
7/84
12/2
8/84
01/1
8/85
02/0
8/85
03/0
1/85
03/2
2/85
04/1
2/85
05/0
3/85
05/2
4/85
06/1
4/85
07/0
5/85
07/2
6/85
08/1
6/85
09/0
6/85
09/2
7/85
10/1
8/85
11/0
8/85
11/2
9/85
12/2
0/85
01/1
0/86
01/3
1/86
02/2
1/86
03/1
4/86
04/0
4/86
04/2
5/86
05/1
6/86
06/0
6/86
06/2
7/86
07/1
8/86
08/0
8/86
18 Per. Mov. Avg.9 per. Mov. Avg.
Gold Futures
BUY
SELL
BUY
SELL
BUY
SELL
Copyright © 1996 – 2006 Investment Analytics Slide: 22
Exponential Moving Averages
Similar to simple moving averageGives more weight to recent observationsFormula: EMAt = wPt + (1 - w) EMAt-1
• W is the ‘weight’• Large w gives more weight to current price• Makes EMA more responsive• Typical w: 2/(N+1) where N is length of MA
EMA is more responsive to recent trends than simple MA
Copyright © 1996 – 2006 Investment Analytics Slide: 23
Exponential & Simple MA’s Compared
65
70
75
80
85
90
95
100
105
13 Day EMA
13 Day MA
Copyright © 1996 – 2006 Investment Analytics Slide: 24
Lab: Self-Assessment Test
Load Excel spreadsheet: technic.xlsRestart testWork through trend & moving average sectionsMA data worksheet
• Charts EMA & MA• Charts MA Crossover• Try different length MA’s for crossover system• Is there a better choice than 9 and 21 ?
Copyright © 1996 – 2006 Investment Analytics Slide: 25
Support & Resistance
Support:• Price where buying power is sufficient to halt downtrend• Bears are hurting, start buying
Resistance:• Price where selling power is sufficient to halt uptrend• Bulls are hurting, start selling
Support & Resistance Lines• Draw horizontal lines through congestion areas• At upper and lower limits of trading range
Copyright © 1996 – 2006 Investment Analytics Slide: 26
Support & Resistance Lines
340.0
350.0
360.0
370.0
380.0
390.0
400.0
410.0
420.0
08/0
4/89
08/1
8/89
09/0
1/89
09/1
5/89
09/2
9/89
10/1
3/89
10/2
7/89
11/1
0/89
11/2
4/89
12/0
8/89
12/2
2/89
01/0
5/90
01/1
9/90
02/0
2/90
02/1
6/90
03/0
2/90
03/1
6/90
03/3
0/90
04/1
3/90
04/2
7/90
05/1
1/90
05/2
5/90
06/0
8/90
06/2
2/90
07/0
6/90
07/2
0/90
08/0
3/90
08/1
7/90
S&P 500 Futures
Resistance
Support
Copyright © 1996 – 2006 Investment Analytics Slide: 27
Support & Resistance Levels
Levels are strongest: • The longer they continue• The more contacts between prices & the level• The wider the range• The greater the volume at the level
If you are riding a trend:• Tighten protective stops as prices near levels
Copyright © 1996 – 2006 Investment Analytics Slide: 28
Support & ResistanceContrarian Trading
As Prices Approach Support:• Place stop order to buy above yesterday’s high• Place protective sell stop below support• If market bounces off support you will be stopped in long
As Prices Approach Resistance:• Place stop order to sell below yesterday’s low• Place protective buy stop above resistance• If market bounces off resistance you will be stopped in short
Copyright © 1996 – 2006 Investment Analytics Slide: 29
Support & Resistance Trading
340.0
350.0
360.0
370.0
380.0
390.0
400.0
410.0
420.0
08/0
4/89
08/1
8/89
09/0
1/89
09/1
5/89
09/2
9/89
10/1
3/89
10/2
7/89
11/1
0/89
11/2
4/89
12/0
8/89
12/2
2/89
01/0
5/90
01/1
9/90
02/0
2/90
02/1
6/90
03/0
2/90
03/1
6/90
03/3
0/90
04/1
3/90
04/2
7/90
05/1
1/90
05/2
5/90
06/0
8/90
06/2
2/90
07/0
6/90
07/2
0/90
08/0
3/90
08/1
7/90
S&P 500 Futures
Resistance
Support
sell
buy
Copyright © 1996 – 2006 Investment Analytics Slide: 30
Trading RangesNAKED (No view on volatility):
• Go long at Support• Reverse & go short at Resistance
GAMMA TRADE (volatility cheap/rising):• Buy Straddles or Strangles (strikes at S/R levels)• Rebalance Delta Neutral at Support/Resistance
VEGA TRADE (volatility rich/falling):• Sell Straddles or Strangles, or• Sell Calls at Resistance, Sell Puts at Support• Roll up(down) or buy back options on breakout
Copyright © 1996 – 2006 Investment Analytics Slide: 31
GapsOccur when market is stampeded
• Caused by news, panic• Breakdown of trend• Breakout of trading range• Losers dumping positions
Breakaway Gap• Prices leap out of congestion area• Signifies start of new trend• Followed by several days of new highs (lows)• Usually market by high volume• Almost never gets closed by subsequent prices
Copyright © 1996 – 2006 Investment Analytics Slide: 32
Gaps
Continuation Gap• Occurs in middle of powerful trend• Accompanied by upsurge in volume• Measure distance from start of trend to gap• Gives target measured move
Exhaustion Gap• Occurs towards the end of a trend• Market fails to follow through with new highs (lows)• Volume may be thin
Copyright © 1996 – 2006 Investment Analytics Slide: 33
Gaps - Illustrated
84
85
85
86
86
87
87
88 Congestion Area
Breakaway Gap Sell short, with stop above rim
Continuation Gap Add to shorts, with stop above rim
Exhaustion GapTarget achieved - take profits
Island Reversal
Dis
tanc
e to
C
ontin
uatio
n G
ap
Target
Copyright © 1996 – 2006 Investment Analytics Slide: 34
Spikes & Tails
Spikes & Tails
• Extreme price move up or down• Occurs in middle of congestion area• No follow-through• A failed ‘test’ of new trend direction• Market often reacts in opposite direction
Copyright © 1996 – 2006 Investment Analytics Slide: 35
Continuation PatternsBull
Flag
Bear
Pennant
Volume
Copyright © 1996 – 2006 Investment Analytics Slide: 36
TrianglesBull
Descending
Bear
Symmetric
Volume
Ascending
Copyright © 1996 – 2006 Investment Analytics Slide: 37
380.0
390.0
400.0
410.0
420.0
430.0
440.0
450.0
460.0
470.0
12/0
6/91
12/2
0/91
01/0
3/92
01/1
7/92
01/3
1/92
02/1
4/92
02/2
8/92
03/1
3/92
03/2
7/92
04/1
0/92
04/2
4/92
05/0
8/92
05/2
2/92
06/0
5/92
06/1
9/92
07/0
3/92
07/1
7/92
07/3
1/92
08/1
4/92
08/2
8/92
09/1
1/92
09/2
5/92
10/0
9/92
10/2
3/92
11/0
6/92
11/2
0/92
12/0
4/92
12/1
8/92
01/0
1/93
01/1
5/93
01/2
9/93
02/1
2/93
02/2
6/93
03/1
2/93
03/2
6/93
Example: Flag & Triangle
S&P 500
Copyright © 1996 – 2006 Investment Analytics Slide: 38
Trading Continuations
These are trend continuation signalsAdd to positions on breakoutBuy (sell) stop 1 tick above pattern boundary, orBuy(sell) on close outside boundary
Copyright © 1996 – 2006 Investment Analytics Slide: 39
Reversal Patterns
Indications of trend endingMost common patterns
Double TopsHead & Shoulders
Price and Volume confirmation requiredGive indication of new price target
Copyright © 1996 – 2006 Investment Analytics Slide: 40
Double Top
480
500
520
540
560
580
600
620
640
02/0
6/87
02/2
7/87
03/2
0/87
04/1
0/87
05/0
1/87
05/2
2/87
06/1
2/87
07/0
3/87
07/2
4/87
08/1
4/87
09/0
4/87
09/2
5/87
10/1
6/87
11/0
6/87
11/2
7/87
12/1
8/87
01/0
8/88
01/2
9/88
02/1
9/88
03/1
1/88
04/0
1/88
04/2
2/88
05/1
3/88
06/0
3/88
06/2
4/88
07/1
5/88
08/0
5/88
08/2
6/88
09/1
6/88
10/0
7/88
Comex Gold Futures
Volume lower on right peak, and declining
Big pickup in volume on breakdown
Short on pullback to resistance on low volume
Measured Move
Copyright © 1996 – 2006 Investment Analytics Slide: 41
Reversal Patterns -Head & Shoulders
Neckline
Head
LeftShoulder
RightShoulder
Target
Declining Volume
Copyright © 1996 – 2006 Investment Analytics Slide: 42
Trading Head & Shoulders
Scale down position as pattern emergesLook for confirmation in declining volumeGet short on right shoulder, with stop above headAdd to short on break of neckline, with stop above necklineAdd to short on pullback to necklinePlace buy limit order at distance of measured move
Copyright © 1996 – 2006 Investment Analytics Slide: 43
Lab: Self Assessment Test
Continue with testWorksheets:
• Support & resistance• Gaps• Spikes• Continuations• Head & Shoulders
Copyright © 1996 – 2006 Investment Analytics Slide: 44
OscillatorsMeasure extremes of market sentimentOscillator: fluctuates between two extreme values
• When market is overbought or oversold • Market likely to reverse
Oscillators work well in trading rangesCan also be used when market trends:
• To time trades in direction of trend• Nb. must filter out trades against the trend• In trending markets oscillators can stay overbought/oversold
for many periods
Copyright © 1996 – 2006 Investment Analytics Slide: 45
Classic Oscillators
MomentumStochasticsRelative Strength Indicator (RSI)Williams %R
Copyright © 1996 – 2006 Investment Analytics Slide: 46
MomentumMeasures trend accelerationWhen Trend is Up
• If oscillator reaches new high, shows uptrend is continuing• When oscillator traces lower peak, shows uptrend may be
weakening
Formula: MN(t) = Pt - Pt-N• Pt is today’s price• Pt-N is price N days ago
E.g 7 Day Momentum• Pt = 24; Price 7 days ago = 18
– 7 day Momentum = (24 - 18) = 6
Copyright © 1996 – 2006 Investment Analytics Slide: 47
Momentum Chart
40
45
50
55
60
65
70
75
80
-10
-5
0
5
10
BUY
Trendline break - take profits
Double Top
Bearish Divergence:Sell short
Copyright © 1996 – 2006 Investment Analytics Slide: 48
Momentum Trading Rules
When Momentum crosses center line & ticks back up
• Stock is oversold• Trend has slowed for a moment• Opportunity to get on board - Buy!
Momentum is a leading indicator• Early warning of downturn in trend
Apply charting techniques to the oscillator• Trendline break: take profits
Copyright © 1996 – 2006 Investment Analytics Slide: 49
Divergence
Bearish Divergence Bullish Divergence
Trading Rule: Trading Rule:• Scale back / go short Scale back / go long
Prices
Oscillator
Prices
Oscillator
Copyright © 1996 – 2006 Investment Analytics Slide: 50
StochasticsTracks relationship of closing price to recent Hi-Lo rangeFormula: %K = Ct - Ln x 100
Hn - Ln
%D = 3 day sum of (Ct - Ln) x 1003 day sum of (Hn - Ln)
• Hn is the high of the last n days• Ln is the low of the last n days• Ct is today’s closing price• n = 5, or 9 is popular choice
Copyright © 1996 – 2006 Investment Analytics Slide: 51
Stochastics
Stochastics fluctuates in range +/- 100• Overbought range: 75-80• Oversold range : 25-30
Plot both %K and %D• Also plot overbought/oversold regions
Sell signal:• %K, %D both in overbought region• %K crosses back down over %D
Buy signal - the reverse
Copyright © 1996 – 2006 Investment Analytics Slide: 52
90.0
95.0
100.0
105.0
110.0
115.0
Stochastics in Trading Range
0
25
50
75
100
Oversold
Overbought
Sell
Buy
Bullish Divergence
Buy
Copyright © 1996 – 2006 Investment Analytics Slide: 53
Trading with StochasticsIdeal for range tradingIn Trends:
• Tends to stay overbought/oversold for long periods• Ignore sell signals in uptrend• Wait for oversold signal on pullback to get on board• Ignore buy signals in downtrends• Wait for overbought signal on pullback to get on board
Charting: look for trendlines on the oscillatorDivergence: trade same way as Momentum
Copyright © 1996 – 2006 Investment Analytics Slide: 54
Indicators
These are trend following toolsUsually based on moving averagesPopular indicators
• MACD (Moving Average Convergence-Divergence)
• Wilder’s ADX system
Copyright © 1996 – 2006 Investment Analytics Slide: 55
MACD Histogram
A variation on the MA crossover idea:• Uses two EMA’s (12 and 26 day)• The difference between them is the fast MACD line• Calculate a 9 day EMA of the fast MACD line (the Signal)• MACD histogram = (Fast MACD - Signal)
Fast MACD
Signal
MACD Histogram
Copyright © 1996 – 2006 Investment Analytics Slide: 56
How to use MACD
Fast MACD reflects short term consensusThe signal indicates consensus over a longer periodWhen the fast MACD rises above the signal, bulls are in control: trade from the long sideWhen the fast MACD falls below the signal, bears are winning: trade from the short side
Copyright © 1996 – 2006 Investment Analytics Slide: 57
The MACD Histogram
Histogram Positive, rising• Meaning: trend strengthening• Trading rule: hold longs
Histogram Positive, falling• Meaning: trend weakening / pullback ahead• Trading rule: (i) tighten protective stops
(ii) place order to buy above yesterdays’ high
Histogram Negative: reverse of above
Copyright © 1996 – 2006 Investment Analytics Slide: 58
The MACD Histogram
Histogram Crosses Zero Line• Meaning: trend change imminent• Trading rule:
(i) liquidate position, if not stopped out(ii) reverse and go short (long)
Copyright © 1996 – 2006 Investment Analytics Slide: 59
MACD Divergence
Bearish Bullish
Copyright © 1996 – 2006 Investment Analytics Slide: 60
Lab: Self Assessment Test
Continue with testsWorksheets:
• Momentum• Stochastics• MACD
Copyright © 1996 – 2006 Investment Analytics Slide: 61
Summary: Technical AnalysisMost useful techniques:
• Trendlines, channel lines, moving averages• Support & resistance
Charting:• Continuation & reversal patterns• Gaps, spikes
Indicators• MACD & other trend indicators
Oscillators• Momentum, Stochastics• Ideal for range trading, timing trend entry
Copyright © 1996 – 2006 Investment Analytics Slide: 62
Problems with Technical TradingTrends
• Identifying new trends• Deciding when trend is over• When to get in/out?
Ranges• Sometimes support & resistance holds, sometimes not• False breakouts
Charting• We tend to see the patterns we want to see• Even random prices show chart patterns & trends
Copyright © 1996 – 2006 Investment Analytics Slide: 63
Trends in Random Prices
40.0
240.0
440.0
640.0
840.0
1040.0
1240.0
LnS S NiidLnS M P LnS
t t t
t t t
( / ) ~( ) * ( )
+
+
= ⇒= + +
1
1
εε
Copyright © 1996 – 2006 Investment Analytics Slide: 64
Linear Behavior in Markets
y = 0.1571x + 100.09R2 = 0.9142
100
102
104
106
108
110
112
114
116
118
02/2
2/95
02/2
7/95
03/0
2/95
03/0
7/95
03/1
0/95
03/1
5/95
03/2
0/95
03/2
3/95
03/2
8/95
03/3
1/95
04/0
5/95
04/1
0/95
04/1
3/95
04/1
8/95
04/2
1/95
04/2
6/95
05/0
1/95
05/0
4/95
05/0
9/95
05/1
2/95
05/1
7/95
05/2
2/95
05/2
5/95
05/3
0/95
06/0
2/95
06/0
7/95
06/1
2/95
06/1
5/95
06/2
0/95
06/2
3/95
06/2
8/95
07/0
3/95
07/0
6/95
07/1
1/95
Sept Bond Futures
Copyright © 1996 – 2006 Investment Analytics Slide: 65
A Foolproof Way to Make Money Using Systems
Devise a trading ruleTest it - make sure it loses moneyReverse the signals Optimize the parametersIgnore commission & slippageSELL THE SYSTEM!
Copyright © 1996 – 2006 Investment Analytics Slide: 66
Technical Analysis & EMH
EMH:All information is incorporated in current pricesPrices only change when new information arrives
CONCLUSION: Technical Analysis is pointlessBUT most traders use it - WHY?
Copyright © 1996 – 2006 Investment Analytics Slide: 67
Rationale for Technical Analysis
‘Rational prices’ argumentPsychological factorsMarket anomalies
Copyright © 1996 – 2006 Investment Analytics Slide: 68
‘Rational prices’ argumentTechnical analysts argue EMH is wrong on at least two counts:
• it says prices are random• it says trends and chart patterns aren't real
BUT: EMH does NOT say prices are random• EMH: price changes are random
EMH does NOT say trends, chart patterns cannot occur
• EMH: patterns occur by random chance & you have no way of knowing in advance which pattern is going to arise
Copyright © 1996 – 2006 Investment Analytics Slide: 69
Psychological factors
Technical analysis is easy‘Working’vs. gamblingComfort factor
• To back up a trading decision• To trade with the crowd
Copyright © 1996 – 2006 Investment Analytics Slide: 70
Market AnomaliesSmall firm in January effect (Banz, 1981)
• Abnormally high returns in first 2 weeks of January• Reasons: tax-loss selling, poor liquidity• ‘Neglected firm’ effect
The Weekend effect (French, 1980)• A negative abnormal return on Mondays • Not large enough to overcome transaction costs• Nonetheless, don’t buy stocks on Fridays!
Value Line (Black, 1971)• Portfolio 1 abnormal +ve returns, Portfolio 5 abnormal
negative returns• Reranked stocks (esp. small) show abnormal returns