TECHNICAL ANALYSISTECHNICAL ANALYSISINVESTMENTS: CHAPTER 11

Young-Ho Oh, Ph.D.Department of ManagementUiduk University

What is Technical Analysis?

Technical analysis is the attempt to forecast stock prices on the basis of market-derived data.

Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time.

They are looking for trends and patterns in the data that indicate future price movements.

http://stockcharts.com

Typical Stock Market Action

Stock Price

Typical Stock Market Action

Stock Price

Declining Trend

Channel

Trough

Buy Point

Rising Trend Channel

Flat Trend Channel

Sell Point

Peak

Declining Trend

Channel TroughBuy Point

Premises of Technical Analysis Market action discounts everything.

All relevant information are already reflected in the market price and any new information will impact the price as soon as they are released.

Prices move in trends. Up, Down, No trend (Trading Range or

Sideways) A trend is in effect until it reverses.

History repeats itself. Patterns in human psychology do not change. 

Why Study Price?

Technical Analysis of Stock Trends, 8th ed. Robert D. Edwards and John Magee

“The market price reflects…the hopes and fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers… Price is the only figure that counts.”

The Potential Rewards

This chart, from Norman Fosbeck, shows how market timing can benefit your returns. The only problem is that you have to be very good at it.

Alternative Market Strategies (1964 to 1984)Strategy Avg. Annual Gain $10,000 Grows ToBuy and Hold 11.46% 87,500$ Avoid Bear Markets 21.48% 489,700$ Long and Short Major Swings 27.99% 1,391,200$ Long and Short Every 5% Swing 93.18% 5,240,000,000$

The Potential Rewards

This chart, from Barron’s, shows the benefit of being smart enough to miss the worst 5 days of the year between Feb 1966 and Oct 2001.

Source: “The Truth About Timing,” by Jacqueline Doherty, Barron’s (November 5, 2001)

Technical vs. Fundamental Analysis

Technical analysis involves the development of trading rules based on past price and volume data for individual stocks and the overall stock market.

Fundamental analysis involves economic, industry, and company analysis that lead to valuation estimates for companies, which can then be compared to market prices to aid in investment decisions.

What is more important than Why

"A technical analyst knows the price of everything, but the value of nothing.”

The price is the end result of the battle between the forces of supply and demand for the company's stock.

By focusing on price and volume, technical analysis represents a direct approach.

Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?

Advantages of Technical Analysis

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 to “correct” prices as quickly.

Challenges to Technical Analysis

Challenges to Basic Assumptions Empirical tests of Efficient Market Hypothesis

(EMH) show that prices do not move in trends.

Challenges to Technical Trading Rules Rules that worked in the past may not be

repeated. Patterns may become self-fulfilling

prophecies. A successful rule will gain followers and

become less successful. Rules all require subjective judgement.

Agenda

General Approach to TA Drawing Charts

Bar Charts and Japanese Candlestick Charts Point and Figure Charts

Basic Technical Tools Trend Lines Moving Averages Price Patterns Indicators

Dow Theory Elliot Wave

General Steps to Technical Analysis

TOP-DOWN approach

1. Broad Market Analysis

2. Sector Analysis

3. Individual Security Analysis

The principles behind TA are UNIVERSAL!

Trading Floor, CBOT

Long term vs. Short term Views

Choose a view that works for you. The longer you plan on your trade lasting, the longer timeframe chart you require.

Longer Timeframes are more “important” than shorter ones.

Drawing Bar (OHLC) Charts Each bar is composed of

4 elements: Open High Low Close

Note that the candlestick body is empty (white) on up days, and filled (some color) on down days

Note: You should print the example charts (next two slides) to see them more clearly

Open

Close

High

Low

StandardBar Chart

JapaneseCandlestick

Open

Close

High

Low

StandardBar Chart

JapaneseCandlestick

Bar Charts

This is a bar (open, high, low, close or OHLC) chart of AMAT from early July to mid October 2001.

Japanese Candlesticks

This is a Japanese Candlestick (open, high, low, close) chart of AMAT from early July to mid October 2001.

Drawing Point & Figure Charts

Point & Figure charts are independent of time.

An X represents an up move.

An O represents a down move.

The Box Size is the number of points needed to make an X or O.

The Reversal is the price change needed to recognize a change in direction.

Typically, P&F charts use a 1-point box and a 3-point reversal.

XXXXX

OO

XXXX

OOOO

Point & Figure Charts

This is a Point & Figure chart of AMAT from early July to mid October 2001.

Basic Technical Tools

Trend Lines Trend lines Support and Resistance Lines

Moving Averages Moving Averages Strategies for Moving Averages

Price Patterns Indicators

Trend Lines

There are three basic kinds of trends: An Up trend where

prices are generally increasing: Higher lows

A Down trend where prices are generally decreasing: Lower highs

A Trading Range

Down Trend①Connect two or more daily price highs (preferably 10 days apart).②When market closes above a down- trend line, a buy signal is generated.

Up Trend①Connect two or more daily price lows (preferably 10 days apart).②When market closes below an uptrend line, a sell signal is generated.

Support & Resistance

Support and resistance lines indicate likely ends of trends.

Resistance results from the inability to surpass prior highs.

Support results from the inability to break below to prior lows.

What was support becomes resistance, and vice-versa.

Support Resistance

Breakout

Support Line①Buy signal if market fails to penetrate②Sell signal if low is taken out

Resistance①Sell signal if market fails to take out resistance②Buy signal if market closes above resistance

Moving Averages (MA)

A moving average is simply the average price over the last n periods.

Commonly used n: 5, 20, 40, 60, 100, 200 days The longer the time span, the less sensitive the

moving average to daily price changes. Moving averages are used to emphasize the

direction of a trend and smooth out price and volume fluctuations (“noise”).

Long MA = Slow MA, Short MA = Fast MA Three types of MA

Simple MA (SMA), Weighted MA (WMA), Exponential MA (EMA)

Calculating SMA, WMA, EMA

n-day

n-day

n-day

SMA vs. WMA vs. EMA

EMA vs. SMA

WMA vs. SMA

Strategies for Moving Averages Three Strategies

Single MA, Double Crossover, Triple Crossover

Single MA employed Dead Cross: Sell signal when price cuts MA from top Golden Cross: Buy signal when price cuts MA from bottom Filters can be used to increase confidence about an

indicator.

Double Crossover: Two MA’s (Long, Short) Dead Cross: Sell signal when shorter cuts longer from top Golden Cross: Buy signal when shorter cuts longer from

bottom

Strategies for Moving Averages Triple Crossover: Three MA’s (Fast, Middle, Slow)

Buy signal when Middle MA crosses to above slow MA from below; AND Fast MA is above middle MA. Close long when fast MA crosses to below middle MA from

above. Sell signal when

Middle MA crosses to below slow MA from above; AND Fast MA is below middle MA. Close short when fast MA crosses to above middle MA from

below.

Filters

No set rules or things to look out for when filtering, just whatever makes you confident enough to invest your money

For example you might want to wait until a security crosses through its moving average and is at least 10% above the average to make sure that it is a true crossover. Remember, setting the percentile too high could result in

"missing the boat" and buying the stock at its peak. Another filter is to wait a day or two after the

security crosses over, this can be used to make sure that the rise in the security isn't a fluke or unsustained. Again, the downside is if you wait too long then you could

end up missing some big profits.

Single MA: Longer or Shorter

Crossovers

Not as easy as filtering Several different types of crossover's, but all of

them involve two or more moving averages. In a double crossover you are looking for a situation

where the shorter MA crosses through the longer one. This is almost always considered to be a buying signal since the longer average is somewhat of a support level for the stock price.

For extra insurance you can use a triple crossover, whereby the shortest moving average must pass through the two higher ones. This is considered to be an even stronger buying indicator.

Double Crossover

Triple Crossover (1)

Triple Crossovers (2)

Moving Averages

Advantages Provide clear market signals No guessing as to chart formation Good if there are trends in the data

Disadvantages May generate multiple trades Don’t perform well in choppy (sideways)

markets

Price Patterns

Technicians look for many patterns in the historical time series of prices.

These patterns are reputed to provide information regarding the size and timing of subsequent price moves.

Reversal Patterns vs. Continuation Patterns Reversal Patterns: Head and Shoulders,

Double Tops and Bottoms, … Continuation Patterns: Triangles, Flags

Head and Shoulders

This formation is characterized by two small peaks on either side of a larger peak.

This is a reversal pattern, meaning that it signifies a change in the trend.

Head

Head

Left Shoulder

Left Shoulder

Right Shoulder

Right Shoulder

Neckline

Neckline

H&S Top

H&S Bottom

Head & Shoulders Example

Sell Signal

Minimum Target PriceBased on measurement rule

Double Tops and Bottoms

These formations are similar to the H&S formations, but there is no head.

These are reversal patterns with the same measuring implications as the H&S.

Target

Double Top

Double Bottom

Target

Double Bottom Example

Rounded Tops & Bottoms

Rounding formations are characterized by a slow reversal of trend.

Rounding Top

Rounding Bottom

Rounded Bottom Chart Example

Broadening Formations

These formations are like reverse triangles.

These formations usually signal a reversal of the trend.

Broadening Tops

Broadening Bottoms

Broadening Formations

Triangles

Triangles are continuation formations.

Three flavors: Ascending Descending Symmetrical

Typically, triangles should break out about half to three-quarters of the way through the formation.

Ascending

Descending

Symmetrical

Symmetrical

Descending Triangle

DJIA Example

What could you have known,and when could you have known it?

DJIA Example

Double bottomGap, should getfilled

Nov to Mar Trading range

Descendingtriangles

Technical Indicators

A technical indicator is a series of data points that are derived by applying a formula to the price and/or volume data of a security.

There are basically four types of technical indicators. Trend indicators: MACD, Parabolic SAR Momentum indicators: CCI, RSI, Stochastics Volatility indicators: ATR, Bollinger Bands Volume indicators: Chaikin Money Flow, OBV

We will look at just a few of them: Moving Average Convergence/Divergence (MACD) Relative Strength Index (RSI) On Balance Volume (OBV) Bollinger Bands

Oscillators

An oscillator is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time.

There are two types of oscillators: centered and banded oscillators.

Centered oscillators They fluctuate above and below a central point or line. They are best suited for analyzing the direction of price momentum. MACD, ROC (Rate Of Change)

Banded oscillators They fluctuate between overbought and oversold extremes. They are best suited for identifying overbought and oversold levels. RSI, CCI (Commodity Channel Index)

MACD (1)

MACD was developed by Gerald Appel in the 1970’s. It is used to spot changes in the strength, direction,

momentum, and duration of a trend in a stock's price. Appel defined MACD as the difference between a

12-day EMA and 26-day EMA. A 9-day EMA of MACD is used to generate signals (signal

line). The divergence between the two (MACD and signal line) is

shown as a histogram or bar graph. MACD is a centered oscillator.

MACD = EMA[fast, 12] – EMA[slow, 26] signal = EMA[period, 9] of MACD histogram = MACD – signal

MACD (2)

MACD generates bullish signals from three main sources. Positive divergence: MACD begins to advance and the price

is still in a downtrend and makes a lower reaction low. Bullish moving average crossover: MACD moves above the

signal line. Bullish centerline crossover: MACD moves above the zero

line. MACD generates bearish signals from three main

sources. Negative divergence: MACD declines and the price

advances or moves sideways. Bearish moving average crossover: MACD moves below the

signal line. Bearish centerline crossover: MACD moves below the zero

line.

MACD Example Chart

MA Crossover and MACD

Relative Strength Index (RSI) RSI was developed by Welles Wilder as an oscillator to

gauge overbought/oversold levels. RSI is a rescaled measure of the ratio of average price

changes on up days to average price changes on down days. (Wilder recommends using 14 periods.)

The calculations for average gain and average loss are simple 14 period averages. Average Gain = Sum of Gains over the past 14 periods / 14 Average Loss = Sum of Losses over the past 14 periods /

14

LossAverage

GainAverageRS

RSRSI ,

100100

An Example of RSI Calculation

Relative Strength Index (RSI) The most important thing to understand about RSI is

that a level above 70 indicates a stock is overbought, and a level below 30 indicates that it is oversold (it can range from 0 to 100). These traditional levels can also be adjusted to better fit the

security or analytical requirements. Raising overbought to 80 or lowering oversold to 20 will reduce the number of overbought/oversold readings.

Short-term traders sometimes use 2-period RSI to look for overbought readings above 80 and oversold readings below 20.

Also, realize that stocks can remain overbought or oversold for long periods of time, so RSI alone isn’t always a great timing tool.

RSI Example Chart

OversoldOverbought

Relative Strength Index (RSI) Divergences

According to Wilder, divergences signal a potential reversal point because directional momentum does not confirm price.

A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum.

A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.

On Balance Volume

On Balance Volume was developed by Joseph Granville, one of the most famous technicians of the 1960’s and 1970’s. (Granville believed that “volume leads price.”)

OBV is calculated by adding volume on up days, and subtracting volume on down days. A running total is kept. Today’s OBV = Yesterday’s OBV + Today’s volume (up days) Today’s OBV = Yesterday’s OBV - Today’s volume (down days) Today’s OBV = Yesterday’s OBV

The idea behind the OBV indicator is that changes in the OBV will precede price changes. A rising volume can indicate the presence of smart money flowing into a security. Then once the public follows suit, the security's price will likewise rise.

On Balance Volume

To use OBV, you generally look for OBV to show a change in trend (a divergence from the price trend). Like other indicators, the OBV indicator will take a direction. A

rising (bullish) OBV line indicates that the volume is heavier on up days. If the price is likewise rising, then the OBV can serve as a confirmation of the price uptrend. In such a case, the rising price is the result of an increased demand for the security, which is a requirement of a healthy uptrend.

However, if prices are moving higher while the volume line is dropping, a negative divergence is present. This divergence suggests that the uptrend is not healthy and should be taken as a warning signal that the trend will not persist.

The numerical value of OBV is not important, but rather the direction of the line. A user should concentrate on the OBV trend and its relationship with the security's price.

OBV Example Chart

Divergence, OBV failed

OBV confirmstrend changebut doesn’t lead

Bollinger Bands

Bollinger bands were created by John Bollinger (former FNN technical analyst, and regular guest on CNBC).

Bollinger Bands are based on a moving average of the closing price.

They are two standard deviations above and below the moving average.

A buy signal is given when the stock price closes below the lower band, and a sell signal is given when the stock price closes above the upper band.

When the bands contract, that is a signal that a big move is coming, but it is impossible to say if it will be up or down.

Bollinger Bands Example Chart

Sell signal

Buy signals

Sometimes, the buysignals just keep coming andyou can go broke!

Dow Theory

Charles Dow is known as the “Godfather of TA.”

This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900 and 1902.

Dow (and later W.P. Hamilton, R. Rhea and E.G. Schaefer) believed that market trends forecast trends in the economy.

Charles Henry Dow(1851 – 1902)

Six Basic Tenets of Dow Theory The market has three movements. Market trends have three phases.

Accumulation, Public Participation, Distribution

The stock market discounts all news. Consistent with one of the premises of the EMH

Stock market averages must confirm each other. Dow Jones Industrial Average vs. Dow Jones Transportation

Average

Trends are confirmed by volume. Price changes accompanied by high volume: True market view

Trends exist until definitive signals prove that they have ended.

Dow Theory Trends (1)

Primary Trend (Main Movement, Primary Movement) Called “the tide” by Dow Long-term direction (up to several years) Secular bull or bear market

Secondary Trend (Medium Swing, Secondary Reaction) Called “the waves” by Dow. Shorter-term departures from the primary trend (weeks to months) Generally retracing from 33% to 66% of the primary price change

since the previous medium swing or the start of the primary movement

Day-to-day Fluctuations (Short Swing, Minor Movement) Not significant in Dow Theory

The three movements may be simultaneous. (e.g.) A daily minor movement in a bearish secondary reaction in a

bullish primary movement

Dow Theory Trends (2)

Does Dow Theory Work?

According to Alfred Cowles, from 1902 to 1929 buy-and-hold strategy produced 15.5% annualized

return, Dow Theory strategy produced 12% annualized return.

According to Martin Pring, from 1897 to 1981 if you had invested $44 and followed all buy and sell

signals, you would have accumulated about $18,000, if you had simply invested $44 and held that portfolio,

you would have accumulated about $960. Many technical analysts consider Dow Theory’s

definition of a trend and its insistence on studying price action as the main premises of modern technical analysis.

Elliot Wave Principle (1)

R.N. Elliot formulated this idea in a series of articles in Financial World in 1939.

Elliot believed that the market has a rhythmic regularity that can be used to predict future prices.

The Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is made up of similar shorter-term cycles.

5 waves in direction of main trend 3 corrective waves

The underlying 5-3 pattern remains constant, though the time span of each may vary.

Elliot Wave adherents also make extensive use of the Fibonacci series.

Elliott Wave Principle (2)

Elliott Wave Principle (3)

Elliott Wave Principle (4)

Elliott Wave Principle (5)

Does Elliot Wave Work?

Who knows? One of the biggest problems with Elliot Wave is that no two practitioners seem to agree on the wave count, and therefore on the prediction of what’s to come.

Robert Prechter (the most famous EW practitioner) made several astoundingly correct predictions in the 1980’s, but hasn’t been so prescient since (he no longer gets much press attention).

For example, in 1985 he predicted that the market would peak in 1987 (correct), but he thought it would peak at 3686 (± 100 points).

The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.

Fibonacci Numbers

Fibonacci numbers are a series where each succeeding number is the sum of the two preceding numbers.

The first two Fibonacci numbers are defined to be 1, and then the series continues as follows: 1, 1, 2, 3, 5, 8, 13, 21…

As the numbers get larger, the ratio of adjacent numbers approaches the Golden Mean: 1.618:1.

This ratio is found extensively in nature, and has been used in architecture since the ancient Greeks (who believed that a rectangle whose sides had the ratio of 1.618:1 was the most aesthetically pleasing).

Technical analysts use this ratio and its inverse, 0.618, extensively to provide projections of price moves.

Fibonacci Numbers – Retracements (1)

Fibonacci Numbers – Retracements (2)

Technical Analysis Summary (1) As noted, there are literally hundreds of indicators

and thousands of trading systems. A whole semester could easily be spent on just a handful of these.

To close, just note that there is nothing so crazy that somebody doesn’t use it to trade.

For example, many people use astrology, geometry, neural networks, chaos theory, etc.

There’s no doubt that each of these (and others) would have made you lots of money at one time or another. The real question is can they do it consistently?

“You pay your money, and you take your chances.”

Technical Analysis Summary (2) Technical Analysis does work.

It requires Work to make it work. You need to study past technical analysis for several

years worth of data on a particular asset before trading. Develop a strategy unique to your personality

and comfort levels. Tweak your strategy until it works the best that it can. Test it using virtual (paper) trading. Do not stray from your system.

Trend is your friend. You should always trade with a trend and not against it.