Lokanandha Reddy Irala / Technical Analysis 1 Technical Analysis  Two Main approaches to valuing stocks include –Fundamental analysis –Technical analysis  Some use only technical analysis while others use both fundamental and technical analysis  Technicians focus on charts of market prices and transactions statistics –Think that these statistics will reveal all  Technicians study patterns in security prices

Lokanandha Reddy Irala / Technical Analysis 2 Theoretical Foundation  Edwards & Magee (1997) state the basic assumptions of technical analysis –A security’s market value is based on supply and demand –Supply and demand are based on both rational and irrational factors –Security prices tend to move in persistent trends –Changes in trends occur due to shifts in supply and demand –Shifts in supply and demand can be detected using charts of market transactions –Some chart patterns tend to repeat themselves

Lokanandha Reddy Irala / Technical Analysis 3 Theoretical Foundation  Technicians believe past patterns will recur –Therefore can be predicted  Technical analysts estimate prices –Whereas fundamental analysts estimate value  Technicians tend to ignore issues such as a firm’s riskiness and earnings growth –Instead focus on barometers of supply and demand

Lokanandha Reddy Irala / Technical Analysis 4 Theoretical Foundation  Technicians claim technical analysis is –Easier –Faster –Can be applied simultaneously to more stocks than fundamental analysis  But, does technical analysis work?  Technicians argue that when using fundamental analysis –Must wait until market realizes a stock is undervalued –Must rely on inadequate accounting statements –It is hard work –Must use ambiguous estimates of growth

Lokanandha Reddy Irala / Technical Analysis 5 The Dow Theory  Originated by Charles Dow –Founder of the Dow Jones Company and editor of Wall Street Journal  Dow Theory presumes market moves in persistent bull and bear trends –Often used for market as a whole, but used for individual securities also  Types of movements defined by Dow theorists –Primary trends (bull or bear market) –Secondary trends (corrections) Market collapses or upward surges lasting a few weeks or months –Tertiary moves (little daily fluctuations) Meaningless random wiggles but should be studied to determine if relate to a primary trend

Lokanandha Reddy Irala / Technical Analysis 6 The Dow Theory

Lokanandha Reddy Irala / Technical Analysis 7 Bar Charts  Represent price (high, low, close) of security over time  Each bar spans the distance from the day’s highest price to the day’s lowest price, and a small cross on each bar marking that day’s closing price

Lokanandha Reddy Irala / Technical Analysis 8 Sample Bar Chart High Low ClosePriceDays

Lokanandha Reddy Irala / Technical Analysis 9 Bar Charts

Lokanandha Reddy Irala / Technical Analysis 10 Support and Resistance Levels  Resistance level –Ceiling (peak) above which stock price is not expected to go Supply of security is expected to increase  Support level –Floor (trough) below which stock price is not expected to drop Demand of security is expected to increase

Lokanandha Reddy Irala / Technical Analysis 11 Contrarian logic : Short Interest  Short Interest - total number of shares that are sold short  When short sales are high : –Market is going to be Bullish  Logic : – when stock is sold short, it must be repurchased to close out position. When short interest is high, there will be buying pressure when shorts close out their positions  Bearish market is not ruled out though –L arge short sales indicate widespread belief that stock prices will fall

Lokanandha Reddy Irala / Technical Analysis 12 Breadth of the Market  It is possible that an index would still be raising for some time after the market for the majority of lesser known stocks have already turned down  Measuring the number of advances and declines  Net advances = # advances - # declines

Lokanandha Reddy Irala / Technical Analysis 13 Breadth of the Market

Lokanandha Reddy Irala / Technical Analysis 14 Breadth of the Market  Breadth statistic may become negative during a bear market  However, it is arbitrary and depends on the date the cumulative breadth series began  Only the direction and not the level of the statistic is important

Lokanandha Reddy Irala / Technical Analysis 15 Breadth of the Market  B-O-M-S is compared with the Market Index  The breadth and the market Index normally move in tandem  TAs watch for the trend in breadth to diverge from the trend in Index

Lokanandha Reddy Irala / Technical Analysis 16 Relative Strength Analysis  Some securities exhibit relative strength –The prices of these securities rise relatively faster in a bull market or decline relatively more slower in a bear market  Watching the price of the security in relation to –Industry –Market

Lokanandha Reddy Irala / Technical Analysis 17 Relative Strength Analysis

Lokanandha Reddy Irala / Technical Analysis 18 Relative Strength Analysis

Lokanandha Reddy Irala / Technical Analysis 19 Relative Strength Analysis Sec / Mkt Ind / Mkt Sec / Ind

Lokanandha Reddy Irala / Technical Analysis 20 Charting Volume of Shares Traded  Technicians argue volume measures the intensity of investor’s feelings  Volume is studied in conjunction with prices  Technicians analyze resistance and support levels along with volume

Lokanandha Reddy Irala / Technical Analysis 21 Charting Volume of Shares Traded Selling Climaxes  When supply and demand are out of balance (price is moving) volume is watched closely –Market is bullish when high volume is combined with a rising price –Market is bearish with high volume and falling prices  Falling prices and high volume are considered bullish if a selling climax occurs

Lokanandha Reddy Irala / Technical Analysis 22 Charting Volume of Shares Traded Speculative Blowoffs  If one believes the end of bear market is near and high volume occurs –Means last of bearish investors are liquidating their holdings Clears the way for bullish investors to start bidding up price  A speculative blowoff marks the end of a bull market –High volume pushes prices to peak Exhausts bullish speculators enthusiasm, enabling bearish market to begin –A bull dies with a bang, not a whimper

Lokanandha Reddy Irala / Technical Analysis 23 Moving Average Analysis  Moving averages are used to provide a smooth reference point for –Individual securities –Market indices –Commodity prices –Interest rates –Foreign exchange rates  Some use a 150-day (30 week) moving average –Changes each day Most recent day is added and oldest day is dropped –Following calculation is performed »M150 P t = (1/150)(Value t + Value t-1 + … Value t-149 )

Lokanandha Reddy Irala / Technical Analysis 24 Moving Average Analysis  Moving averages computed over short time frames follow daily prices more closely –More volatile than longer-term moving averages  Technicians analyze difference between daily price and moving average –If daily prices penetrate moving average line it is a signal to take action If daily price moves down through a moving average, price fails to rise for many months –Sell signal If daily prices are above moving average but difference is narrowing –Signals end of bull market may be near

Lokanandha Reddy Irala / Technical Analysis 25 Moving Average Analysis – Buy Signals  Moving average analysts recommend buying stock if 1. Moving average line flattens and stock price moves up through moving average line 2. Price of stock falls (temporarily) below moving average line that is rising 3. Stock price is above moving average line, falls, turns around and rises again without penetrating moving average line

Lokanandha Reddy Irala / Technical Analysis 26 Moving Average Analysis – Sell Signals  Moving average analysts recommend selling stock if 1. Moving average line flattens and stock price drops down through moving average line 2. Stock price temporarily rises above a declining moving average line 3. Stock price falls through moving average line and turns around only to fall again without penetrating above moving average line  Strategy is more successful if moving average is calculated over a longer time frame

Lokanandha Reddy Irala / Technical Analysis 27 Moving Average Analysis Sell Signal Buy Signal B1 B3 S1

Lokanandha Reddy Irala / Technical Analysis 28 The Bottom Line  Technical tools are used to detect price patterns  Technical analysis assumes shifts in supply and demand occur gradually over time  Price change pattern is extrapolated to predict future price changes  Many financial economists believe technical analysis cannot predict market prices –Believe security prices are a random walk Occur in reaction to random arrival of new information –Believe a series of similar independent changes in prices are coincidence