1

Technical Analysis

CHAPTER 19

Technical Analysis Technical analysis is a security analysis technique that

claims the ability to forecast the future direction of prices through the study of past market data, primarily price and volume. In its purest form, technical analysis considers only the actual price and volume behavior of the market or instrument. Technical analysts, sometimes called "chartists", may employ models and trading rules based on price and volume transformations

Technical Analysis

Technical analysis stands in distinction to fundamental analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity.

Any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team

Technical Analysis

Technical analysis is widely used among traders and financial professionals, and is particularly widely used by active day traders, market makers, and pit traders.

In the 1960s and 1970s it was widely discredited by academic mathematics, but 56 of 95 modern studies found it produces positive results

Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis

Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.

The market value of any good or service is determined solely by the interaction of supply and demand

Supply and demand are governed by numerous factors, both rational and irrational

Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time

Underlying Assumptions of Technical Analysis

Underlying Assumptions of Technical Analysis

Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself

See Exhibit 15.1 It shows the process wherein new information causes

a decrease in the equilibrium price for a security but the price adjustment is not rapid

Exhibit 15.1

Advantages of Technical Analysis

Technical analysis is not heavily dependent on financial accounting statements. The technician contends that there are several major problems with accounting statements: Lack information needed by security analysts GAAP allows firms to select reporting procedures,

resulting in difficulty comparing statements from two firms

Non-quantifiable factors do not show up in financial statements

Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium

Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly

Advantages of Technical Analysis

Challenges to Technical Analysis

For Assumptions of Technical Analysis Empirical tests of Efficient Market Hypothesis (EMH)

show that prices do not move in trends For Technical Trading Rules

The past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less

successful Rules require a great deal of subjective judgement

Technical Analysis Rationale

A typical stock price cycle for the market or a stock goes through a peak and trough as well as trends

By analyzing the trend patterns (rising trend, flat trend, declining trend) and the change in trend, a technical analyst would be able to decide what trade is needed (Exhibit 15.2)

Exhibit 15.2

Dow Theory The primary trend is the long-term movement of prices,

lasting from several months to several years Secondary trend or intermediate trends are caused by

short-term deviations of prices from primary trend. These deviations are eliminated via corrections when prices revert back to trend values

Tertiary or minor trends are daily fluctuations of little importance

Figure 9.3 Dow Theory Trends

Dow Theory Trends

Dow Theory: Signals and Identification of Trends

An upward trend in Dow theory is a series of successively higher peaks and higher troughs.

Dow Theory: Signals and Identification of Trends

A downward trend is a series of successively lower peaks and lower troughs.

Dow Theory: Signals and Identification of TrendsUpward trend reversal: A reversal in the primary trend is signaled when the market is unable to create another successive peak and trough in the direction of the primary trend. For an uptrend, a reversal would be signaled by an inability to reach a new high followed by the inability to reach a higher low. In this situation, the market has gone from a period of successively higher highs and lows to successively lower highs and lows, which are the components of a downward primary trend

Dow Theory: Signals and Identification of Trends

The reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs. This happens when the market establishes a peak that is higher than the previous peak followed by a trough that is higher than the previous trough, which are the components of an upward trend.

Point-and-Figure Charts

Identifies price levels that support or resist price changes

Breaking support or resistance levels are buy and sell signals.

Figure 9.5 Point and Figure Chart

Figure 9.6 Point and Figure Chart for Atlantic Richfield

23

Buy and Sell Indicators

Moving averages

Average price over some historical period (5 weeks or 200 days)

When current price crosses the average a trading signal occurs

Bullish signal when the current price rises above the moving average

Bearish sign when the current price falls below the moving average

Moving averages

Figure 9.7 Share Price and 50-Day Moving Average for Apple Computer

27

Figure 14.3 Dow Jones Industrial Average and a Six-Month Moving Average

Breadth

The extent to which movements in a broad index are reflected widely in movements of individual stocks

Spread between advancing stocks and declining stocks

Also used in industry indexes

Breadth

Table 9.2 Breadth

Sentiment Indicators Trin Statistics:

Trin > 1: bearish Trin < 1: bullish

Relative strengthMeasures the extent to which a security has outperformed or

underperformed either the market or its industry

advancingnumber advancing/ Volume

decliningnumber declining/ Volume trin

Sentiment Indicators

Confidence indexRatio of the average yield on 10 top-rated

corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds

Put/call ratioCall options give investors the right to buy at a

fixed exercise price and a put is the right to sell at a fixed exercise price

Change in ratio can be given a bullish or bearish interpretation

Sentiment Indicators

Short Interest - total number of shares that are sold shortWhen short sales are high a signal occursBullish interpretationBearish interpretation

A Warning

Although the ability to discern apparent patterns with stock market prices is irresistible—it is also possible to perceive patterns that may not exist

Figure 9.10 Actual and Simulated Levels for Stock Market Prices of 52 Weeks

Figure 9.11 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks