Technical Analysis

Dr. Amir Rafique

 Technical Analysis
 Technical Analysis is the study of the various
forces at work in the marketplace

 Focus is on trends in stock prices/ volume and the overall

stock market

 Stock prices are a function of supply and demand

 Several technical tools may be used together

A Brief Comparison
Technical Analysis and
Fundamental Analysis
• Technical analysis attempts to exploit stock
price patterns for profit

• Fundamental analysis is based on the

comparison of intrinsic and market value
Technical Analysis and EMH

• Technical analysis clashes with the EMH

hypothesis

• EMH predicts rapid adjustment of prices with

the onset of new information
Technical Analysis (Summary)
 Conceptual basis
 All technical analysis (TA) assume that there are
recurring and predictable patterns in stock prices

 Technical analysts believe:

 Market prices conform to new data only slowly
(Slow adjustments)

 Prices are affected by predictable behavioral or

psychological factors
Assumptions of Technical
Analysis
Underlying Assumptions
of Technical Analysis
1. The market value is determined solely by the
interaction of supply and demand

2. Supply and demand are directed 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 and these
shifts can be detected in the action of the market
Advantages and Challenges to
Technical Analysis
Advantages of Technical Analysis
 Not heavily dependent on financial statements
 Problems with accounting statements:
 Lack information (Non-Financial Information)

 GAAP/ IFRS allows firms to select reporting procedures,

resulting in difficulty comparing statements from two firms

 Non-quantifiable factors do not show up in financial

statements (psychological and other)

 Technicians trade immediately

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
 A successful rule will gain followers and become
less successful
 Rules require a great deal of subjective judgment
Technical Trading Rules and
Stock Market Cycle
Typical Stock Market Cycle
 Stock cycles typically go through peaks and
troughs

 Typical stock price cycles show a rising trend

channel, a flat trend channel, a declining
trend channel, and indications of when to
trade
Typical Stock Market Cycle
Stock
Price
Typical Stock Market Cycle
Stock
Price

Declining Peak
Trend
Channel
Flat Trend Channel

Sell Point
Rising Trend Channel

Declining
Buy Point Trend Buy Point
Channel Trough
Trough
Technical Analysis Tool-kit
 Technical Indicators
 Sentiment Indicators: Market Volume (Trin Statistic);
Odd-lot Trading; Confidence Index; Put/Call Ratio;
 Flow of Funds: Short Interest; Credit Balances in
Brokerage Accounts, Mutual Fund Cash Position
 Market Structure: Moving Averages; Breadth;
Relative Strength

 Charting: The analysis of “charts” of stock price and

volume:
 The Dow Theory
 Point and Figure Chart
 Other Charts
Technical Indicators
Sentiment Indicators
Market Volume
 Pure supply and demand analysis for common
stocks

 Strong market when volume goes up with prices

 Weak market when volume goes down with

prices
Market Volume and Odd-lot
Trading
• Market Volume: Higher volume gives strong confirmation to
price trend. The Trading Index (TRIN) is:

Volume declining/Number declining

Trin 
Volume advancing/Number advancing

Trin>1: Bear Market; Trin<1: Bull Market

• Odd-lot Trading (less than 100 shares): Small investors tend to

miss key market turning points. Assumes that small investor are
stupid! (Contrary Opinion)

- Odd-lot buying heavy investors should be bearish

- Odd-lot selling heavyinvestors should be bullish

Other Sentiment Indicators
 Confidence Index:
Average Yield on 10 top - rated Corporate Bonds
Average Yield on 10 intermediate grade Corporate Bonds

 Closer to 100% investors should be bullish

 Away from 100% investors should be bearish

 Put/Call Ratio:
 Rising ratio investors should be bearish?
 Decreasing ratio investors should be bullish?
Technical Indicators
Flow of Funds
Short Interest and Credit Balance
in Brokerage Accounts
• Short Interest: The volume of short selling

High volume investors should be bullish?

Low volumeinvestors should be bearish?

• Credit Balances in Brokerage Accounts

High balance bullish?

• Mutual Fund Cash Positions

More cash  ?
Mutual Fund Cash Position
 Mutual Fund Cash Ratio (MFCR)
 High cash positions in mutual funds provides liquidity
for future stocks purchases or protection from future
mutual fund withdrawals
MFCR  Mutual fund cash position  Total assets under management

 Bull market when MFCR values are higher

 Bear market when MFCR values are lower
Technical Indicators
Market Structure
Moving Averages
 When current price crosses the average
value over time a trading signal occurs

 Bullish signal when the current price rises

above the moving average

 Bearish sign when the current price falls

below the moving average
Moving Averages
•MA piercing price from below: bullish signal (shift from falling to raising)

•Price piercing MA from above: bearish signal (shift from raising to falling)
Price
Price Bullish Signal
And
M.A. Bearish Signal

Moving Average
Time
Averaging interval
Breadth and Relative Strength
• Breadth: The spread between the number of advancing issues and
the number of declining issues
Advances > declines  bullish
Advances < declines  bearish

• Relative Strength:
Price of a Stock Price Index of an Industry
Price Index for the Industry or Market Price Index
ΔPi / ΔIndex

Persistent Rising ratio  bullish

Persistent Falling ratio bearish

Charting
Charting
 Shows visual summary of stock market activity
over time

 Easy to use and to understand

 Use to spot developing trends

Charting: The Dow Theory

• Uses price and volume trends to predict prices

• Attempts to discern long and short-term trends

• Identifies primary, secondary, and tertiary

trends
Dow Theory Trends
Point and Figure Charts

 Only shows significant changes in stock price patterns

 Up patterns are shown as an “X” and down patterns are

shown as an “O”
Point and Figure Chart
Candlestick Chart
 Charting: A Warning

• Seeing patterns that do not exist

• What has worked in the past may not work in

the future
Conclusion
Technical Analysis and Market
Efficiency
• EMH  new information is quickly reflected in
prices

• Technical analysis long-lived trends play out

slowly and predictably

• A useful technical rule would be invalidated once

the mass of traders attempt to exploit it
EMH vs. Technical vs.
Fundamental
 There is growing consensus that markets
may not be perfectly efficient, but they may
be at least reasonably efficient

 Integrated Approach?
Issues