Investment Analysis and Portfolio Management

Technical Analysis

Technical Analysis
Trading rules from past price movements Identifies stocks and the timing for investments and divestments Price pattern is not used blindly and exclusively; other indicators like cycles, volume and trend-following indicators are used

Why does it work?
‘Stocks don’t sell for what they are worth, but for what people think they are worth’ Prices are determined by psychology – people’s attitudes toward the emerging fundamentals TA assumes that these attitudes are reflected in price action History repeats, may not be exactly; similarity of people’s attitudes shows up in identifiable price patterns

Empirical studies in the areas of serial correlation of prices and profitability of trading strategies have turned out against TA Multiple interpretation of same patterns A great deal of subjectivity in decision making Efficacy of a particular trading rule may be short lasting due to its exploitation

Charting Techniques
To look for patterns in past price data, one of the following methods may be used to chart the prices
– Bar Charts – Japanese Candlestick Charts – Point and Figure Charts


Drawing Bar Charts
 Each bar is composed of 4 elements:
– – – – Open High Low Close
High Close Open High

 Note that the candlestick body is empty (white) on up days, and filled (some color) on down days

Open Low Low


Standard Bar Chart

Japanese Candlestick

Standard Bar Chart

Japanese Candlestick


Bar Charts
 This is a bar (open, high, low, close or OHLC) chart of AMAT from early July to mid October 2001.


Japanese Candlesticks
 This is a Japanese Candlestick (open, high, low, close) chart of AMAT from early July to mid October 2001


Point & Figure Charts
 Point & Figure charts are independent of time.  An X represents an up move.  An O represents a down move.  The Box Size is the number of points needed to make an X or O.  The Reversal is the price change needed to recognize a change in direction.  Typically, P&F charts use a 1-point box and a 3point reversal.


Point & Figure Charts
 This is a Point & Figure chart of AMAT from early July to mid October 2001.


A Few Basic TA Tools


Trend is a time measurement in which a price moves in an irregular but persistent direction Secular Trend: 12 -25 years Primary Trend: 9 months – 2 years Intermediate Trend: 6 weeks – 9 mo.s Short-term Trend: 2 – 6 weeks Intraday Trend: minutes and hours

Trends continued
Longer-term dominates near-term action Need to understand which type of trend is being reversed A rising trend consists of a series of rallies and reactions – each high is higher than its predecessor as is each low When the series of rising peaks and troughs is interrupted, a trend reversal is signaled – should have support of other technical indicators


Support and Resistance
 Support and resistance lines indicate likely ends of trends.  Resistance results from the inability to surpass prior highs.  Support results from the inability to break below to prior lows.  What was support Support becomes resistance, and vice-versa.




 Fundamental building block of pattern identification  When the price breaks free of the trendline, a trend change signals  There are three basic kinds of trends:
– An Up trend where prices are generally increasing. – A Down trend where prices are generally decreasing. – A Trading Range.


Moving Averages
A moving average is simply the average price (usually the closing price) over the last N periods. They are used to smooth out fluctuations of less than N periods. Movement of MA lines suggest possible change in trends When short-term MA line and longterm MA line intersects and are supported by other indicators like volume, they are interpreted as strong change signals 16

Head and Shoulders
 This formation is characterized by two small peaks on either side of a larger peak.  This is a reversal pattern, meaning that it signifies a change in the trend.
H&S Top

Left Shoulder

Right Shoulder


H&S Bottom

Left Shoulder

Right Shoulder



Head and Shoulders Example

Sell Signal

Minimum Target Price Based on measurement rule


Importance of Volume
Volume is an independent variable from price and normally goes with the trend When volume trends are moving in a direction opposite to that of price, that is abnormal and either warns of an impending trend reversal or emphasizes the significance of any breakout Ratio of up/down volume is used as an indicator of short-term market momentum (>1.5 = Bullish and <0.75 = Bearish)

Other Indicators
Breadth of market: number of scripts that increased each day versus the number that declined Short Interest: Uncovered short sale outstanding divided by average daily trading volume Margin Debt from Brokers: Balances and changes therein indicate the attitude of informed investors Put/Call Ratio: number of puts traded divided by the number of call


A Few TA Methods


Dow Theory
This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900 and 1902. Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the economy. A change in the trend of the DJIA must be confirmed by a trend change in the DJTA in order to generate a valid signal 22

Moving Average Convergence/Divergence
 MACD was developed by Gerald Appel as a way to keep track of a moving average crossover system.  Appel defined MACD as the difference between a 12-day and 26-day moving average. A 9-day moving average of this difference is used to generate signals.  When this signal line goes from negative to positive, a buy signal is generated.  When the signal line goes from positive to negative, a sell signal is generated.  MACD is best used in choppy (trendless) markets, and is subject to whipsaws (in and out rapidly with little or no profit).


MACD Example Chart


Bollinger Bands
Bollinger bands were created by John Bollinger (former FNN technical analyst, and regular guest on CNBC). Bollinger Bands are based on a moving average of the closing price. They are two standard deviations above and below the moving average. A buy signal is given when the stock price closes below the lower band, and a sell signal is given when the stock price closes above the upper band. When the bands contract, that is a signal that a big move is coming, but it is impossible to say if it will be up or down. 25

Bollinger Bands Example Chart
Sell signal

Buy signals Sometimes, the buy signals just keep coming and you can go broke!


Survey article on Indian TA practitioners
Number of Respondents 25 Most use TA along with FA and do not think volume data is superior to price Do not use time series analysis Used the same tools for individual stocks as for the market as a whole None of the TA methods beat ‘Buy and Hold’ strategy!

Leland O’Brien Case
Market existed for products capping the downside risk while retaining the upward potential of portfolio In 1981, there were no S&P 500 index futures and put option market was thin Synthetic put option requires short sale of portfolio and frequent rebalancing due to price change and this precluded rapid business growth as the clients found it to be costly 28

Leland O’Brien Case Continued…
In 1984, with the advent of S&P 500 Index Futures, the hedging strategy shifted a little wherein the client is to park a small portion of their portfolio in cash with LOR which the firm used to transact futures at a considerably reduced transaction cost and provide hedge against the market movement as against the client’s specific portfolio

Leland O’Brien Case Continued…
Since the ‘portfolio insurance’ system was not patentable, other players entered in the fray In order to compete, LOR in 1985 licensed their system to other financial services firms and this increased the assets under management manifolds Standard Portfolio Insurance contract was for a fixed period of 3 years at a cost of 3-4% of client portfolio plus a declining scale of annual fees based on asset size 30

Leland O’Brien Case Continued…
Variations in product included different periods of contracts including perpetual insurance, lower protection level in order to reduce costs, change in protection level with the market movement, protection from sudden jump in the index up to a limit For the insurance protection to work
– Price changes must be small – Futures and Stock market must be active and orderly

Case Questions
Potential Customers:
– Those funds which have outflow commitments and are extremely averse to fund value falling below a particular level – Those who are running after alphas would like to limit the risks of their portfolio within reasonable distance of the benchmark while they pursue the alphas


Portfolio Insurance
– Short on S&P 500 Index Futures and long on Treasury Bills – Matches the Put option delta at each level of stock price – Rebalancing is done at pre-specified levels of stock price change and is cash neutral for small changes – Protection is provided for very small change in stock price as for larger change, synthetic put fails to match the non-linearity of actual put option value


To make the portfolio ‘jump’ proof
– Not sufficient to make the portfolio deltaneutral, it has to be made gamma-neutral too – Gammas are small for options far in and out-of-money and large for at the money options – Since the gammas of stocks, futures and T-bills are all zeros, replicating portfolio gamma can be made zero only by adding options


Transaction Cost
– Higher the transaction cost, the more costly it is to rebalance and the optimal frequency of rebalancing will decline – Rebalancing is particularly costly for atthe-money options which have large gammas – An option’s gamma represents the change in the number of shares in replicating portfolio for a small change in stock price
• Transaction cost associated with each rebalancing = gamma x stock price x .4%

Benefit of Index Futures
– No need to disturb the original portfolio and hence the client can be spared of the task of actually creating the put – Transaction cost was much lower


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