Week 6

1
Week 6

• Technical Analysis

2
Technical Analysis

• Attempt to exploit recurring and predictable
  patterns in stock prices to generate abnormal
  trading profits.
• Stock market moves in trends which are determined
  by the changing attitudes of investors to a
  variety of economic, monetary, political and
  psychological forces.
• Identify changes in trends at an early stage and
  Maintain an investment until a reversal of that
  trend is indicated.
• Technicians believe
• Shifts in market fundamentals can be discerned
  before the impact is fully reflected in prices.
• Fundamentals can be perturbed by irrational
  factors.
• When there is a shift in market fundamentals,
  price adjustment to a new equilibrium is gradual,
  leading recognizable trend.

3
Technical Analysis

• The presumptions in technical analysis are not
  consistent with EMH.
• Exploitable trends in stock prices would be the
  evidence against EMH, as they would indicate
  profit opportunities that market participants had
  left unexploited.
• The notion of evolving patterns is consistent
  with almost but not-quite efficient markets.
• There are patterns in stock prices that can be
  exploited, but once investors identify and
  attempt to profit from these patterns, their
  trading activities affect prices, thereby
  altering prices.
• The patterns that characterize the stock prices
  will be constantly evolving, and only the best
  analysts who can identify new patterns earliest
  will be rewarded.

4
Charting The Dow Theory

• A technique that attempts to discern long- and
  short-term trends in stock market prices.
• Two indicators used
• DJIA Key indicator of underlying trends
• DJTA Indicator for confirming or rejecting the
  signal
• Three forces that simultaneously affect stock
  prices
• Primary trend Long-term movements of prices
  (several month to several years)
• Secondary or intermediate trends Short-term
  deviations of prices from the underlying trend
  line, which are eliminated via corrections toward
  trend values.
• Tertiary or minor trends Daily fluctuations of
  little importance.

5
Charting The Dow Theory

• Support and resistance levels in stock prices
• Support level A value below which a stock or
  stock index is relatively unlikely to fall.
• Resistance level A value above which a stock or
  stock index is difficult to rise.
• Support and resistance levels are determined by
  the recent history of stock prices.
• Piercing the resistance level is a bullish
  signal.
• Piercing the support level is a bearish signal.
• Technicians see these levels as resulting from
  common psychological investor traits.
• The contradictory signal between DJIA and DJTA
  (nonconfirmation by DJTA) is a warning sign.

6
Charting The Dow Theory

• EMH and the Dow theory
• The EMH holds that if any pattern is exploitable,
  many investors attempt to profit from such
  predictability, which would ultimately move
  prices and cause trading strategy to
  self-destruct.
• Recent variations on the Dow theory
• The Elliott wave theory Stock prices can be
  described by a set of wave patterns By
  interpreting the long- and short-term cycles, one
  can predict broad movements.
• The theory of Kondratieff waves Macroeconomy
  (stock market) moves in broad waves lasting
  between 48 and 60 years.

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Charting Other Techniques

• Point and figure chart
• Simply trace significant upward or downward
  movements in stock prices without regard to their
  timing.
• It is customary to require reasonably substantial
  price changes before marking pluses or minuses.
• Sell (buy) signals are generated when the stock
  price penetrates previous lows (highs).
• Candlestick chart
• The box with the vertical line drawn through it
  allows to ascertain the open and close price for
  the day, as well as the high and low price.
• If the price increases during the day, the box is
  shaded.
• The chart conveys a considerable amount of
  information about recent stock price history.

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Charting Warning

• Unfortunately, it is possible to perceive
  patterns that really do not exist.
• The simulated data from a random number generator
  (patternless by construction) can display the
  pattern that is very similar to a pattern in the
  real stock prices.
• Data mining
• After the fact, you can always find patterns and
  trading rules that would have generated big
  profits If you test enough rules, some will have
  worked in the past.
• Unfortunately, picking a theory that would have
  worked after the fact carries no guarantee of
  future success.
• In evaluating trading rules, you should always
  ask whether the rule would have seemed reasonable
  before you looked at the data.

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Technical Indicators

• Sentiment Indicators
• Measure the expectations of various groups of
  investors, for example, mutual fund managers,
  corporate insiders, or NYSE specialists.
• Flow of funds indicators
• Measure the potential for various investor groups
  to buy or sell stocks in order to predict the
  price pressure from those actions.
• Market structure indicators
• Monitor price trends and cycles.
• Examples Charting techniques.

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Sentiment Indicators

• Trin Statistic
• Market volume can measure the strength of a
  market rise or fall Market advances (reversals)
  are considered more bullish (bearish) when
  associated with increased trading volume.
• Trin Number Advancing / Number Declining
• Volume Advancing / Volume Declining
• Volume Declining / Number
  Declining
• Volume Advancing / Number Advancing
• Average Volume in Declining Issues
• Average Volume in Advancing Issues
• Ratios above 1.0 are considered bearish because
  the falling stocks would have higher average
  volume than advancing stocks, indicating net
  selling pressure.

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Sentiment Indicators

• Odd-Lot Trading
• An odd lot is a transaction of fewer than 100
  shares.
• Odd-lot traders are almost always small
  individual traders.
• The odd-lot theory
• Small investors tend to miss key market turning
  points, typically buying stocks a bull market has
  already run its course and selling too late into
  a bear market.
• When odd-lot traders are widely buying, you
  should sell and vice versa.
• The ratio of odd-lot purchases to sales which is
  above 1.0 indicates the bearish market because
  small traders are net buyers.

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Sentiment Indicators

• Confidence Index
• Presumption Actions of bond traders reveal
  trends that will emerge soon in the stock market.
• The ratio of the average yield on 10 top-rated
  corporate bonds divided by the average yield on
  10 intermediate-grade corporate bonds Always
  below 100.
• The higher values are bullish signal because
  default premium on lower rated bonds will be
  smaller when bond traders are optimistic about
  the economy.
• Put/Call Ratio
• The ratio of outstanding put options to
  outstanding call options Typically, about 65.
• Deviations of the ratio from historical norm can
  be a signal of market sentiment and predictive of
  market movements.

13
Sentiment Indicators

• Put/Call Ratio
• Increase in the ratio as Bearish Growing
  interest in puts as a hedge against market
  declines.
• Contrarian investors would consider an increase
  in the ratio as a signal of a buy opportunity, as
  they believe that a good time to buy is when the
  rest of the market is bearish.
• Mutual Fund Cash Positions
• Presumption Mutual funds act incorrectly before
  a market turning points Become more bullish and
  hold lower cash position (fully invested) when
  the market is at, or near, a peak.
• The percentage of cash held in mutual fund
  portfolios is one common measure of sentiment
  This percentage moves in the opposite direction
  of the stock market.

14
Flow of Funds Indicators

• Short Interest
• Total number of shares currently sold short in
  the market.
• High levels of short interest can be interpreted
  as bullish, some as bearish.
• Bullish All short sales must be covered,
  suggesting short interest represents latent
  future demand for the stocks.
• Bearish Short sellers tend to be larger, more
  sophisticated investors, and increased short
  interest reflects bearish sentiment of those
  investors.
• Credit Balances in Brokerage Accounts
• Investors with brokerage accounts often leave
  balances when they plan to invest in the near
  future.
• Credit balances may be viewed as measuring the
  potential for new stock purchases High balances
  - Bullish sign.

15
Market Structure Indicators

• Moving Averages
• Moving average of a stock index is the average
  level of index over a given interval of time.
• 52-week moving average Each week, the moving
  average is recomputed using index values of most
  recent 52-week.
• After a period in which prices have generally
  been falling, the moving average will be above
  the current price (the moving average averages in
  the older and higher prices).
• When the current price breaks through the moving
  average line from below A bullish sign A shift
  from a falling trend (with prices below the
  moving average) to a rising trend (with prices
  above the moving average).
• When the current price breaks through the moving
  average line from above A bearish sign.

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Market Structure Indicators

• Breadth
• A measure of the extent to which movement in a
  market index is reflected widely in the price
  movements of all the stocks in the market.
• The most common measure Spread between the
  number of stocks that advance and decline in
  price.
• If advances outnumber decline by a wide margin,
  the market is viewed as being stronger.
• Some analysts cumulate breadth data each day.
• The cumulative breadth for each day That days
  net advances (or declines) Previous days
  total.
• The direction of cumulative breadth is used to
  identify broad market trends.

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Market Structure Indicators

• Relative Strength
• A measure of the extent to which a security has
  outper-formed or underperformed either the market
  as a whole or its particular industry.
• The most common measure Ratio of the price of
  the security to a price index for the industry.
• A rising ratio implies the stock has been
  outper-forming the rest of industry.
• If relative strength can be assumed to persist
  over time, this would be a signal to buy stock.
• The relative strength of an industry relative to
  the whole market can be computed for tracking the
  ratio of the industry price index to the market
  price index.

18
Value Line System

• Value Line System is widely followed by investors
  and displays the evidence of superior
  performance.
• Value Line ranks stocks on a timeliness scale of
  one (best buy expected to perform the best) to
  five (sell expected to perform the worst).
• The evidence shows that the different groups
  perform just as the rankings predict.
• Value Line System is predominately a technical
  system.
• The ranking procedure has three components
  relative earnings momentum, earnings surprise,
  and value index.
• Points assigned for each factor determine the
  stocks overall ranking.
• Value Line System is difficult to implement in
  market Underperformance of Value lines mutual
  fund.

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Technical Analysis in Efficient Markets

• Self-destructing Patterns
• The idea behind the technical analysis is
  inconsistent with EMH.
• The real test of EMH Whether a technical rule
  that seems to work will continue to work in the
  future (that, is become reflected in stock
  prices) once it becomes widely recognized
  Self-destructing.
• Market dynamic Search for profitable trading
  rules ? Destruction ? Another search for
  yet-discovered rules.
• Modern View of Technical Analysis
• Prices reveal and reflect information and become
  useful to traders.
• This view can reconcile technical analysis with
  the usual assumption of rational traders
  participating in efficient markets.