Transcript Chapter 1: The philosophy of technical analysis

Doğu Akdeniz Üniversitesi
Faculty of Business and Economics
Department of Banking and Finance
Saeed Ebrahimijam
FINA417
Spring 2013
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Principal of Stock Market Investment
The Basic Principals
Technical analysis defined
Adaptability to Different Market and
Investment Time Horizons
Dow Theory
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and Algorithmic Trading
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price volatility in the all stock exchanges is
common.
obtaining to the method with the least
prediction error is one of the challenging
issues of financial and investment markets
analyzers.
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Generally there are two viewpoints of analyzing:
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Fundamental:
The stock market has no
memory and prices are changed randomly
according to economic and financial variables,
reports and news.
Technical: The market has undergone a pseudo
psychological mode and history is always
repeatable. Like: RSI, MACD, %K, Fibonacci,…
Fundamental analysts believe, “Technical analysis based
on the weak principles”.
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Charts vs. Financial Statements
At the most basic level, a technical analyst
approaches a security from the charts, while a
fundamental analyst starts with the financial
statements.
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“Sell on good news.” Why ???
Because if the actual news is as expected, it
is, of course, already discounted and
reflected in the market price. Therefore, you
would expect no further rise in price based
on that news.
A related paper:
“Buy on bad news, sell on good news: How insider trading analysis can benefit
from textual analysis of corporate disclosures,” Hagenau et all.
http://www.krannert.purdue.edu/faculty/kkarthik/wise12/papers%5Cwise12_
submission_36.pdf
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1. Everything (All economic factors dealing with
stock price) are hidden is discounted and
reflected in market prices.
2. Prices move in trends, and trends persist.
3. Market action is repetitive.
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Technical analyzers believe that all the
important
information
of
company
(lose/profit report,
balance sheet,…),
economical, political, psychological and…
conditions are all reflects in the stock
prices.
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As a rule, people will act the same way they
have in the past.
The stock market is a reflection of the actions
of people, technicians study it to determine
how people will react under certain
conditions and, thus, how security prices will
move.
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The real value of a share of stock or other market
instrument at any point is determined solely by
supply and demand as reflected in trading
activity.
Price movements and fluctuations are simply the
reflection of changes in supply and demand.
The technician does not care what the underlying
forces of a shift in supply and demand are.
The study of market prices is all that is
necessary.
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Consider:
 Stock prices are determined solely by the
interaction of demand and supply.
 Stock prices tend to move in trends.
 Shifts in demand and supply cause reversals
in trends.
 Shifts in demand and supply can be detected
in charts.
 Chart patterns tend to repeat themselves.
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From a technical analyst's perspective, a trend is a
directional movement of prices that remains in effect
long enough to be identified and still be playable.
Anything less makes technical analysis useless.
If a trend is not identified until it is over, we cannot
make money from it.
If it is unrecognizable until too late, we cannot make
money from it.
In retrospect, looking at a graph of prices, for
example, many trends can be identified of varying
length and magnitude, but such observations are
observations of history only.
A trend must be recognized early and be long enough
for the technician to profit from it.
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A rising trend, or "uptrend," occurs when
prices reach higher peaks and higher troughs.
A declining trend, or "downtrend," is the
opposite—when prices reach lower troughs
and lower peaks.
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“The trend is your friend,” is true because,
once begun, a trend is likely to continue. By
following it, you increase your probability of
making money.
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The price changes are function of specific
trends. The trends are always consistent and
don’t change without any reasons.
Moving car on the road!!!
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First, they begin in one direction, up or down,
creating a trend. That trend persists until the
price movement slows and gives warning
before finally reversing and moving in the
opposite direction. At that point a new trend
is initiated.
As illustrated in Figure, trends can be easily
spotted on charts. The chart patterns show
the balance of supply and demand for a
particular stock or other market instrument.
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In its basic form, technical analysis is the
study of past market data, primarily price and
volume data; this information is used to make
trading or investing decisions.
Technical analysis is rooted in basic
economic theory?
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Giving consideration to the principles
discussed above, technical analysis can be
defined as simply the study of individual
securities and the overall market based on
supply and demand.
Technicians record, usually in chart form,
historical price and volume activity and
deduce from that pictured
probable future trend of prices.
history
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it can be applied effectively to virtually any
trading medium and investment time horizon.
A technician can analyze stocks, bonds,
options, mutual funds, commodities, and
many other forms of investments(Gold, Oil,
real states,…) for buy and sell opportunities.
one can do so by examining tic-by-tic,
intraday, daily, weekly, monthly, or some
other interval of time to use technical analysis
for a wide range of time horizons—from very
short-term to very long-term perspectives.
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Technical analysis is used in two major ways:
 Predictive
 Reactive
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Those who use technical analysis for predictive
purposes use the analysis to make predictions
about future market moves.
Generally, these individuals make money by
selling their predictions to others. Market letter
writers in print or on the web and the technical
market gurus who frequent the financial news fall
into this category.
The predictive technical analysts include the
more well-known names in the industry; these
individuals like publicity because it helps market
their services.
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On the other hand, those who use technical
analysis in a reactive mode are usually not
well-known.
Traders and investors use techniques of
technical analysis to react to particular
market conditions to make their decisions.
For example, a trader may use a moving
average crossover to signal when a long
position should be taken.
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There are several requirements needed to convert
pure technical analysis into money.
The first and most important, of course, is to
determine when a trend is beginning or ending. The
money is made by "jumping" on the trend as early as
possible.
Theoretically,
this
sounds
simple,
consistently is not so easy.
The indicators and measurements that technical
analysts use to determine the trend are not crystal
balls that perfectly predict the future. Under certain
market conditions, these tools may not work. Also, a
trend may suddenly change direction without
warning. Thus, it is imperative that the technical
investor be aware of risks and protect against such
occurrences causing losses
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From a strategic standpoint, then, the technical
investor must decide two things:
- First, when to enter a position,
- Second, when to exit a position.
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Choosing when to exit a position is composed of
two decisions:
1- when to capture profit (take profit).
2- when to exit from position at a loss (stop loss)
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The wise investor is aware of the risk that the
trend may differ from what she expected.
Making the decision of what price level to
sell and cut losses before even entering into a
position is a way in which the investor
protects against large losses.
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In sum, the basic ways to make money using
technical methods are
"The trend is your friend"—play the trend.
Don't lose—control risk.
Manage your money—avoid ruin.
when the analysis is wrong and the position
must be closed.
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Adam smith:
“If you don’t know who you are, the stock
market is an expensive place to find out”
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Technical analysis method should be different
by characteristics of the person. Level of
Stress, behaviors and wealth.
Complementary of person’s characteristics
and investment philosophy.
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Obviously, those whose time, nerves, and
capital are limited will want to pass up very
short-term trading opportunities (such as
intraday trading of stock index futures) and,
perhaps, use longer-term technical analysis–
derived buy and sell signals for stocks,
exchange traded funds (ETFs), or mutual
funds.
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Joseph Kennedy:
“ Waiting for the ceiling price to sell shares is
what silly people do….”
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Joseph Kennedy was a stock market investor in the late 1920's. One day, in the
Summer of 1929, he overheard an elevator boy boasting about how much money
he had made in the stock market. Joseph Kennedy reasoned that if totallyuneducated low-income employees have now been attracted to the stock market,
then the prices must be at their all-time highest. So, he raced to the floor of the
stock exchange and famously yelled: SELL! For months, his friends laughed at him
as prices kept rising and rising and rising. Then, one day, October 29, 1929, the
market crashed. Joseph Kennedy and his family were safe. They had no money
whatsoever in the market.
Joseph Kennedy waited. Prices fell. He waited. Prices fell. Then, one day, in 1932, a
full three years later, he bought a chain of department stores at 5 on the dollar.
He bought the real estate, the buildings, the inventory, the goodwill - everything
at a 95% discount. He then parlayed that brilliant purchase into a fortune that
spawned a political dynasty of famous and politically successful Kennedy's,
including one President John Kennedy. His wealth and his influence will last for
centuries - because he had the courage to go against the conventional wisdom. He
played the INNER game instead of just reading the newspaper headlines.
Joseph Kennedy SOLD when everyone was buying. Then, he BOUGHT when the
Depression was at its very worst. He made a gigantic fortune BECAUSE of The
Great Depression. We are not in a Depression now, but we are in a serious
Recession. And, you can make your fortune right now - BECAUSE of the Recession.
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Charles Dow never formalized the Dow Theory.
But his work has formed the basis for modernday technical analysis.
Despite the many changes that have occurred in
the securities markets over the past century,
much of Dow's basic work and ideas remain
pertinent today.
Although Dow might be surprised at the analysis
that more advanced tools and computer power
allow, his classic work provides the basic theory
that these contemporary models build upon.
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The market has three movements:
1. “main movement” primary movement: may last from less than a year to several years
2. "medium swing", secondary reaction: may last from ten days to three months
3. "short swing" or minor movement varies with opinion from hours to a month or more
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Market trends have three phases
1. accumulation phase
2. public participation (or absorption) phase,
3. distribution phase.
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The stock market discounts all news
Stock market averages must confirm each other
Trends are confirmed by volume
Trends exist until definitive signals prove that
they have ended
http://en.wikipedia.org/wiki/Dow_theory
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