technical analysis

Chapter 15

Investment by

Dr. Kumail Rizvi, CFA, FRM

Chapter 15 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?


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?


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?


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?


What is the rationale behind the relative strength

line for an industry or a stock and how is it

interpreted?

How are bar charts different from point-and-

figure charts?

What are some uses of technical analysis in

foreign security markets?

How is technical analysis used when analyzing

bond?

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

Underlying Assumptions

of Technical Analysis

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.

Advantages of Technical Analysis

Not heavily dependent on financial accounting statements

Problems with accounting statements:

1. Lack information needed by security analysts

2. GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms

3. 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 their prices as quickly

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 prophecies

A successful rule will gain followers and become

less successful

Rules require a great deal of subjective judgement

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

Typical Stock Market Cycle Stock

Price

Buy Point

Rising Trend

Channel

Flat Trend Channel

Sell Point

Peak

Declining

Trend

Channel Trough


Price

Rising Trend

Channel

Flat Trend Channel

Sell Point

Peak

Declining

Trend

Channel Trough


Price

Flat Trend Channel

Declining

Trend

Channel Trough


Price

Flat Trend Channel

Trough


Price

Trough


Price

02,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

99 00 01 02 03 04 05 06 07 08 09

KSE


Price Exhibit 15.2

Declining

Trend

Channel

Trough

Buy Point

Rising Trend

Channel

Flat Trend Channel

Sell Point

Peak

Declining

Trend

Channel Trough

Buy Point

Contrary-Opinion Rules

Many analysts rely on rules developed from

the premise 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

Contrary-Opinion Rules

Mutual fund cash positions (at 4%, S; 11% B)

Credit balances in brokerage accounts (LS; HB)

Investment advisory opinions (Bear/Bull)

OTC versus NYSE volume (87 B, 112 S)

Chicago Board Options Exchange (CBOE) Put-

Call ratio (0.4 S, 0.6 B)

Futures traders bullish on stock-index futures

Follow the Smart Money

Indicators showing behavior of sophisticated

investors

The Barrons Confidence Index (HGY/AvgY)

T-Bill - Eurodollar yield spread

Short sales by specialists

Debit balances in brokerage accounts (margin

debt) (High..B; Low..S)

Other Market Indicators

Momentum Indicators

Breadth of market

Advance-decline

Diffusion index

Short interest

Stocks above their 200-day moving average

Block uptick-downtick ratio

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

Importance of volume

Ratio of upside-downside volume

Support and resistance levels

Moving average lines

Stock Price and Volume Techniques

Relative-strength (RS) ratios

For individual stocks and industry groups

Bar charting

Multiple indicator charts

Point-and-figure charts

Overall feel from a consensus of

numerous technical indicators

Technical Analysis

of Foreign Markets

Foreign stock market series

Technical analysis of foreign

exchange rates

Technical analysis of bond markets

The Internet Investments Online

http://www.mta.org

http://www.bigcharts.marketwatch.com

http://www.stockcharts.com

End of Chapter 15

Technical Analysis

Future topics

Chapter 16 Equity Portfolio Management

Strategies

technical analysis

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