price patterns, charts and technical...
TRANSCRIPT
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PRICEPATTERNS,CHARTSANDTECHNICALANALYSIS:TECHNICALANALYSIS
AswathDamodaran
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FoundationsofTechnicalAnalysis:Whataretheassumptions?
1. Priceisdeterminedsolelybytheinteractionofsupply&demand.
2. Supplyanddemandaregovernedbynumerousfactors,bothrationalandirrational.Themarketcontinuallyandautomaticallyweighsallthesefactors.
3. Disregardingminorfluctuationsinthemarket,stockpricestendtomoveintrendswhichpersistforanappreciablelengthoftime
4. Changesintrendarecausedbyshiftsindemandandsupply.Theseshiftsnomatterwhytheyoccur,canbedetectedsoonerorlaterintheactionofthemarketitself.
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TechnicalIndicators
¨ Therearehundreds(perhapsthousands)ofchartpatternsandtechnicalindicatorsthatinvestorsclaimworksatmakingthemmoney.
¨ Ratherthantrytodealwiththemindividually,wewillarguethatalltechnicalindicatorsarebuiltonthepresumptionofinvestorirrationalityonaglobalscaleandthattheycanthereforebeclassifiedonthatbasis.
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I.Marketsoverreact:TheContrarianIndicators
Basis:Researchinexperimentalpsychologysuggeststhatpeopletendtooverreacttounexpectedanddramaticnewsevents.Inrevisingtheirbeliefs,individualstendtooverweightrecentinformationandunderweightpriordata.Empiricalevidence:
(1)Extrememovementsinstockpriceswillbefollowedbysubsequentpricemovementsintheoppositedirection.(2)Themoreextremethepriceadjustment,thegreaterwillbethesubsequentadjustment
Issues:(1) Why,ifthisistrue,isisthatcontrarianinvestorsaresofewin
numberormarketpowerthattheoverreactiontonewinformationisallowedtocontinueforsolong?
(2) Isthemarketmoreefficientaboutincorporatingsometypesofinformationthanothers?
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Technicaltradingrules:ContrarianOpinion
1. Odd-lottrading:Theodd-lotrulegivesusanindicationofwhatthemanonthestreetthinksaboutthestock(Ashegetsmoreenthusiasticaboutastockthisratiowillincrease).
2. MutualFundCashpositions:Historically,theargumentgoes,mutualfundcashpositionshavebeengreatestatthebottomofabearmarketandlowestatthepeakofabullmarket.Henceinvestingagainstthisstatisticmaybeprofitable.
3. InvestmentAdvisoryopinion:Thisistheratioofadvisoryservicesthatarebearish.Whenthisratioreachesthethreshold(eg 60%)thecontrarianstartsbuying.
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II.DetectingshiftsinDemand&Supply:TheLessonsinPricePatterns
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ShiftIndicators
1. Breadthofthemarket:Thisisameasureofthenumberofstocksinthemarketwhichhaveadvancedrelativetothosethathavedeclined.Amarketadvancewithlessbreadthisanindicationofademandshift(down).
2. Support&ResistanceLines:Ifeitherisbroken,themarketispoisedforamajormove.
3. Movingaverages:Amovingaveragelinesmooths outfluctuationsandenablesthechartisttoseetrendsinthestockprice.Howthattrendisinterpretedthendependsuponthechartist.
4. Volumeshifts:Sometechnicalanalystsbelievethatthereisinformationaboutfuturepricechangesintradingvolumeshifts.
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PriceFeedbackloops
¨ Whilethenotionofsupport/resistancelinesorpriceleveltargets(baseduponthepastorarbitraryroundnumbers)seemsfarfetched,thereisanargumenttobemadethathittingtheselevelscanhavefeedbackeffects,whichcanbepositiveornegative:¤ Thepositive:Itispossiblethathittingthespecifiedpricelevelcanaddtothemomentumonthestock,causingupward(downward)movingstockstomoveup(down)evenmore.
¤ Thenegative:Inanalternatestory,hittingthespecifiedpricelevelcanleadinvestorstoreassessthecompany’svalue,andcorrectoverreach,pushingpricesbackdown(up),iftheyhavewanderedwayabove(below)value.
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III.Marketlearnslowly:TheMomentumInvestors
¨ Basis:Theargumenthereisthatmarketslearnslowly.Thus,investorswhoarealittlequickerthanthemarketinassimilatingandunderstandinginformationwillearnexcessreturns.Inaddition,ifmarketslearnslowly,therewillbepricedrifts(i.e.,priceswillmoveupordownoverextendedperiods)andtechnicalanalysiscandetectthesedriftsandtakeadvantageofthem.
¨ TheEvidence:Thereisevidence,albeitmild,thatpricesdodriftaftersignificantnewsannouncements.Forinstance,followinguponpricechangesafterlargeearningssurprisesprovidesthefollowingevidence.
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MomentumIndicators
1. RelativeStrength:Therelativestrengthofastockistheratioofitscurrentpricetoitsaverageoveralongerperiod(eg.sixmonths).Therulesuggestsbuyingstockswhichhavethehighestrelativestrength(whichwillalsobethestocksthathavegoneupthemostinthatperiod).
2. TrendLines:Youlookpasttheday-to-daymovementsinstockpricesattheunderlyinglong-termtrends.Thesimplestmeasureoftrendisatrendline.
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TradingVolume:Thetechnicalanalyst’ssecretweapon
!
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IV.FollowingtheSmartInvestors:TheFollowers
• Thisapproachistheflipsideofthecontrarianapproach.Insteadofassumingthatinvestors,onaverage,arelikelytobebewrong,youassumethattheyareright.
• Tomakethisassumptionmorepalatable,youdonotlookatallinvestorsbutonlyatthesmartestinvestors,whopresumablyknowmorethantherestofus.
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SmartInvestorIndicators
1. Specialistshortsales:Theassumptionisthatspecialistshavemoreinformationaboutfuturepricemovementsthanotherinvestors.Investorswhousethisindicatorwilloftensellstockswhenspecialistsdo,andbuywhentheydo.
2. Insiderbuying/selling:Theratioofinsiderbuyingtosellingisoftentrackedforstockswiththeideathatinsiderswhoarebuyingmusthavepositiveinformationaboutastockwhereasinsiderswhoaresellingarelikelytohavenegativeinformation.
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V.Marketsarecontrolledbyexternalforces:TheMystics
¨ TheElliotWave:Elliot'stheoryisthatthemarketmovesinwavesofvarioussizes,fromthoseencompassingonlyindividualtradestothoselastingcenturies,perhapslonger."Byclassifyingthesewavesandcountingthevariousclassificationsitispossibletodeterminetherelativepositionsofthemarketatalltimes"."Therecanbenobullofbearmarketsofone,sevenorninewaves,forexample.
¨ TheDowTheory:"Themarketisalwaysconsideredashavingthreemovements,allgoingatthesametime.Thefirstisthenarrowmovement(dailyfluctuations)fromdaytoday.Thesecondistheshortswing(secondarymovements)runningfromtwoweekstoamonthandthethirdisthemainmovement(primarytrends)coveringatleastfouryearsinitsduration.
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DeterminantsofSuccessatTechnicalAnalysis
1. Behavioralbasis:Ifyoudecidetouseachartingpatternortechnicalindicator,youneedtobeawareoftheinvestorbehaviorthatgivesrisetoitssuccess.Youcanmodifyorabandontheindicatoriftheunderlyingbehaviorchanges.
2. Don’ttrust,verify:Itisimportantthatyouback-testyourindicatortoensurethatitdeliversthereturnsthatarepromised.Inrunningthesetests,youshouldpayparticularattentiontothevolatilityinperformanceovertimeandhowsensitivethereturnsaretoholdingperiods.
3. Timelytrading:Theexcessreturnsonmanyofthestrategiesthatwedescribedinthischapterseemtodependupontimelytrading.Tosucceedatsomeofthesestrategies,youmayneedtomonitorpricescontinuously,lookingforthepatternsthatwouldtriggertrading.
4. Goldilockstimehorizons:Buildingonthethemeoftimehorizons,successatchartingcanbeverysensitivetohowlongyouholdaninvestment.
5. Controltradingcosts:Thestrategiesthatcomefromtechnicalindicatorsaregenerallyshort-termstrategiesthatrequirefrequentandtimelytrading.Notsurprisingly,thesestrategiesalsogeneratelargetradingcoststhatcanveryquicklyeatintoanyexcessreturnsyoumayhave.