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CHAPTER 16

TECHNICAL ANALYSIS

Answers to Questions

1. The principal contention of technicians is that stock prices move in trends that persist for
long periods of time. Because these trends persist they can be detected by analyzing past
prices.

2. Technicians expect trends in stock price behavior because they believe that new
information that causes a change in the relationship between supply and demand does not
come to the market at one point in time - i.e., they contend that some investors get the
information before others. Also, they believe that investors react gradually over time to
new information. The result is a gradual adjustment of stock prices.

3. The problems encountered when doing a fundamental analysis of financial statements

are: (1) much of the information in financial statements is not useful; (2) there are
comparability problems for firms using alternative accounting practices; and (3) there are
important psychological factors not included in financial statements. Also, with technical
analysis it is not necessary to invest until the move to a new equilibrium begins.

4. The disadvantages of technical analysis are: (1) past price patterns may not be repeated in
the future; (2) the intense competition of those using the trading rules will render the
technique useless; (3) the trading rules require a great deal of subjective judgment; and
(4) the values that signal action are constantly changing.

5. The mutual fund cash position of 10 percent is relatively high. This would indicate a
bullish market because: (1) the theory of contrary-opinion states that mutual funds are the
odd-lot trader of the institutional market and typically make the wrong decision by
holding excess cash near a trough when they should be fully invested; and (2) the large
cash positions of mutual funds represent potential buying power.

6. Credit balances result when investors sell securities and leave the proceeds with their
broker with the intent of reinvesting the funds shortly. Therefore, they can be considered
a source of potential buying power. Given this line of reasoning, a decline in credit
balances would indicate a decline in potential buying power, which is bearish. Another
line of reasoning is based on contrary opinion. It is assumed that these balances are
generally maintained by small investors who draw them down to invest at the peak, so
this is bearish for the contrary opinion technician.

7. This index indicates what proportion of investment advisory services are bearish and 61
percent is a fairly high ratio. To a contrary opinion technician this is bullish because so
many of the services are bearish.
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8. Debit balances represent borrowing by sophisticated investors, therefore higher debit

balances indicate optimism on the part of these investors. The problem with the debit
balance measure is that it only represents borrowing through brokers and it ignores the
amount of borrowing from alternative sources.

9. The Dow Theory contends that stock prices move in waves. Specifically, these waves
may be grouped into three categories based upon the period of the wave: (1) major trends
for long periods (tides); (2) intermediate trends (waves); and (3) short-run movements for
very short periods (ripples). The major trend (the tide) is most important to investors. An
intermediate reversal occurs when some investors decide to take profits.

10. The direction of a price movement accompanied by high volume is more important than
if the same price change is associated with light volume. If prices decline (advance) on
heavy volume it is bearish (bullish) since it indicates numerous sellers (buyers).

11. The breadth of the market index is a time series calculated as the cumulative number of
net advances or net declines. It indicates a peak or trough in stock prices prior to the peak
(or trough) in the aggregate price series by showing a broadly based decline in the
majority of individual stocks. The technician would expect that at a turning point this
decline (advance) in the breadth index would be moving in the opposite direction of a
rising (falling) market price index series - i.e., the aggregate price series would still be
rising (falling) when most individual stocks are beginning to decline (advance).

12. Technicians following the breadth of market rules might interpret the event as indicative
of a possible market peak. Since the DJIA is a value-weighted series confined to 30 large
well-known stocks, the past trading period indicates that while the large stocks are still
advancing, the majority of individual issues are declining. Due to the technical analyst’s
belief that information is disseminated on an unequal basis, the technicians would
interpret a net cumulative decline as a sign of a market turn that has not been interpreted
yet by small investors who hold funds of the large, well-known stocks.

13. A support level is a price range where considerable demand is expected, while a
resistance level is a price range where a large supply is expected. Support and resistance
levels exist due to the behavior of a number of investors who are closely monitoring the
market and will trade quickly at attractive price levels. Specifically, a support level
occurs after a stock has increased in price followed by a brief period of profit-taking at
which time some investors who did not get in on the first round decide to take the
opportunity to get in. A resistance level occurs after a stock has declined and when it
experiences a recovery, some investors who missed selling at a price peak take the
opportunity to sell.

A price break through a resistance level on strong volume would be considered very
bullish. This is because as the price rises to the target price set by investors, the supply
increases usually causing the price increase to reverse. Thus, a price breakthrough on
strong volume would be bullish because it would mean the excess supply is gone.
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14. A moving average line indicates the major trend of a security’s price. When daily prices
break through the long-term trend from below on heavy volume it is considered a bullish
action. The move above the trend line may indicate a new upward change in the trend.

15. If current prices break through the 50-day MA line from above on heavy volume,
technicians would expect a reversal of a rising trend and become bearish. If the 50-day
MA line crosses the 200-day MA line from above on good volume, technicians would
again expect a reversal in rising prices and become bearish.

16. Relative strength is the ratio of a firm’s stock price to a market price series. If the relative
strength ratio is increasing during a bear market it means that the stock is not declining as
much as the aggregate market. Under such favorable conditions, the technician would
expect the stock to likewise outperform the market in the ensuing bull market.

17. Technicians recognize that there is no single technical trading rule that is correct all the
time - even the best ones miss certain turns or give false signals. Also, various indicators
provide different information for alternative segments of the market. Therefore, you don't
want to depend on any one technique, but look at several and derive a consensus.

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CHAPTER 16

Answers to Problems

1. Student Exercise

2. Student Exercise

3. Student Exercise

4. 40
39
38 X 0
37 X 0
36 X 0
35 X 0
34 X 0
33 X 0
32 X 0
31 X 0
30 X 0 X
29 X 0 X
28 X 0 X
27 X 0 X
26 X 0 X
25 X
24 X
23 X

The price of the stock went to 38 1/2 before declining. Therefore, at the current price of
around 30, the chart could imply a buying opportunity since the price has risen recently
from 26 to 30 without a reversal.

5.a. Day 4 = (12,010 + 12,100 + 12,165 + 12,080)/4 = 48,355/4 = 12,088.75

Day 5 = (12,100 + 12,165 + 12,080 + 12,070)/4 = 48,415/4 = 12,103.75

Day 6 = (12,165 + 12,080 + 12,070 + 12,150)/4 = 48,465/4 = 12,116.25

Day 7 = (12,080 + 12,070 + 12,150 + 12,220)/4 = 48,520/4 = 12,130.00

Day 8 = (12,070 + 12,150 + 12,220 + 12,130)/4 = 48,570/4 = 12,142.50

Day 9 = (12,150 + 12,220 + 12,130 + 12,250)/4 = 48,750/4 = 12,187.50

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Day 10 = (12,220 + 12,130 + 12,250 + 12,315)/4 = 48,915/4 = 12,228.75

Day 11 = (12,130 + 12,250 + 12,315 + 12,240)/4 = 48,935/4 = 12,233.75

Day 12 = (12,250 + 12,315 + 12,240 + 12,310)/4 = 49,115/4 = 12,278.75

5.b. This would indicate a the continuation of a bullish trend, because the index closed above
its 4-day moving average for day 13 of 12,291.25, which it has done for the last several
days.

6. Day 1 2 3 4 5

Net advances +448 +95 +519 -499 -193

(advances minus declines)

Cumulative net +448 +543 +1062 +563 +370

advances

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