Chapter 13

Technical Analysis

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 Chapter 13
Technical Analysis
Questions to consider:
• 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?
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 Chapter 13
Technical Analysis
• 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?

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 Chapter 13
Technical Analysis
• 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?

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 Chapter 13
Technical Analysis
• Why do technicians consider the volume of
trading important and how do they use it in
their analysis?
• What are support and resistance levels, how
are they identified, and how are they used by
technicians?
• What is the purpose of moving average lines
and how does the technician use one or several
of them to detect major changes in trends?

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 Chapter 13
Technical Analysis
• 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 markets?
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 Technical Analysis As An Art
• Prices are Determined by Investors’ Attitudes
– Prices move in trends
• Changing Attitude Toward
– Economic forces
– Monetary forces
– Political forces
– Psychological forces

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Technical Analysis As A Science

• Study of the Action of the Market

• Science of Recording in Graphic Form
– Price changes, volume, highs and lows,…
– The averages of above
• Deducing the Probable Future Trend

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Is Technical Analysis An Art Or
Science?
• Art
– Martin J. Pring

• Science
– Robert D. Edwards and John Magee

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 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

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 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

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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. Nonquantifiable factors do not show up in
financial statements

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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

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Challenges to Technical Analysis
• Assumptions - Empirical tests of Efficient Market
Hypothesis (EMH) show that prices do not move in
trends
• 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 all require subjective judgement

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Is There Any Empirical Evidence
To Support Technical Analysis
(TA)?
• Patterns in Security Prices
– Fall one week, bounce back next week
– Monthly returns over a long time
– Seasonal patterns
• January effect
• Resent Research Merits TA

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 Charting
• Bar Charts
– Illustrates each days
• High, low, and closing price
– Looks at stock price behavior over time
• Point-and-Figure Charts
– Identifies stock price reversals
– Does not consider time
• Candlestick Charts
– Illustrates each days
• Opening, high, low, and closing price

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 Bar Charts
• Trendline
– Drawn on chart to identify trend
• Channel
– Pattern formed by 2 trendlines
• Resistance
– Downward price movement
• Support
– Upward price movement

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 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

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 Typical Stock Market Cycle
Stock
Price

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 Typical Stock Market Cycle
Stock
Price

Declining Peak
Trend
Channel Flat Trend Channel

Sell Point
Rising Trend
Channel Declining
Buy Point Trend Buy Point
Trough
Trough Channel
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 Point-And-Figure Charts

• A Series of Xs and Os

• Same as Bar Charts

• Popular Tool

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 Candlestick Chart
• Candlestick Line
– Real body
• Difference between opening and closing price
– Shadow
• Vertical line identifying the high and low price
– Can be constructed with Different Time Data
• Intraday
• Weekly

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 Summary Of Charts
Bar Point-Figure Candlestick

Data High Close Open

Low High
Close Low
Close
Time Days None Days/Weeks

App Trendlines Trendlines Pattern and

Shapes

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 Contrary-Opinion
• 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

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 Contrary-Opinion Rules
• Mutual fund cash positions
• Credit balances in brokerage accounts
• Investment advisory opinions
• OTC versus NYSE volume
• Chicago Board Options Exchange (CBOE)
put/call ratio
• Futures traders bullish on stock index
futures

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 Follow the Smart Money
• Indicators showing behavior of
sophisticated investors
• The Barron’s Confidence Index
• T-Bill - Eurodollar yield spread
• Short sales by specialists
• Debit balances in brokerage accounts
(margin debt)

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 Other Market Indicators
• Breadth of market
– Advance-decline
– Diffusion index
• Short interest
• Stocks above their 200-day moving average
• Block uptick-downtick ratio

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Stock Price and Volume Techniques
• The Dow theory
– 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
– 5-day
– 200-day

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Stock Price and Volume Techniques
• Relative-strength indexes (RSI)
– For individual stocks and industry groups
• Bar charting
• Multiple indicator charts
• Point-and-figure charts
• Overall feel from a consensus of numerous
technical indicators

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 Dow Theory
• Primary Trend - “Tides”
– Cycle in years
• Intermediate Trend - “waves”
– 3 Weeks to 6 months
• Short-Term Trend - “ripples”
– Volatile and erratic
• Basic Tenets next slide

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 Basic Tenets Of Dow Theory
• Requires Data on Stock Indexes
– No additional information
• Types of Financial Market Movements
– Primary
– Intermediate
– Short-term
• Positive Relationship Between
– Trend
– Volume of shares traded

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 RSI
• Range From 0% to 100%
• High
– Industry stock prices outperform the market
– Indicate a sell signal? Buy signal?
• Low The trend is your friend!
– Market outperforming the industry stock
– Indicates a buy signal? Sell signal?

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 Technical Indicators
• Breadth Indicators
– Advance-decline line (ADL)
– Volume
– New high/new low
• Sentiment Indicators
– Stock market newsletter
– Odd-lot trading
– Put/call trading
– Specialists short selling

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Advance-Decline Line

ADLt = At - Dt + ADLt - 1

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 Technical Analysis
of Foreign Markets
• Foreign stock market series
• Technical analysis of foreign
exchange rates
• Technical analysis of bond
markets

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Recap & Further Illustration
 Technical Analysis
• What is it?
– Historic price and volume behavior
– Investor sentiment
– Bulls and bears….
• Dow theory
– Three trends: primary, secondary, daily
– Corrections/confirmations: DJIA/DJTA
• Support and resistance areas
– Support level / Bottom feeders
– Resistance level / Topping out / profit taking
– Breakouts

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 Dow Theory

Primary trend
Prices

Secondary reactions

Daily trend not shown

Time

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 Charting
Reading the tea leaves…
• Advance / decline line: Closing Arms or Trin
• Relative strength
• Moving averages
• High-lo-close chart
• Candlestick chart
• Point-and-figure chart
• Chart formations: head-and-shoulders
• Other indicators
– Odd lot / Contrarian / Hemlines

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 Examples
• Closing Arms: Trin

Trin = Declining volume / Declines

Advancing volume / Advances
• Relative strength:
assume 4 shares of Stock A @ $25 per share and 2 shares of
Stock B @ $50 per share
Month Stock A Stock B Rel. Str.
1 $100 $100 1.00
2 $88 $90 0.98
3 $88 $80 1.10

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Three Period Moving Average
Time Mini Dow MA
1 11
2 12 11 + 12 + 14 = 12.33
3 14 12.33
3
4 13 13.00
5 16 14.33
6 17 15.33
7 19 17.33
8 18 18.00
9 17 18.00
10 18 17.67

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 Moving Average Graph
20
19
18
Stock Prices

17
16
15
14
13
12
11
10
0 1 2 3 4 5 6 7 8 9 10 11

Time
Mini Dow MA

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 Candlestick Making
High

Upper Shadow

Close

Body

Open

Lower Shadow

Low
Bullish Bearish

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 Candlestick Formations

Bearish
Dark cloud engulfing
cover Harami
pattern

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 Point and Figure Chart
60
Congestion Buy
58
56 Areas 0
54 0 0 0 0
52 0 0 0 0 0
50 0 0 0 0
48 0 0 0 0 0 0 0
46 0 0 0 0 0 0 0
44 0 0 0 0 0 0
42 0 0 0 0
40 0 0 0
38 0 0
36 0
Sell
34
32
30
28

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 Head and Shoulders Formation
Head

Right
Left Shoulder
Shoulder

Neckline

Throw
Back

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 The Internet
Investments Online
www.mta-usa.org
www.bigcharts.com
www.dailystocks.com
www.investools.com
www.siliconinvestor.com
www.stockmaster.com
www.dbc.com
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