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    Price Pa) Erns, Charts and Technical Analysis: Technical Analysis

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    satish s
    This document discusses the key assumptions and indicators of technical analysis. It examines four main foundations of technical analysis: 1) price is determined by supply and demand, 2) supply and demand are influenced by rational and irrational factors automatically weighed by the market, 3) stock prices tend to move in trends that persist for some time, and 4) shifts in trends can be detected in market action. It then analyzes contrarian indicators, techniques for detecting shifts in demand and supply like breadth and moving averages, momentum investing based on markets learning slowly, and specific momentum indicators like relative strength and trend lines.

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    Price Pa) Erns, Charts and Technical Analysis: Technical Analysis

    Uploaded by

    satish s
    16 views13 pages
    This document discusses the key assumptions and indicators of technical analysis. It examines four main foundations of technical analysis: 1) price is determined by supply and demand, 2) supply and demand are influenced by rational and irrational factors automatically weighed by the market, 3) stock prices tend to move in trends that persist for some time, and 4) shifts in trends can be detected in market action. It then analyzes contrarian indicators, techniques for detecting shifts in demand and supply like breadth and moving averages, momentum investing based on markets learning slowly, and specific momentum indicators like relative strength and trend lines.

    Original Description:

    trading notes

    Original Title

    Session 11

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    This document discusses the key assumptions and indicators of technical analysis. It examines four main foundations of technical analysis: 1) price is determined by supply and demand, 2) supply and demand are influenced by rational and irrational factors automatically weighed by the market, 3) stock prices tend to move in trends that persist for some time, and 4) shifts in trends can be detected in market action. It then analyzes contrarian indicators, techniques for detecting shifts in demand and supply like breadth and moving averages, momentum investing based on markets learning slowly, and specific momentum indicators like relative strength and trend lines.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    16 views13 pages

    Price Pa) Erns, Charts and Technical Analysis: Technical Analysis

    Uploaded by

    satish s
    This document discusses the key assumptions and indicators of technical analysis. It examines four main foundations of technical analysis: 1) price is determined by supply and demand, 2) supply and demand are influenced by rational and irrational factors automatically weighed by the market, 3) stock prices tend to move in trends that persist for some time, and 4) shifts in trends can be detected in market action. It then analyzes contrarian indicators, techniques for detecting shifts in demand and supply like breadth and moving averages, momentum investing based on markets learning slowly, and specific momentum indicators like relative strength and trend lines.

    Copyright:

    © All Rights Reserved
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    Download as pdf or txt
    of 13

    Price

    pa)erns, charts and technical


    analysis: Technical Analysis
    Aswath Damodaran

    Founda;ons of Technical Analysis:


    What are the assump;ons?
    1.
    2.

    3.

    4.

    Price is determined solely by the interac;on of supply & demand


    Supply and demand are governed by numerous factors both ra;onal and
    irra;onal. The market con;nually and automa;cally weighs all these
    factors. (A random walker would have no qualms about this assump;on
    either. He would point out that any irra;onal factors are just as likely to
    be one side of the market as on the other.)
    Disregarding minor uctua;ons in the market, stock prices tend to move
    in trends which persist for an appreciable length of ;me. ( Random
    walker would disagree with this statement. For any trend to persist
    there has to be some collec;ve 'irra;onality')
    Changes in trend are caused by shiSs in demand and supply. These shiSs
    no ma)er why they occur, can be detected sooner or later in the ac;on
    of the market itself. (In the nancial economist's view the market,
    through the price, will instantaneously reect any shiSs in the demand
    and supply.)

    I. Markets overreact: The Contrarian


    Indicators
    Basis: Research in experimental psychology suggests that people tend
    to overreact to unexpected and drama;c news events. In revising their
    beliefs, individuals tend to overweight recent informa;on and
    underweight prior data.
    Empirical evidence:
    (1) Extreme movements in stock prices will be followed by subsequent
    price movements in the opposite direc;on.
    (2) The more extreme the price adjustment, the greater will be the
    subsequent adjustment

    Issues:

    (1) Why, if this is true, is is that contrarian investors are so few in


    number or market power that the overreac;on to new informa;on
    is allowed to con;nue for so long?
    (2) Is the market more ecient about incorpora;ng some types of
    informa;on than others?

    Technical trading rules: Contrarian


    Opinion
    1. Odd-lot trading: The odd-lot rule gives us an indica;on of
    what the man on the street thinks about the stock (As he
    gets more enthusias;c about a stock this ra;o will
    increase).
    2. Mutual Fund Cash posi;ons: Historically, the argument
    goes, mutual fund cash posi;ons have been greatest at
    the bo)om of a bear market and lowest at the peak of a
    bull market. Hence inves;ng against this sta;s;c may be
    protable.
    3. Investment Advisory opinion: This is the ra;o of advisory
    services that are bearish. When this ra;o reaches the
    threshold (eg 60%) the contrarian starts buying.

    II. Detec;ng shiSs in Demand &


    Supply: The Lessons in Price Pa)erns

    ShiS Indicators
    1. Breadth of the market: This is a measure of the number of
    stocks in the market which have advanced rela;ve to
    those that have declined. A market advance with less
    breadth is an indica;on of a demand shiS (down).
    2. Support & Resistance Lines: If either is broken, the
    market is poised for a major move.
    3. Moving averages: A moving average line smooths out
    uctua;ons and enables the char;st to see trends in the
    stock price. How that trend is interpreted then depends
    upon the char;st.
    4. Volume shiSs: Some technical analysts believe that there
    is informa;on about future price changes in trading
    volume shiSs.

    III. Market learn slowly: The


    Momentum Investors
    Basis: The argument here is that markets learn slowly.
    Thus, investors who are a li)le quicker than the market
    in assimila;ng and understanding informa;on will earn
    excess returns. In addi;on, if markets learn slowly,
    there will be price driSs (i.e., prices will move up or
    down over extended periods) and technical analysis
    can detect these driSs and take advantage of them.
    The Evidence: There is evidence, albeit mild, that
    prices do driS aSer signicant news announcements.
    For instance, following up on price changes aSer large
    earnings surprises provides the following evidence.

    Momentum Indicators
    1. Rela;ve Strength: The rela;ve strength of a
    stock is the ra;o of its current price to its
    average over a longer period (eg. six months).
    The rule suggests buying stocks which have the
    highest rela;ve strength (which will also be the
    stocks that have gone up the most in that
    period).
    2. Trend Lines: You look past the day-to-day
    movements in stock prices at the underlying
    long-term trends. The simplest measure of trend
    is a trend line.

    Trading Volume: The technical


    analysts secret weapon

    IV. Following the Smart Investors: The


    Followers
    This approach is the ip side of the contrarian
    approach. Instead of assuming that investors, on
    average, are likely to be be wrong, you assume
    that they are right.
    To make this assump;on more palatable, you do
    not look at all investors but only at the smartest
    investors, who presumably know more than the
    rest of us.

    Smart Investor Indicators


    1. Specialist short sales: The assump;on is that
    specialists have more informa;on about future
    price movements than other investors. Investors
    who use this indicator will oSen sell stocks
    when specialists do, and buy when they do.
    2. Insider buying/selling: The ra;o of insider
    buying to selling is oSen tracked for stocks with
    the idea that insiders who are buying must have
    posi;ve informa;on about a stock whereas
    insiders who are selling are likely to have
    nega;ve informa;on.

    V. Markets are controlled by external


    forces: The Mys;cs
    The Elliot Wave: Elliot's theory is that the market moves in
    waves of various sizes, from those encompassing only
    individual trades to those las;ng centuries, perhaps longer.
    "By classifying these waves and coun;ng the various
    classica;ons it is possible to determine the rela;ve
    posi;ons of the market at all ;mes". "There can be no bull
    of bear markets of one, seven or nine waves, for example.
    The Dow Theory:" The market is always considered as
    having three movements, all going at the same ;me. The
    rst is the narrow movement (daily uctua;ons) from day
    to day. The second is the short swing (secondary
    movements) running from two weeks to a month and the
    third is the main movement (primary trends) covering at
    least four years in its dura;on.

    Determinants of Success at Technical


    Analysis
    1.
    2.

    3.

    4.
    5.

    Behavioral basis: If you decide to use a char;ng pa)ern or technical indicator,


    you need to be aware of the investor behavior that gives rise to its success. You
    can modify or abandon the indicator if the underlying behavior changes.
    Dont trust, verify: It is important that you back-test your indicator to ensure that
    it delivers the returns that are promised. In running these tests, you should pay
    par;cular a)en;on to the vola;lity in performance over ;me and how sensi;ve
    the returns are to holding periods.
    Timely trading: The excess returns on many of the strategies that we described
    in this chapter seem to depend upon ;mely trading. To succeed at some of these
    strategies, you may need to monitor prices con;nuously, looking for the pa)erns
    that would trigger trading.
    Goldilocks ;me horizons: Building on the theme of ;me horizons, success at
    char;ng can be very sensi;ve to how long you hold an investment.
    Control trading costs: The strategies that come from technical indicators are
    generally short-term strategies that require frequent and ;mely trading. Not
    surprisingly, these strategies also generate large trading costs that can very
    quickly eat into any excess returns you may have.

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