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Chapter 4 notes 2012 08 02


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Chapter 4 notes 2012 08 02

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 4Technical and Statistical AnalysisAugust 2012
  2. 2. Chapter summary and outlineThis chapter explains the concepts of technical analysis and statistical analysis,such as charts and patterns, momentum, etc. The chapter also covers otherpopular theories of technical and statistical analysis, including Dow theory, ElliotWave theory, cycle theory, random walk theory and contrarian theory.Chapter outline:• Technical analysis• Charts and charting• Dow Theory• Trendlines and channels, support and resistance• Volume and open interest• Major chart patterns• Statistical analysis• Elliot Wave Theory• Cycle Theory• Random Walk Theory• Contrarian TheoryfinlogIQ 2
  3. 3. Technical Analysis• Technical analysis tries to forecast future price movements by studying the price patterns, volume and open interest.• Quantitative criteria for estimating the relative strength of buying and selling, determining what to buy and sell, entry and exit points.Advantages:• Based on prices which never get revised, needs minimal input (price only) and is objective.• A good timing tool• Helps to instil discipline in tradingCornerstone of technical analysis:• Identify a trend via certain chart patterns and performing some statistical analysis,• The art is to identify the trend and ride on it till the weight of evidence indicates that the trend has reversed.finlogIQ 3
  4. 4. Charts and ChartingBar Charts:• Most widely used chart• Requires data on opening, high, low and closing prices• Time series chart -- Daily, weekly, monthly basis or for any period• Single vertical line that represents the range, a left horizontal tick that represents the open and a right horizontal tick that represents the close• Can be overlaid with volume and open interest on the same chartfinlogIQ 4
  5. 5. Charts and ChartingCandle Charts:• It requires data on open, high, low and close as well• Time series chart but differs from a bar chart in that it has a body that represents the opening and closing range and shadows that show the high and low of the day,• When open is higher than the close, the body is black• When Open is lower than close, the body is white• A candle chart is said to provide a superior signalfinlogIQ 5
  6. 6. Charts and ChartingPoint and Figure Charts:• Allow the user to specify the criteria for significant price movements• Not a time series chart - it requires only the high and low of the day• Two parameters are - box size and reversal number – Box size determines the sensitivity of the chart while the reversal number specifies the minimum number of boxes that the price trend must change to terminate one column and initiate a new one• Advantages: – It captures intra-day trading better – Provides a method for calculating price objectives• Disadvantages: − Tedious − Certain price patterns are not shownfinlogIQ 6
  7. 7. Charts and ChartingPoint and Figure Charts: (cont..)• The horizontal count for price objective is:-• Price objective = P +/- (W x RV) – where P = the extreme value W = the base width excluding breakout column RV = the reversal value• The vertical count is a measure of volatility and can be used to determine the size of retracement after a major price move.• Price objective = Extreme box +/- Number of boxes in first reversal x minimum number of boxes in chart reversal.finlogIQ 7
  8. 8. Dow Theory• Originally developed by Charles H. Dow to determine the trend direction of the stock market• Theory does not forecast the magnitude and duration of the trend• The theory is popular among chartists for equity markets as well as among those for other financial markets.• The limitations of this theory are – The buy/sell signals are slow by the time confirmation appears – To overcome this, traders should consider the weight of other evidence and factors like maturity of cycles and price volume divergence• There are six TenetsFirst Tenet:• The Averages (industrial and transport) discount everything known to the market.• The changes in prices reflect the aggregate judgment of all market participants, having digested all available facts.finlogIQ 8
  9. 9. Dow Theory – 6 TenetsSecond Tenet:• There are three types of movements: primary trends, secondary reactions and minor movements• Primary trend lasts less than 1 year to several years• Main objective of Dow theory is indeed to identify the primary trend where the significant movement takes place.• Secondary reactions normally last from 3 weeks to 3 months• Usual decline in a bull market or advance in a bear market• Retracements can extend from 33% to 67% of the primary trend• Minor movements can last from hours to 3 weeks• Insignificant price changes and so there are little forecasting values• They merely form parts of primary or secondary movesfinlogIQ 9
  10. 10. Dow Theory – 6 TenetsThird Tenet:• Lines (consolidation) indicate price movements of 2 weeks or longer• Represent narrow price variations approximately 5% of mean• During Consolidation: market players either accumulate (buying by strong hands hence bullish) or distribute (buying by weak hands hence bearish)Fourth Tenet:• Price and volume relationship: merely background information or additional evidence of a trend,• Wether the trend continues or reverses can only be confirmed by pricesFifth Tenet:• Price actions determine the trend• Successive higher peaks and troughs evidence an uptrend while a downtrend is shown by successive lower troughs and peaks.Sixth Tenet:• The Industrial and Transport Averages must confirm each otherfinlogIQ 10
  11. 11. Trendlines and Channels, Support andResistanceTrendlines:• Indicate the general direction of market• Commonly used for identifying support and resistance points• Connecting at least two successive low points where the latter is higher than the former draws an up trendline• Conversely, connecting at least two successive high points where the latter is lower than the former draws a downtrend line• Assumption: Existing trend is intact until subsequent closing prices penetrate the trendline• Penetration of trendlines can signal reversal, consolidation or continuation• A trendline is more reliable – the longer it remains intact and the more times it is tested – Gradual rather than a steep ascent/descent• Latest trendline has more influencefinlogIQ 11
  12. 12. Trendlines and Channels, Support andResistance - 2Channels• Formed by parallel or almost parallel lines connecting the high and low points• Channels are also used for identifying points of support and resistance• The penetration of channels signifies trend acceleration or deceleration• Sometimes penetration can also signify reversal when price moves out of a channel only to fall back and break the channel in the opposite directionfinlogIQ 12
  13. 13. Trendlines and Channels, Support andResistance - 3Support Levels• The price where the majority of investors believe that prices will move higherResistance Levels• The price at which majority of investors feel prices will move lower• Penetration of support/resistance – Can be triggered by fundamental changes that are above or below investor expectations – Chart points develop at supports and resistances – Support once broken will become the resistance for next up move – Resistance once broken will become the support for the next down move – Whether a chart point can be breached depend on: Loss cutting, profit taking and new entryfinlogIQ 13
  14. 14. Volume and Open Interest• Volume measures the number of contracts traded – Good indication of the intensity of a move reflecting the demand and supply – When prices are rising and volume is increasing • Expect the trend to continue – When prices are rising but volume is decreasing • Present trend may not sustain• Open interest measures the outstanding uncovered contracts – In a bull market where higher prices are accompanied by increasing open interest, it means there are new buyers entering the market • Expect the trend to continue – As open interest continues to build up, it will eventually reach an overbought situation – Open interest can be used in conjunction with other indicators to determine overbought and oversold conditions• In general, any sustained move should be backed by prices, increasing volume and open interest.finlogIQ 14
  15. 15. Major Chart Patterns: Reversal Patterns• Reversal Patterns –Indicate the ending of an existing trend and beginning of a new trendHead and Shoulders Top:• Reversal of an uptrend• Consist of an head and two shoulders – Head is higher than shoulders – Right shoulder is formed by a rally on small volume – The formation is confirmed by breaking of the neckline on a decline from the right shoulder. This is then a signal to sell.• Volume is used as an additional confirmation indicator. Sometimes prices may retrace to the neckline after the break.finlogIQ 15
  16. 16. Major Chart Patterns: Reversal Patterns - 2Head and Shoulders Bottom/ Inverted Head and Shoulders:• Signals that the market is turning bullish and is the opposite of a head and shoulders top formation.• Usually observed that the right shoulder declines on light volume but then rallies on high volume.Double Top:• Formed by price move that fails to exceed the previous top• Followed by a violation of the previous low• Second top is normally formed on low volumeDouble Bottom:• Is the opposite of double top and indicates that the market has bottomed and prices will rise after breaching the neckline.finlogIQ 16
  17. 17. Major Chart Patterns: Reversal Patterns - 3Triple Top and Bottom:• A more significant indication of trend reversal than the double top or bottom.• Occurs less frequently than double top or bottom• Has the same volume conditions to be valid and measurement of objective as those of a double top or bottomfinlogIQ 17
  18. 18. Major Chart Patterns: Continuation PatternsContinuation Patterns• Shorter in duration and represents pauses in existing trendsTriangle:• Most common but least reliable pattern• Has both reversal and continuation patterns• 2 main types: – Symmetrical – Right angled triangles• For symmetrical triangle: two converging lines joining the peaks and troughs form it• Right angled triangle: is formed when one of the lines is perpendicular to the vertical axis• A triangle is supposed to show the direction for the next movefinlogIQ 18
  19. 19. Major Chart Patterns: Continuation Patterns - 2Triangle (cont.)• Sometimes does not work as it turns into a rectangle instead• Symmetrical triangles - preferably have four reversal points under gradually lower volume conditions, increasing open interest and the first reversal point should be the highest or the lowest point.• Right-angled triangles, both ascending and descending, are better predictors of the future direction of prices than symmetrical triangles.• To measure price objective assuming a breakout on the upside – draw line parallel to the lower side of the triangle and expects prices to rally up to that linefinlogIQ 19
  20. 20. Major Chart Patterns: Continuation Patterns - 3Wedges:• Are intermediate continuation or consolidation patterns,• For a rising wedge: bearish sign once broken out of the wedge• A falling wedge is a bullish sign• Wedges may take 2-8 weeks to complete, hence appear only in a weekly chartsFlags:• Formed during a narrow band range• Normally short duration dynamic congestion phases• Attraction is: they provide favourable risks/rewards for trading• Occur after a sharp straight-line price move• Represent mid-way consolidation of a move• Flags normally slopes in the opposite direction of a trendfinlogIQ 20
  21. 21. Major Chart Patterns: Continuation PatternsPennants:• Develop under similar circumstances as flags• Converging, rather than parallel lines like the flags, bound them• Should conform to three rules to be considered valid – Firstly, they should occur after a very sharp up or down move. – Secondly, the volume should decline throughout the duration of the pattern and – Finally the prices should breakout of the pattern within a matter of a few weeks.• Formula: simply adds the height of the pole, formed in the move preceeding the formation to the breakout point of the flagfinlogIQ 21
  22. 22. Major Chart Patterns: Minor Trend ChangeIndicatorsMinor Trend Change Indicators• Used to help ascertain price direction for the next few sessions• Are very short-term indicatorsKey reversal day:• Normally occurs after an extended move,• Formed when prices have reached a significant new high or low but close in the opposite direction,• Accompanied by high volume and declining open interestInside range day:• Occurs when prices move within the range of the previous day• More importantly it is which wary prices move out of ranges in the following sessionsOutside day range:• Formed when day’s high is higher than previous high and the low is lower than the previous low.finlogIQ 22
  23. 23. Major Chart Patterns: Gaps• Technically these are open gaps where no trading takes placeCommon gap:• This occurs within trading range or congestion areas and therefore has very little or no forecasting valueBreakaway gap:• Occurs at the completion of a pattern or a penetration of trendline• Normally accompanied by high volumeIsland reversal gap:• Price gap higher or lower, trade in a narrow range then gap lower or higher• Marks the end of a trend convincinglyfinlogIQ 23
  24. 24. Major Chart Patterns: Gaps - 2Runaway Gap:• Occurs during a straight line advance or decline• Either closes quickly or otherwise will remain open for a long period.• Runaway gap happens mid-way of a price move and hence it is also called a measuring gap.Exhaustion Gap:• A large gap formed after an extended move• Marks the end of a trend• It is hard to identify and we can assume that it is more likely if price objectives have been met and other gaps have been formed previously.finlogIQ 24
  25. 25. Statistical Analysis: Moving Average• Smoothing aims to identify the trend by eliminating unnecessary price moves. – Serves to determine only the direction of the trend but, not the extent or objective of the price move – It assumes that the trend will continue.Moving Average (“MA”)• Derived by continuously computing the average of the most recent n days of closing prices.• Can be plotted from the open, high, low, close or average for the day prices, but closing price is the preferred one.• Period for the moving average will determine the sensitivity and speed of trend change.• Period selected will vary according to the type of commodities analyzed and the market trend wanted: short, intermediate or primary.• Moving average can represent areas of support and resistance and the longer the period the more significant the crossover, similar to trendlines.finlogIQ 25
  26. 26. Statistical Analysis: Moving Average - 2Moving Average (“MA”) (cont.)• Three methods to use MA to evaluate the market• The MA itself – When the MA turns, the existing position will be liquidated and a new position in the opposite direction is initiated.• The crossover method – first we plot the prices and superimpose the moving average on the same chart – whenever the closing price crosses over the MA, a signal is generated crosses the MA from below, a buy signal is given – Whenever it crosses the MA from above, a sell signal is indicated – To prevent being caught in a whipsaw in a range trading market, filters are adopted - in the form of percentage penetration or period of violation• Multiple moving averages method – uses two or more MAs of different periods – Slower MA is used to identify the trend – Faster one is used to time the entry and exit points – Convergence of moving averages indicates temporary balance of buyers and sellers and warns of imminent big moves – When the balance is tipped one way or others, market moves very quicklyfinlogIQ 26
  27. 27. Statistical Analysis: Moving Average - 3• Limitation: MA is a lagging indicator – When signal is generated the trade can only be executed at a price away from the level of the signal. – Moreover, MA of closing prices also means that the turning of MA cannot be ascertained till market close.• Sometimes market gaps and thus entry levels may not be favorable. – Unfavourable entry points mean greater price risk• Inability to execute trades at the market top or bottom limits the usefulness of the technique to markets experiencing major and sustained movesfinlogIQ 27
  28. 28. Statistical Analysis: Moving Average - 4• The simple moving average:• The weighted moving average (WMA): – More sensitive than SMA hence will generate a timelier signal – WMA itself changes direction the signal is generated rather than waiting for the crossover• The exponential moving average: – Calculate 5 days exponential moving average – Exponent = 2/period = 2/5 = 0.4 – Longer the period the less sensitive it becomes – Sometimes 2 parallel lines are plotted at certain percentage away from the MA to create an envelope to provide indications when the move is over extended.finlogIQ 28
  29. 29. Statistical Analysis: Oscillators and Momentum• Momentum can warn of latent (hidden) strengths or weaknesses in the price being studied, well ahead of the turning points. – Refer to rate of change in price or the gradient of the line representing the price change. – Used to identify trend reversal and duration of the trend. – Not able to determine the price objective• Tools for momentum: Rate of change (“ROC”), MACD, relative strength index (“RSI”)• Two types of momentum: – price momentum and – breadth momentumRate of Change (“ROC”)• Measures the rate at which prices change over a period of timefinlogIQ 29
  30. 30. Statistical Analysis: Relative Strength IndexRelative Strength Index (“RSI”)• While ROC does not provide guidelines for high and low, the RSI eliminates this problem by confining the values within 0 to 100,• Any value below 30 indicates oversold while any value above 70 indicates overbought,• advantage of RSI over ROC is that it takes out erratic movements by averaging the price change• There are 4 general interpretations of momentum (see next slide)finlogIQ 30
  31. 31. Statistical Analysis: Relative Strength Index - 2Overbought and oversold• Sometimes prices could exceed these extremes for a long period of time.• By waiting for prices to go into oversold or overbought areas and fall back before decisions are made, it allows the signal to be filtered first.Divergence between price and momentum charts• Implies a weak technical structure and corrections may be due soon• Merely warns of weakening market conditions and is not a signal to sell.• Confirmation: violation of trendlines, crossover of moving average or price pattern formation.Complex divergence• Uses two momentum indicators of different time spans• By overlaying two momentum indicators from two different time spans we can compare them and look for divergences between themTrendline violation• Both momentum and prices need to break their trendlines to confirm trend reversalfinlogIQ 31
  32. 32. Elliot Wave Theory• Developed from observations that all natural phenomena repeat themselves in regular rhythms – It assumes that markets will move forward in a series of five waves then retraces in series of three waves• Drawback of the method is that it is subjective – User needs to judge the beginning and ending of waves – Involves recognition of the current market position within completed form, and – To anticipate the likely paths for the market - once waves of a smaller degree are recognised, waves of the next higher degree can be anticipated.finlogIQ 32
  33. 33. Elliot Wave Theory - 2•Wave 1 - This represents the end ofthe correction and the marketturning point.•Wave 2 - Wave 2 is normallyaccompanied by an oversoldreading in oscillators.•Wave 3 - This is the most powerfuland explosive move and the longestin distance.•Wave 4 – It is also often equal toWave 2•Wave 5 – It is equal to Wave 1•Waves A, B, C - These are theretracement Waves finlogIQ 33
  34. 34. Cycle Theory• Movement in financial markets depends on attitudes of investors on the business cycle; – Different markets peak and trough during different points of business cycle – During expansion interest rates rise and bond prices drop, but stocks continue to rise so long as profits continue to increase. – Stocks start to turn down when investors feel that further improvement in earnings is limited, – Gold may still go up as inflation, a lagging indicator, continues to rise though the economy has slowed. – Therefore, what happened is that the stock market is expected to peak after the bond market peaks and followed by the gold market.• Relationship between different market cycle are signposts as to the future direction of different financial instruments. – But it is difficult to predict the time lead/lag between the different financial instrumentsfinlogIQ 34
  35. 35. Random Walk Theory• In an efficient market, prices are said to move in a random manner and as such any attempts to predict future prices will be futile.• There are three hypotheses under this theory: – Weak form • Under this hypothesis, it is believed that past price records do not hold definite relationships to future prices. • Forecasting on this basis is therefore useless. – Semi-strong form • Historical price relationships have no value and therefore cannot be used to extrapolate future prices. – Strong Form • All material information is embedded in current prices and has no impact on future prices.finlogIQ 35
  36. 36. Contrarian Theory• Technique of holding a view opposite to what is prevalent and generally believed by the majority of market players.• Assumes that the majority, i.e. the crowd, is unable to think rationally and intelligently due to crowd psychology and a false sense of security would creep in• This is particularly useful in stock prediction as some classes of investors are traditionally wrong.• Moreover, when demand is strong, the next shift in sentiment is more likely to lower demand.finlogIQ 36
  37. 37. Contrarian Theory - 2• Contrarian Indicators – Odd lot trading • Assumes that small odd lot traders are usually wrong at market extremes – Short/long interest • If the ratio of shorts to longs is great, then the market is bullish, and vice versa. Such information can be deduced from open interest figure. – Mutual funds cash level • When mutual funds are bearish on stocks they hold more cash. • Additional cash implies future buying power and so the market is likely to move up then down. – Put/call ratio • Higher puts to calls ratio is due to bearish sentiment. But it also makes the next move more likely to be up. – Investment advisory sentiment • Sentiment is bullish, it’s time to sell as most likely the professional investment community is already long in stocks.finlogIQ 37