Technical Analysis To “non-believers,” technical analysis can sound like a lot of focus-pocus!
Introduction 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.
Important view points Price Time Volume Pure supply and demand analysis for common stocks Strong market when volume goes up Weak market when volume goes down Breadth Looks at number of stock prices that go up (advances) versus number of stock prices that go down (declines) Strong market when advances outnumber declines Weak market when declines outnumber advances
Underlying Assumptions of TechnicalAnalysis The market discounts everything. Price moves in trends. History tends to repeat itself The market and/or an individual stock acts like a barometer rather than thermometer. The market value of any good or service is determined solely by the interaction of supply and demand. Supply and demand are governed by numerous factors, both rational and irrational.
Advantages of Technical Analysis Unlike fundamental analysis, technical analysis is not heavily dependent on financial accounting statements Problems with accounting statements: Lack information needed by security analysts GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements between firms Many psychological and other non-quantifiable factors do not show up in financial statements
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 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 judgment.
Typical Stock Market CycleStockPrice Declining Peak Trend Channel Flat Trend Channel Sell Point Rising Trend Channel Declining Buy Point Trend Buy Point Channel Trough Trough
Content Charting Stocks Line charts Bar Charts and Japanese Candlestick Charts Point and Figure Charts Major Chart Patterns Price-based Indicators Volume-based Indicators Dow Theory
Charting the Market Chartists use line chart, bar charts, candlestick, or point and figure charts to look for patterns which may indicate future price movements. They also analyze volume and other psychological indicators (breadth, % of bulls vs % of bears, put/call ratio, etc.). Strict chartists don’t care about fundamentals at all.
Drawing Bar (OHLC) Charts andJapanese candlestick chart Each bar is composed of 4 elements: Open High High High Low Close Open Close Note that the candlestick body is empty (white) on up days, and filled (some color) on Open Close down days Low Low Standard Japanese Standard Japanese Bar Chart Candlestick Bar Chart Candlestick
Japanese Candlesticks Japanese Candlestick chart with open, high, low, close
Different Kinds of Formation ofCandlesticks Long Candlesticks Long wicks Short Candlesticks Wicks
Patterns of Candlestick Charts The Spinning Top Doji Candlestick Pattern The Bullish and Bearish Engulfing Patterns The Hammer and The Hanging Man Candlestick Pattern Morning and Evening Star Pattern
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. X The Reversal is the price X change needed to recognize a X X O X X O change in direction. XO O Typically, P&F charts use a 1- XO O X point box and a 3-point reversal.
Trend Lines There are three basic kinds of trends: An Up trend where prices are generally increasing. A Down trend where prices are generally decreasing. A Trading Range.
Support & Resistance Support and resistance lines indicate likely ends of trends. Resistance results from the Breakout 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
Support and resistance 95 BALLARPUR INDS (104.900, 109.500, 104.500, 107.750, +3.45000) 95 90 90 85 85 80 80 75 75 70 70 65 65 60 60 55 55 50 50 45 45 40 40 35 Support 35 Nov Dec 2001 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2002 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2003 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2004 Feb RELIANCE CAPITAL (594.000, 673.800, 594.000, 670.300, +77.7500) 85 85 80 80 75 75 70 Resistance 70 65 65 60 60 55 55 50 50 45 45 40 40 35 35 30 30Aug Sep Oct Nov Dec 2002 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2003 Feb Mar Apr May Jun Jul Aug Sep Oct
Simple Moving Averages A moving average is simply the average price (usually the closing price) over the last N MSFT Daily Prices with 10-day MA 9/23/93 to 9/21/94 periods. 60 55 They are used to smooth out fluctuations of less than N 50 periods. Price 45 This chart shows MSFT with 40 a 10-day moving average. 35 Note how the moving average 30 1 21 41 61 81 101 121 141 161 181 201 221 241 shows much less volatility Date than the daily stock price.
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. But don’t forget that the EMH says these patterns are illusions, and have no real meaning. In fact, they can be seen in a randomly generated price series.
Head and Shoulders H&S Top This formation is Head characterized by two small peaks on either Left Shoulder Right Shoulder side of a larger peak. This is a reversal pattern, Neckline meaning that it signifies H&S Bottom a change in the trend. Neckline Left Shoulder Right Shoulder Head
Head & Shoulders Example Sell Signal Minimum Target Price Based on measurement rule
Double Tops and Bottoms Double Top These formations are similar to the H&S formations, but there is no head. These are reversal Target patterns with the same Target measuring implications as the H&S. Double Bottom
Triangles Triangles are continuation formations. Three flavors: Ascending Ascending Descending Symmetrical Symmetrical Typically, triangles Symmetrical should break out about half to three-quarters of Descending the way through the formation.
Rounded Tops & Bottoms Rounding formations are Rounding characterized by a slow Bottom reversal of trend. Rounding Top
Broadening Formations These formations are like reverse triangles. Broadening Bottoms These formations usually signal a reversal of the trend. Broadening Tops
Technical Indicators There are, literally, hundreds of technical indicators used to generate buy and sell signals. We will look at just a few that I use: Moving Average Convergence/Divergence (MACD) Relative Strength Index (RSI) On Balance Volume Bollinger Bands
Trend indicators: Simple Moving Average:Moving averages are one of the easiest toolsavailable for technical analysis. They smooth adata series and make it easier to mark trendswhich are very helpful in volatile markets.
MACD MACD was developed by Gerald Appel as a way to keep track of a moving average crossover system. Appel defined MACD as the difference between a 12- day and 26-day moving average. A 9-day moving average of this difference is used to generate signals. When this signal line goes from negative to positive, a buy signal is generated. When the signal line goes from positive to negative, a sell signal is generated. MACD is best used in choppy (trendless) markets, and is subject to whipsaws (in and out rapidly with little or no profit).
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. 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). Also, realize that stocks can remain overbought or oversold for long periods of time, so RSI alone isn’t always a great timing tool.
Dow Theory This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900 and 1902. Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the economy. A change in the trend of the DJIA must be confirmed by a trend change in the DJTA in order to generate a valid signal.
Market’s performance is based upon long-term price trend (primary trend) in overall market Used to signal end of both bull and bear markets An after-the-fact measure with no predictive power
Dow Theory Trends (1) Primary Trend Called “the tide” by Dow, this is the trend that defines the long-term direction (up to several years). Others have called this a “secular” bull or bear market. Secondary Trend Called “the waves” by Dow, this is shorter-term departures from the primary trend (weeks to months) Day to day fluctuations Not significant in Dow Theory
Too Many Others To List As noted, there are literally hundreds of indicators and thousands of trading systems. 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 (Gann angles), 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? As the carneys used to say, “You pays your money, and you takes your chances.”