Transcript Technical Analysis - TalkTalk Business

Week 6
Technical Analysis
Technical Analysis
 Attempt to exploit recurring and predictable patterns in
stock prices to generate abnormal trading profits.
Stock market moves in trends which are determined by the
changing attitudes of investors to a variety of economic,
monetary, political and psychological forces.
Identify changes in trends at an early stage; and Maintain an
investment until a reversal of that trend is indicated.
 Technicians believe:
Shifts in market fundamentals can be discerned before the
impact is fully reflected in prices.
Fundamentals can be perturbed by irrational factors.
When there is a shift in market fundamentals, price
adjustment to a new equilibrium is gradual, leading
recognizable trend.
Technical Analysis
 The presumptions in technical analysis are not consistent
with EMH.
Exploitable trends in stock prices would be the evidence
against EMH, as they would indicate profit opportunities that
market participants had left unexploited.
 The notion of evolving patterns is consistent with almost
but not-quite efficient markets.
There are patterns in stock prices that can be exploited, but
once investors identify and attempt to profit from these
patterns, their trading activities affect prices, thereby altering
prices.
The patterns that characterize the stock prices will be
constantly evolving, and only the best analysts who can
identify new patterns earliest will be rewarded.
Charting: The Dow Theory
 A technique that attempts to discern long- and short-term
trends in stock market prices.
 Two indicators used
DJIA: Key indicator of underlying trends
DJTA: Indicator for confirming or rejecting the signal
 Three forces that simultaneously affect stock prices
Primary trend: Long-term movements of prices (several
month to several years)
Secondary or intermediate trends: Short-term deviations of
prices from the underlying trend line, which are eliminated
via corrections toward trend values.
Tertiary or minor trends: Daily fluctuations of little
importance.
Charting: The Dow Theory
 Support and resistance levels in stock prices
Support level: A value below which a stock or stock index is
relatively unlikely to fall.
Resistance level: A value above which a stock or stock index
is difficult to rise.
Support and resistance levels are determined by the recent
history of stock prices.
Piercing the resistance level is a bullish signal.
Piercing the support level is a bearish signal.
Technicians see these levels as resulting from common
psychological investor traits.
The contradictory signal between DJIA and DJTA
(nonconfirmation by DJTA) is a warning sign.
Charting: The Dow Theory
 EMH and the Dow theory
The EMH holds that if any pattern is exploitable,
many investors attempt to profit from such
predictability, which would ultimately move
prices and cause trading strategy to self-destruct.
 Recent variations on the Dow theory
The Elliott wave theory: Stock prices can be
described by a set of wave patterns – By
interpreting the long- and short-term cycles, one
can predict broad movements.
The theory of Kondratieff waves: Macroeconomy
(stock market) moves in broad waves lasting
between 48 and 60 years.
Charting: Other Techniques
 Point and figure chart
Simply trace significant upward or downward movements in
stock prices without regard to their timing.
It is customary to require reasonably substantial price
changes before marking pluses or minuses.
Sell (buy) signals are generated when the stock price
penetrates previous lows (highs).
 Candlestick chart
The box with the vertical line drawn through it allows to
ascertain the open and close price for the day, as well as the
high and low price.
If the price increases during the day, the box is shaded.
The chart conveys a considerable amount of information
about recent stock price history.
Charting: Warning
 Unfortunately, it is possible to perceive patterns that
really do not exist.
The simulated data from a random number generator
(patternless by construction) can display the pattern that is
very similar to a pattern in the real stock prices.
 Data mining
After the fact, you can always find patterns and trading rules
that would have generated big profits: If you test enough
rules, some will have worked in the past.
Unfortunately, picking a theory that would have worked after
the fact carries no guarantee of future success.
In evaluating trading rules, you should always ask whether
the rule would have seemed reasonable before you looked at
the data.
Technical Indicators
 Sentiment Indicators
Measure the expectations of various groups of investors,
for example, mutual fund managers, corporate insiders, or
NYSE specialists.
 Flow of funds indicators
Measure the potential for various investor groups to buy or
sell stocks in order to predict the price pressure from those
actions.
 Market structure indicators
Monitor price trends and cycles.
Examples: Charting techniques.
Sentiment Indicators
 Trin Statistic
Market volume can measure the strength of a market rise or
fall: Market advances (reversals) are considered more bullish
(bearish) when associated with increased trading volume.
Trin = Number Advancing / Number Declining
Volume Advancing / Volume Declining
= Volume Declining / Number Declining
Volume Advancing / Number Advancing
= Average Volume in Declining Issues
Average Volume in Advancing Issues
Ratios above 1.0 are considered bearish because the falling
stocks would have higher average volume than advancing
stocks, indicating net selling pressure.
Sentiment Indicators
 Odd-Lot Trading
An odd lot is a transaction of fewer than 100 shares.
Odd-lot traders are almost always small individual traders.
The odd-lot theory
Small investors tend to miss key market turning points,
typically buying stocks a bull market has already run its
course and selling too late into a bear market.
When odd-lot traders are widely buying, you should sell
and vice versa.
The ratio of odd-lot purchases to sales which is above 1.0
indicates the bearish market because small traders are net
buyers.
Sentiment Indicators
 Confidence Index
Presumption: Actions of bond traders reveal trends that will
emerge soon in the stock market.
The ratio of the average yield on 10 top-rated corporate
bonds divided by the average yield on 10 intermediate-grade
corporate bonds: Always below 100%.
The higher values are bullish signal because default premium
on lower rated bonds will be smaller when bond traders are
optimistic about the economy.
 Put/Call Ratio
The ratio of outstanding put options to outstanding call
options: Typically, about 65%.
Deviations of the ratio from historical norm can be a signal
of market sentiment and predictive of market movements.
Sentiment Indicators
 Put/Call Ratio
Increase in the ratio as Bearish: Growing interest in puts as a
hedge against market declines.
Contrarian investors would consider an increase in the ratio
as a signal of a buy opportunity, as they believe that a good
time to buy is when the rest of the market is bearish.
 Mutual Fund Cash Positions
Presumption: Mutual funds act incorrectly before a market
turning points – Become more bullish and hold lower cash
position (fully invested) when the market is at, or near, a
peak.
The percentage of cash held in mutual fund portfolios is one
common measure of sentiment: This percentage moves in the
opposite direction of the stock market.
Flow of Funds Indicators
 Short Interest
 Total number of shares currently sold short in the market.
High levels of short interest can be interpreted as bullish,
some as bearish.
Bullish: All short sales must be covered, suggesting short
interest represents latent future demand for the stocks.
Bearish: Short sellers tend to be larger, more sophisticated
investors, and increased short interest reflects bearish
sentiment of those investors.
 Credit Balances in Brokerage Accounts
Investors with brokerage accounts often leave balances
when they plan to invest in the near future.
Credit balances may be viewed as measuring the potential
for new stock purchases: High balances - Bullish sign.
Market Structure Indicators
 Moving Averages
Moving average of a stock index is the average level of
index over a given interval of time.
52-week moving average: Each week, the moving
average is recomputed using index values of most recent
52-week.
After a period in which prices have generally been
falling, the moving average will be above the current
price (the moving average averages in the older and
higher prices).
When the current price breaks through the moving average
line from below: A bullish sign – A shift from a falling trend
(with prices below the moving average) to a rising trend
(with prices above the moving average).
When the current price breaks through the moving average
Market Structure Indicators
 Breadth
A measure of the extent to which movement in a market
index is reflected widely in the price movements of all the
stocks in the market.
The most common measure: Spread between the number of
stocks that advance and decline in price.
If advances outnumber decline by a wide margin, the
market is viewed as being stronger.
Some analysts cumulate breadth data each day.
The cumulative breadth for each day = That day’s net
advances (or declines) + Previous day’s total.
The direction of cumulative breadth is used to identify
broad market trends.
Market Structure Indicators
 Relative Strength
A measure of the extent to which a security has outperformed or underperformed either the market as a whole or
its particular industry.
The most common measure: Ratio of the price of the
security to a price index for the industry.
A rising ratio implies the stock has been outper-forming
the rest of industry.
If relative strength can be assumed to persist over time,
this would be a signal to buy stock.
The relative strength of an industry relative to the whole
market can be computed for tracking the ratio of the
industry price index to the market price index.
Value Line System
 Value Line System is widely followed by investors and
displays the evidence of superior performance.
Value Line ranks stocks on a timeliness scale of one (best
buy; expected to perform the best) to five (sell; expected to
perform the worst).
The evidence shows that the different groups perform just as
the rankings predict.
 Value Line System is predominately a technical system.
The ranking procedure has three components: relative
earnings momentum, earnings surprise, and value index.
Points assigned for each factor determine the stock’s overall
ranking.
 Value Line System is difficult to implement in market:
Underperformance of Value line’s mutual fund.
Technical Analysis in Efficient Markets
 Self-destructing Patterns
The idea behind the technical analysis is inconsistent with
EMH.
The real test of EMH: Whether a technical rule that seems to
work will continue to work in the future (that, is become
reflected in stock prices) once it becomes widely
recognized: Self-destructing.
Market dynamic: Search for profitable trading rules 
Destruction  Another search for yet-discovered rules.
 Modern View of Technical Analysis
Prices reveal and reflect information and become useful to
traders.
This view can reconcile technical analysis with the usual
assumption of rational traders participating in efficient
markets.