CHAPTER EIGHTEEN

Technical Analysis

CHAPTER EIGHTEEN

Technical Analysis

Cleary / Jones Investments: Analysis and

Management

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

To define technical analysis and To define technical analysis and explain why it is usedexplain why it is used

To describe the major techniques To describe the major techniques used in technical analysisused in technical analysis

To discuss the limitations of To discuss the limitations of technical analysistechnical analysis

What is Technical What is Technical Analysis?Analysis?

What is Technical What is Technical Analysis?Analysis?

Use of published market data for Use of published market data for analysis of both aggregate stock prices analysis of both aggregate stock prices and individual stocksand individual stocks

May produce insight into the May produce insight into the psychological dimensions of the marketpsychological dimensions of the market

Used by investors and investment Used by investors and investment advisory firmsadvisory firms

Oldest approach to stock selectionOldest approach to stock selection

Technical ApproachTechnical ApproachTechnical ApproachTechnical Approach

Prices move in trends determined by Prices move in trends determined by changing attitudes of investorschanging attitudes of investors

Identify change in trend at an early stage Identify change in trend at an early stage and maintain investment posture until and maintain investment posture until evidence indicates otherwiseevidence indicates otherwise

Market itself is the best source of data Market itself is the best source of data about trendsabout trends– Data includes prices, volume, and technical Data includes prices, volume, and technical

indicatorsindicators

Technicians disagree with fundamental Technicians disagree with fundamental analysis because they believe it is analysis because they believe it is extremely difficult to estimate intrinsic extremely difficult to estimate intrinsic value and to obtain and analyze value and to obtain and analyze information consistentlyinformation consistently– Technicians believe market data indicates Technicians believe market data indicates

forces of demand and supplyforces of demand and supply– Record of investor mood that can be Record of investor mood that can be

detected and is likely to continue detected and is likely to continue

Technical ApproachTechnical ApproachTechnical ApproachTechnical Approach

Tools For Technical Tools For Technical AnalysisAnalysis

Tools For Technical Tools For Technical AnalysisAnalysis

Use of graphs, charts, and technical Use of graphs, charts, and technical trading rules and indicatorstrading rules and indicators

Price and volume are primary tools of Price and volume are primary tools of the pure technical analyst the pure technical analyst – Technicians use charts to identify trends Technicians use charts to identify trends

and patterns in stock prices that provide and patterns in stock prices that provide trading signalstrading signals

– Volume data used to gauge market Volume data used to gauge market condition and to assess its trend condition and to assess its trend

The Dow TheoryThe Dow TheoryThe Dow TheoryThe Dow Theory

Based on three types of price movementsBased on three types of price movements– Primary move:Primary move: a broad market movement a broad market movement

that lasts several yearsthat lasts several years– Secondary moves:Secondary moves: occurring within primary occurring within primary

move, lasting several weeks or monthsmove, lasting several weeks or months– Day-to-day moves:Day-to-day moves: occurring randomly occurring randomly

around primary and secondary movesaround primary and secondary moves Bull (bear) market refers to upward Bull (bear) market refers to upward

(downward) primary move(downward) primary move

Bull market occurs when successive rallies Bull market occurs when successive rallies penetrate previous highspenetrate previous highs– Declines remain above previous lowsDeclines remain above previous lows

Bear market occurs when successive Bear market occurs when successive rallies fail to penetrate previous highsrallies fail to penetrate previous highs– Declines penetrate previous lowsDeclines penetrate previous lows

Secondary moves called technical Secondary moves called technical correctionscorrections– Day-to-day “ripples” are of minor importanceDay-to-day “ripples” are of minor importance

The Dow TheoryThe Dow TheoryThe Dow TheoryThe Dow Theory

Price changes can be recognized and Price changes can be recognized and categorizedcategorized

Support price level:Support price level: significant increase significant increase in demand is expectedin demand is expected

Resistance price level:Resistance price level: significant significant increase in supply is expectedincrease in supply is expected

Trendline:Trendline: identifies a trend or direction identifies a trend or direction Momentum:Momentum: speed of price changes speed of price changes

Charting Price PatternsCharting Price PatternsCharting Price PatternsCharting Price Patterns

Bar ChartBar Chart– Vertical bar’s top (bottom) represents the Vertical bar’s top (bottom) represents the

high (low) price of the dayhigh (low) price of the day Point-and-Figure ChartPoint-and-Figure Chart

– Compresses price changes into small Compresses price changes into small spacespace

Areas of “congestion” identifiedAreas of “congestion” identified

– X (O) used to indicate significant upward X (O) used to indicate significant upward (downward) movement(downward) movement

Charting Price PatternsCharting Price PatternsCharting Price PatternsCharting Price Patterns

Moving AveragesMoving AveragesMoving AveragesMoving Averages

Used for analyzing both the overall Used for analyzing both the overall market and individual stocksmarket and individual stocks

Used specifically to detect both the Used specifically to detect both the direction and rate of changedirection and rate of change– New value for moving average calculated New value for moving average calculated

by dropping earliest observation and by dropping earliest observation and adding latest observation to the averageadding latest observation to the average

– Comparison to current market prices Comparison to current market prices produces buy or sell signalproduces buy or sell signal

Relative StrengthRelative StrengthRelative StrengthRelative Strength

Ratio of a stock’s price to a market or Ratio of a stock’s price to a market or industry index industry index – Ratios plotted to form graph of Ratios plotted to form graph of relative relative

priceprice across time across time– Rising (falling) ratio indicates relative Rising (falling) ratio indicates relative

strength (weakness)strength (weakness)– What if overall market is weak?What if overall market is weak?– What if a stock is declining less quickly What if a stock is declining less quickly

than the market?than the market?

Breadth IndicatorsBreadth IndicatorsBreadth IndicatorsBreadth Indicators

Advance-Decline Line Advance-Decline Line – Measures the net difference between Measures the net difference between

number of stocks advancing and decliningnumber of stocks advancing and declining– Plot of running total across time is Plot of running total across time is

compared to a stock average to analyze compared to a stock average to analyze any divergenceany divergence

Divergence implies trend changingDivergence implies trend changing

Number hitting new highs (lows)Number hitting new highs (lows) High trading volume regarded as bullishHigh trading volume regarded as bullish

Sentiment IndicatorsSentiment IndicatorsSentiment IndicatorsSentiment Indicators Short interest is number of stocks that have Short interest is number of stocks that have

been sold shortbeen sold short Short interest ratio =Short interest ratio =

Total shares sold short/Average daily trading Total shares sold short/Average daily trading volumevolume

– Indicates number of days needed to “work off” Indicates number of days needed to “work off” the short interestthe short interest

Many technicians take a high short interest Many technicians take a high short interest ratio as a bullish signratio as a bullish sign– Short interest figures may be distortedShort interest figures may be distorted

Mutual Fund LiquidityMutual Fund LiquidityMutual Fund LiquidityMutual Fund Liquidity

Based on contrary opinionBased on contrary opinion Mutual funds, viewed like odd-lotters, Mutual funds, viewed like odd-lotters,

assumed to act incorrectly before a assumed to act incorrectly before a market turning pointmarket turning point– Low liquidity implies funds fully invested Low liquidity implies funds fully invested

(bullish) and market is near or at peak(bullish) and market is near or at peak– High liquidity implies funds are bearishHigh liquidity implies funds are bearish

Considered a good time to buy Considered a good time to buy

Put/Call RatioPut/Call RatioPut/Call RatioPut/Call Ratio

Speculators buy calls (puts) when Speculators buy calls (puts) when stock prices expected to rise (fall) stock prices expected to rise (fall)

Rise (fall) in ratioRise (fall) in ratio of put option of put option purchases to call option purchases purchases to call option purchases indicates pessimism (optimism)indicates pessimism (optimism)– Buy (sell) signal to a contrarianBuy (sell) signal to a contrarian– Extreme readings (below .7 or above .9) Extreme readings (below .7 or above .9)

convey trading information convey trading information

Testing Technical Testing Technical Analysis StrategiesAnalysis StrategiesTesting Technical Testing Technical

Analysis StrategiesAnalysis Strategies What constitutes a fair test of a What constitutes a fair test of a

technical trading rule?technical trading rule?– Risk considerationsRisk considerations– Include transaction and other costsInclude transaction and other costs– Consistency in performanceConsistency in performance– Out-of-sample validationOut-of-sample validation

Filter rule tests Filter rule tests – Trades made when price change greater Trades made when price change greater

than predetermined filterthan predetermined filter

Conclusions About Conclusions About Technical AnalysisTechnical AnalysisConclusions About Conclusions About Technical AnalysisTechnical Analysis

Thorough tests of technical analysis Thorough tests of technical analysis have failed to confirm their value, given have failed to confirm their value, given all trading costs and the alternatives, all trading costs and the alternatives, such as a buy-and-hold strategysuch as a buy-and-hold strategy

Several interpretations of each Several interpretations of each technical tool and chart pattern are not technical tool and chart pattern are not only possible, but usualonly possible, but usual– Art or science?Art or science?

Conclusions About Conclusions About Technical AnalysisTechnical AnalysisConclusions About Conclusions About Technical AnalysisTechnical Analysis

Strong evidence exists suggesting Strong evidence exists suggesting that stock price changes are weak-that stock price changes are weak-form efficientform efficient

Impossible to test all techniques of Impossible to test all techniques of technical analysistechnical analysis

Regardless of evidence, technical Regardless of evidence, technical analysis remains popular with many analysis remains popular with many investorsinvestors