2. Technical Analysis
Questions to be answered:
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?
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3. 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?
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4. 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?
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5. Technical Analysis
Why is volume of trading important and how do
technicians use it?
What are support and resistance levels and how are they
used?
How do technicians use moving-average lines to detect
changes in trends?
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6. Technical Analysis:
•Technical analysts base trading decisions on examinations of prior
price and volume data to determine past market trends from which
they predict future behavior for the market as a whole and for
individual securities.
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7. 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
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. These shifts, no matter why they occur,
can be detected sooner or later in the action of the market itself.
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8. Assumptions:
•The first two assumptions are almost universally accepted by
technicians and non-technicians.
•Significant difference of opinion regarding the speed of adjustment
of stock prices to changes in supply and demand.
•Technical analysts expect stock prices to move in trends that persist
for long periods .
•New information does not come to the market at one point in time
but rather enters the market over a period of time
•Technicians do not expect the price adjustment to be as abrupt as
fundamental analysts and efficient market supporters do rather, they
expect a gradual price adjustment to reflect the gradual dissemination
of information.
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9. Advantages of Technical Analysis
Not heavily dependent on financial accounting statements
Problems with accounting statements:
1. Lack of lot of information needed by security analysts, such as
information related to sales, earnings, and capital utilized by
product line and customers.
2.GAAP allow firms to choose among several procedures for reporting
expenses, assets, or liabilities.
These alternative procedures can produce very much different
values for expenses, income, return on assets, and return on equity,
resulting in difficulty comparing statements from two firms.
3. Many psychological factors and other non-quantifiable variables do
not appear in financial statements.
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10. Advantages of Technical Analysis
Fundamental analyst must process new information and quickly
determine a new intrinsic value, but technical analyst simply has to
recognize a movement to a new equilibrium
Fundamental analyst determines that a given security is under- or
overvalued a long time before other investors.
For example, assume that based on your analysis in February, you
expect a firm to report substantially higher earnings in June.
Although you could buy the stock in February, you would be better
off waiting until about May to buy the stock so that your funds
would not be tied up for an extra three months.
Technicians do not invest until the move to the new equilibrium is
underway, they challenge that they are more likely than a
fundamental analyst to experience ideal timing. 10
11. Challenges to Technical Analysis
Assumptions of Technical Analysis
Empirical tests of Efficient Market Hypothesis (EMH) show that
prices do not move in trends.
Technical Trading rules
The past may not be repeated
Patterns may become self-fulfilling forecasts.
For Example, assume that many analysts expect a stock selling at
$40 a share to go to $50 or more if it should rise above its current
pattern and break through its channel at $45. As soon as it reaches
$45, enough technicians will buy to cause the price to rise to $50,
exactly as predicted.
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12. Challenges to Technical Analysis
•A successful rule will gain followers and become less
successful.
For example, suppose it becomes known that technicians who
employ short-selling data have been enjoying high rates of return.
Based on this knowledge, other technicians will likely start using
these data and thus accelerate the stock price pattern following
changes in short selling. As a result, this profitable trading rule may
no longer be profitable after the first few investors react.
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13. Challenges to Technical Analysis
•Rules require a great deal of subjective judgment
Two technical analysts looking at the same price pattern may
arrive at widely different interpretations of what has happened and,
therefore, will come to different investment decisions.
•The standard values that signal investment decisions can
change over time.
Technical analysts adjust the specified values that trigger
investment decisions to conform to the new environment. In other
cases, trading rules have been discarded because they no longer
work.
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14. 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
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16. 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
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17. Contrary-Opinion Rules
Many analysts rely on rules developed from the idea 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
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18. Contrary-Opinion Rules
Mutual fund cash positions
Contrary-opinion technicians believe that mutual funds usually are wrong at
peaks and troughs.
They expect mutual funds to have a high percentage of cash near a market
trough—the time when they should be fully invested to take advantage of
the future market rise.
At the market peak, these technicians expect mutual funds to be almost fully
invested with a low percentage of cash when they should be selling stocks
and realizing gains.
Contrary-opinion technicians watch for the mutual fund cash position to
approach one of the extremes and act contrary to the mutual funds.
Specifically, they would tend to buy when the cash ratio is high and to sell
when the cash ratio is low.
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19. •Credit balances in brokerage accounts
Technical analysts view these credit balances as potential
purchasing power, a decline in these balances is considered
bearish because it indicates lower purchasing power as the market
approaches a peak. Alternatively, a buildup of credit balances
indicates an increase in buying power and is a bullish signal.
Investment advisory opinions
•OTC versus NYSE volume
Many technicians believe that if a large proportion of investment
advisory services are bearish, this signals the approach of a
market trough and the onset of a bull market
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20. •Chicago Board Options Exchange (CBOE) Put-Call ratio
Contrary-opinion technicians use put options, which give the
holder the right to sell stock at a specified price for a given time
period, as signals of a bearish attitude. A higher put-call ratio
indicates a pervasive bearish attitude for investors, which
technicians consider a bullish indicator.
•Futures traders bullish on stock-index futures
This contrary opinion measure is the percentage of speculators in
stock-index futures who are bullish regarding stocks based on a
survey of individual futures traders. These technicians would
consider it a bearish sign when more than 70 percent of the
speculators are bullish, and a bullish sign when this ratio declines
to 30 percent or lower.
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21. Follow the Smart Money
Indicators showing behavior of sophisticated investors
The Barron’s Confidence Index
The Confidence Index (CI) is the ratio of Barron’s average yield on the “Best grade
Bonds” list to the average yield on the Dow Jones “Intermediate Grade Bonds”
list.
This index measures the change in yield spread over time between high-grade and
intermediate grade bonds. this ratio should approach 100 as the spread between
the two sets of bonds gets smaller.
Technicians believe the ratio is a bullish indicator ,because during periods of high
confidence, investors are willing to invest in lower-quality bonds for the added
yield, which causes a decrease in the yield spread between the intermediate grade
bonds and best grade bonds. Therefore, the Confidence Index will increase.
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22. •When investors are pessimistic, the yield spread will increase, and
there is a decline in the Confidence Index
•This interpretation assumes that changes in the yield spread are
caused almost exclusively by changes in investor demand for
different quality bonds. In fact, the yield differences have frequently
changed because of changes in the supply of bonds
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23. •T-Bill - Eurodollar yield spread
The spread between T-bill yields and Eurodollar rates measured as
the ratio of T-bill/Eurodollar yields. It is argued that, at times of
international crisis, this spread widens as the smart money flows to
safe-haven U.S. T-bills, which causes a decline in this ratio. It is
argued that the stock market typically experiences a trough shortly
thereafter.
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24. •Debit balances in brokerage accounts (margin debt)
Debit balances in brokerage accounts represent borrowing (margin
debt) by knowledgeable investors from their brokers.
Hence, these balances indicate the attitude of sophisticated
investors who engage in margin transactions. Therefore, an
increase in debit balances implies buying by these sophisticated
investors and is considered a bullish sign, while a decline in debit
balances would indicate selling and would be a bearish indicator.
•Short sales by specialists
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25. Other Market Indicators
Momentum Indicators
Breadth of market
The breadth of market series measures the number of issues that
have increased each day and the number of issues that have
declined. It helps explain what caused a change of direction in a
composite market index such as the S&P 500 Index.
A stock-market index can experience an overall increase while
the majority of the individual issues are not increasing, which
means that most stocks are not participating in the rising market.
Such a divergence can be detected by examining the advance-
decline figures for all stocks on the exchange, along with the
overall market index.
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26. •The advance-decline index is typically a cumulative index of
net advances or net declines.
•Technicians often compute moving averages of an index to
determine its general trend. The market is considered to be
overbought and subject to a negative correction when more than 80
percent of the stocks are trading above their 200-day moving
average. In contrast, if less than 20 percent of the stocks are selling
above their 200-day moving average, the market is considered to be
oversold, which means investors should expect a positive correction.
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27. Stock Price and Volume Techniques
The Dow theory – oldest technical trading rule
1. Major trends are like tides in the ocean
2. Intermediate trends resemble waves
3. Short-run movements are like ripples
Followers of the Dow Theory attempt to detect the direction of
the major price trend (tide), recognizing that intermediate
movements (waves) may occasionally move in the opposite
direction. They recognize that a major market advance does not
go straight up, but rather includes small price declines as some
investors decide to take profits.
Importance of volume
Ratio of upside-downside volume
Support and resistance levels
Moving average lines
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28. Stock Price and Volume Techniques
Relative-strength (RS) ratios
For individual stocks and industry groups
Bar charting
Candlestick Charts
Multiple indicator charts
Point-and-figure charts
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29. Technical Analysis of Foreign Markets
Foreign stock market series
Technical analysis of foreign exchange rates
Technical analysis of bond markets
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