Technical Analysis

Instructor: Rashik Amin, CFA

Introduction
• Technical analysts develop technical trading rules from observations
of past price movements of the stock market and individual stocks.
• Contrary to efficient market hypothesis- past performance has no
influence on future performance
• Contrary to fundamental analysis
• Technical analysis is a is a method of evaluating securities by analyzing
statistics generated by market activity
• Alternative method of marking the investment decision
Introduction
• Technical analysts see no need to study economic, industry, and
company variables to arrive at an estimate of future value
• They believe that past price and volume movements or some other
market series will signal future price movements.
• Technicians also believe that a change in the price trend may predict a
forthcoming change in some fundamental variables such as earnings
and risk before the change is perceived by most fundamental analysts
Underlying Assumptions
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 rational (economic
variables) and irrational factors (opinions, moods, and guesses).
3. 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.
Underlying Assumptions

Difference of opinion regarding the assumption about the speed of adjustment of

stock prices to changes in demand and supply
Advantages of Technical Analysis
• Technical analysts do not believe the majority of investors can
consistently get new information before other investors and
consistently process it correctly and quickly.
• Not heavily dependent on financial accounting statements
• They lack a great deal of information needed by security analysts
• May choose among several procedures for reporting expenses, assets, or
liabilities (makes comparison difficult)
• Many psychological factors and other nonquantifiable variables do not appear
in financial statements.
Advantages of Technical Analysis
• Fundamentalists must process new information quickly and correctly
to derive an intrinsic value before others. Technicians only need to
quickly recognize a movement to a new equilibrium value (whatever
the reason)
Challenges to Technical Analysis
(Assumption)
• Market HAS to be inefficient i.e. market would be slow to adjust
prices to the arrival of new information {weak-form efficient market
hypothesis (EMH)}
Challenges to Technical Analysis (Technical
Trading Rules)
• Past price patterns or relationships between specific market variables
and stock prices may not be repeated. As a result, a technique that
previously worked might miss subsequent market turns.
• Many price patterns become self-fulfilling prophecies
• The success of a particular trading rule will encourage many investors
to adopt it. It is contended that this popularity and the resulting
competition will eventually neutralize the technique.
• Most of the trading rules require a great deal of subjective judgment.
Two technical analysts looking at the same price pattern may arrive at
widely different interpretations of what has happened.
Technical Trading Rules & Indicators
Technical Trading Rules & Indicators
Contrary Opinion Rules
• Many technical analysts rely on technical trading rules that assume
that the majority of investors are wrong as the market approaches
peaks and troughs. Therefore, these technicians try to determine
when the majority of investors is either strongly bullish or bearish
and then trade in the opposite direction.
Technical Trading Rules & Indicators
Contrary Opinion Rules
• Mutual Funds Cash Positions:
• Mutual funds hold some part of their portfolio in cash.
• One of the reasons- portfolio manager might be bearish on the market and
want to increase the fund’s defensive cash position.
• Contrary-opinion technicians believe that mutual funds usually are wrong at
peaks and troughs. Thus, they expect mutual funds to have a high percentage
of cash near a market trough—the time when they should be fully invested to
take advantage of the impending market rise. At the market peak, these
technicians expect mutual funds to be almost fully invested with a low
percentage of cash when they should be selling stocks and realizing gains.
Technical Trading Rules & Indicators
Contrary Opinion Rules
• Credit Balances in Brokerage Accounts
• Because technical analysts view these credit balances as potential purchasing
power, a decline in these balances is considered bearish because it indicates
lower purchasing power as the market approaches a peak. Alternatively, a
buildup of credit balances indicates an increase in buying power and is a
bullish signal.
Technical Trading Rules & Indicators
Contrary Opinion Rules
• Investment Advisory Opinions
• Many technicians believe that if a large proportion of investment advisory
services are bearish, this signals the approach of a market trough and the
onset of a bull market.
Technical Trading Rules & Indicators
Contrary Opinion Rules
• Put/Call Ratio
• A higher put-call ratio indicates a pervasive bearish attitude for investors,
which technicians consider a bullish indicator
Technical Trading Rules & Indicators
Follow the Smart Money
• Confidence Index
• T-bill-Eurodollar Yield Spread
• Debit Balances in Brokerage Accounts (Margin Debt)
• An increase in debit balances implies buying by these sophisticated investors
and is considered a bullish sign, while a decline in debit balances would
indicate selling and would be a bearish indicator.
Technical Trading Rules & Indicators
Momentum Indicators
• Breadth of Market
• The breadth of market series measures the number of issues that have
increased each day and the number of issues that have declined.
• It helps explain what caused a change of direction in a composite market index
such as the S&P 500 Index.
• Most stock-market indexes are heavily influenced by the stocks of large firms
because the indexes are value weighted. Therefore, a stock-market index can
experience an overall increase while the majority of the individual issues are
not increasing, which means that most stocks are not participating in the rising
market. Such a divergence can be detected by examining the advance-decline
figures for all stocks on the exchange, along with the overall market index.
Stock Price and Volume Techniques
• Dow Theory
• Dow described stock prices as moving in trends analogous to the movement of
water. He postulated three types of price movements over time:
• (1) major trends that are like tides in the ocean,
• (2) intermediate trends that resemble waves, and
• (3) short-run movements that are like ripples.
• Followers of the Dow Theory attempt to detect the direction of the major price trend
(tide), recognizing that intermediate movements (waves) may
• occasionally move in the opposite direction. They recognize that a major market
advance does
• not go straight up, but rather includes small price declines as some investors decide
to take profits
 Stock Price and Volume Techniques

• Importance of Volume
Technician looks for a
price increase on heavy
volume relative to the
stock’s normal trading
volume as an indication
of bullish activity
Stock Price and Volume Techniques
• Support and Resistance Levels
• A support level is the price range at which the technician would
expect a substantial increase in the demand for a stock. Generally, a
support level will develop after a stock has enjoyed a meaningful price
increase. Technicians reason that at some price below the recent peak
other investors who did not buy during the first price increase
(waiting for a small reversal) will get into the stock.
Stock Price and Volume Techniques
• Support and Resistance Levels
• A resistance level is the price range at which the technician would
expect an increase in the supply of stock and a price reversal. A
resistance level develops after a significant decline from a higher price
level. After the decline, the stock begins to recover, but the prior
decline in price leads some investors who acquired the stock at a
higher price to look for an opportunity to sell it near their breakeven
points.
Stock Price and Volume Techniques
• Moving Average Lines
• Consider 50- and 200-day MA lines
• When these two lines cross, it confirms a change in the overall trend.
Specifically, if the 50-day MA line crosses the 200-day MA line from
below on good volume, this would be a bullish indicator (buy signal)
because it confirms a reversal in trend from negative to positive. In
contrast, when the 50-day line crosses the 200-day line from above, it
confirms a change to a negative trend and would be a sell signal.
Stock Price and Volume Techniques
• Moving Average Lines
Stock Price and Volume Techniques
• Relative Strength: Technicians believe that once a trend begins, it will
continue until some major event causes a change in direction. They
believe this is also true of relative performance. If an individual stock
or an industry group is outperforming the market, technicians believe
it will continue to do so.
• RS Ratio
Stock Price and Volume Techniques
• Bar Charting (High, Low, (Opening) and Closing Prices
• Candlestick Charts: Candlestick charts are basically an extension of
the bar chart. In addition to high, low, and closing prices for each
trading day, they also include the opening price and indicate the
change from open to close by shading whether the market or
individual stock went down (dark shading) or up (white bar) for the
day
Stock Price and Volume Techniques
Stock Price and Volume Techniques
• Bar Charting: Technicians include as many price and volume
indicators as are reasonable on one chart and then, based on the
performance of several technical indicators, try to arrive at a
consensus about the future movement for the stock. (MA, RS etc.)
• Point-and-Figure Charts: It includes only significant price changes,
regardless of their timing.