Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 13 Technical Analysis

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 13 Technical Analysis Questions to consider: How does technical analysis differ from fundamental analysis? What are the underlying assumptions of technical analysis? What major assumption causes a difference between technical analysis and the efficient market hypothesis?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 13 Technical Analysis What are the major advantages of technical analysis compared to fundamental analysis? What are the major challenges to the assumptions of technical analysis and its rules? What is the logic for the major contrary opinion rules used by technicians?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 13 Technical Analysis What are some of the significant rules used by technicians who want to follow the smart money and what is the logic of those rules? What are the breadth of market measures and what are they intended to indicate? What are the types of price movements postulated in the Dow Theory and how are they used by a technician?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 13 Technical Analysis Why do technicians consider the volume of trading important and how do they use it in their analysis? What are support and resistance levels, how are they identified, and how are they used by technicians? What is the purpose of moving average lines and how does the technician use one or several of them to detect major changes in trends?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Chapter 13 Technical Analysis What is the rationale behind the relative strength line for an industry or a stock and how is it interpreted? How are bar charts different from point-and- figure charts? What are some uses of technical analysis in foreign security markets? How is technical analysis used when analyzing bond markets?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Analysis As An Art Prices are Determined by Investors’ Attitudes –Prices move in trends Changing Attitude Toward –Economic forces –Monetary forces –Political forces –Psychological forces

Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Analysis As A Science Study of the Action of the Market Science of Recording in Graphic Form –Price changes, volume, highs and lows,… –The averages of above Deducing the Probable Future Trend

Copyright © 2000 by Harcourt, Inc. All rights reserved. Is Technical Analysis An Art Or Science? Art –Martin J. Pring Science –Robert D. Edwards and John Magee

Copyright © 2000 by Harcourt, Inc. All rights reserved. Underlying Assumptions of Technical Analysis 1. The market value of any good or service is determined solely by the interaction of supply and demand 2. Supply and demand are governed by numerous factors, both rational and irrational

Copyright © 2000 by Harcourt, Inc. All rights reserved. Underlying Assumptions of Technical Analysis 3. 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 4. Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can be detected in the action of the market

Copyright © 2000 by Harcourt, Inc. All rights reserved. Advantages of Technical Analysis Not heavily dependent on financial accounting statements –Problems with accounting statements: 1. Lack information needed by security analysts 2. GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms 3. Nonquantifiable factors do not show up in financial statements

Copyright © 2000 by Harcourt, Inc. All rights reserved. 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 their prices as quickly

Copyright © 2000 by Harcourt, Inc. All rights reserved. Challenges to Technical Analysis Assumptions - Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends 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 all require subjective judgement

Copyright © 2000 by Harcourt, Inc. All rights reserved. Is There Any Empirical Evidence To Support Technical Analysis (TA)? Patterns in Security Prices –Fall one week, bounce back next week –Monthly returns over a long time –Seasonal patterns January effect Resent Research Merits TA

Copyright © 2000 by Harcourt, Inc. All rights reserved. Charting Bar Charts –Illustrates each days High, low, and closing price –Looks at stock price behavior over time Point-and-Figure Charts –Identifies stock price reversals –Does not consider time Candlestick Charts –Illustrates each days Opening, high, low, and closing price

Copyright © 2000 by Harcourt, Inc. All rights reserved. Bar Charts Trendline –Drawn on chart to identify trend Channel –Pattern formed by 2 trendlines Resistance –Downward price movement Support –Upward price movement

Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Trading Rules and Indicators Stock cycles typically go through a peak and trough Analyze the following chart of a typical stock price cycle and we will show a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would want to trade

Copyright © 2000 by Harcourt, Inc. All rights reserved. Typical Stock Market Cycle Stock Price

Copyright © 2000 by Harcourt, Inc. All rights reserved. Typical Stock Market Cycle Stock Price Declining Trend Channel Trough Buy Point Rising Trend Channel Flat Trend Channel Sell Point Peak Declining Trend Channel Trough Buy Point

Copyright © 2000 by Harcourt, Inc. All rights reserved. Point-And-Figure Charts A Series of Xs and Os Same as Bar Charts Popular Tool

Copyright © 2000 by Harcourt, Inc. All rights reserved. Candlestick Chart Candlestick Line –Real body Difference between opening and closing price –Shadow Vertical line identifying the high and low price –Can be constructed with Different Time Data Intraday Weekly

Copyright © 2000 by Harcourt, Inc. All rights reserved. Summary Of Charts

Copyright © 2000 by Harcourt, Inc. All rights reserved. Contrary-Opinion Many analysts rely on rules developed from the premise that the majority of investors are wrong as the market approaches peaks and troughs Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction These positions have various indicators

Copyright © 2000 by Harcourt, Inc. All rights reserved. Contrary-Opinion Rules Mutual fund cash positions Credit balances in brokerage accounts Investment advisory opinions OTC versus NYSE volume Chicago Board Options Exchange (CBOE) put/call ratio Futures traders bullish on stock index futures

Copyright © 2000 by Harcourt, Inc. All rights reserved. Follow the Smart Money Indicators showing behavior of sophisticated investors The Barron’s Confidence Index T-Bill - Eurodollar yield spread Short sales by specialists Debit balances in brokerage accounts (margin debt)

Copyright © 2000 by Harcourt, Inc. All rights reserved. Other Market Indicators Breadth of market –Advance-decline –Diffusion index Short interest Stocks above their 200-day moving average Block uptick-downtick ratio

Copyright © 2000 by Harcourt, Inc. All rights reserved. Stock Price and Volume Techniques The Dow theory –1. Major trends are like tides in the ocean –2. Intermediate trends resemble waves –3. Short-run movements are like ripples Importance of volume –Ratio of upside-downside volume Support and resistance levels Moving average lines –5-day –200-day

Copyright © 2000 by Harcourt, Inc. All rights reserved. Stock Price and Volume Techniques Relative-strength indexes (RSI) –For individual stocks and industry groups Bar charting Multiple indicator charts Point-and-figure charts Overall feel from a consensus of numerous technical indicators

Copyright © 2000 by Harcourt, Inc. All rights reserved. Dow Theory Primary Trend - “Tides” –Cycle in years Intermediate Trend - “waves” –3 Weeks to 6 months Short-Term Trend - “ripples” –Volatile and erratic Basic Tenets next slide

Copyright © 2000 by Harcourt, Inc. All rights reserved. Basic Tenets Of Dow Theory Requires Data on Stock Indexes –No additional information Types of Financial Market Movements –Primary –Intermediate –Short-term Positive Relationship Between –Trend –Volume of shares traded

Copyright © 2000 by Harcourt, Inc. All rights reserved. RSI Range From 0% to 100% High –Industry stock prices outperform the market –Indicate a sell signal? Buy signal? Low The trend is your friend! –Market outperforming the industry stock –Indicates a buy signal? Sell signal?

Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Indicators Breadth Indicators –Advance-decline line (ADL) –Volume –New high/new low Sentiment Indicators –Stock market newsletter –Odd-lot trading –Put/call trading –Specialists short selling

Copyright © 2000 by Harcourt, Inc. All rights reserved. Advance-Decline Line ADL t = A t - D t + ADL t - 1

Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Analysis of Foreign Markets Foreign stock market series Technical analysis of foreign exchange rates Technical analysis of bond markets

Recap & Further Illustration

Copyright © 2000 by Harcourt, Inc. All rights reserved. Technical Analysis What is it? –Historic price and volume behavior –Investor sentiment –Bulls and bears…. Dow theory –Three trends: primary, secondary, daily –Corrections/confirmations: DJIA/DJTA Support and resistance areas –Support level / Bottom feeders –Resistance level / Topping out / profit taking –Breakouts

Copyright © 2000 by Harcourt, Inc. All rights reserved. Dow Theory Primary trend Secondary reactions Daily trend not shown Time Prices

Copyright © 2000 by Harcourt, Inc. All rights reserved. Charting Reading the tea leaves… Advance / decline line: Closing Arms or Trin Relative strength Moving averages High-lo-close chart Candlestick chart Point-and-figure chart Chart formations: head-and-shoulders Other indicators –Odd lot / Contrarian / Hemlines

Copyright © 2000 by Harcourt, Inc. All rights reserved. Examples Closing Arms: Trin Relative strength: assume 4 shares of Stock $25 per share and 2 shares of Stock $50 per share MonthStock AStock BRel. Str. 1$100$ $88$ $88$ Trin = Declining volume / Declines Advancing volume / Advances

Copyright © 2000 by Harcourt, Inc. All rights reserved. Three Period Moving Average =

Copyright © 2000 by Harcourt, Inc. All rights reserved. Moving Average Graph

Copyright © 2000 by Harcourt, Inc. All rights reserved. Candlestick Making

Copyright © 2000 by Harcourt, Inc. All rights reserved. Candlestick Formations

Copyright © 2000 by Harcourt, Inc. All rights reserved. Point and Figure Chart

Copyright © 2000 by Harcourt, Inc. All rights reserved. Head and Shoulders Formation

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