Course Name: Analysis of Financial Investment
Chapter 16 : Technical Analysis
Technical Analysis
Technical analysis involves the examination of past
market data such as price and the volume of trading,
which leads to an estimate of future price trends, and
therefore, an investment decision.
The technical analysis believes that using data from the
market itself it is a good idea because the market is its
own best predictor
Technical analysis is an alternative method of making
the investment decision and answering the questions:
i) what securities should an investor
buy or sell?
ii) when should these investment be
made?
Technical analysts develop technical trading rules from
observations of past price movements of the stock
market and individual stocks.
Technical Analysis differ from Fundamental
Analysis
In fundamental analysis past performance has no influence
on future performance or market values.
Fundamental analysis which involved making investment
decisions based on the examination of the economy, an
industry and company variables that lead to an estimate of
value for an investment but;
The technical analysis see no need to study the multitude of
economic, industry and company variables to arrive at an
estimate of future value because they believe that past price
movement will signal future price movements.
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.
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 itself.
Advantages of Technical Analysis
Not heavily dependent on financial accounting
statements
Problems with accounting statements:
1. Lack of information needed by security analysts
2. GAAP allows firms to select reporting
procedures, resulting in difficulty comparing
statements from two firms
3. Non-quantifiable factors do not show up in
financial statements
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
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
Patterns may become self-fulfilling prophecies
A successful rule will gain followers and become less
successful
Rules require a great deal of subjective judgment
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
Typical Stock Market Cycle
Stock Exhibit 16.2
Price
Typical Stock Market Cycle
Stock Exhibit 16.2
Price
Declining Peak
Trend
Channel Flat Trend Channel
Sell Point
Rising Trend
Channel Declining
Buy Point Trend Buy Point
Trough
Trough Channel
Technical Trading Rules and Indicators
Technical trading rules used by analysts into four
sections based on the attitude by technical analysts.
1. Like to trade against the crowd using contrary opinion
signals.
2. Attempt to emulate astute investors that is smart money.
3. Technical indicators that are very popular but not easily
classified.
4. Covers pure price and volume techniques including
Dow Theory.
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
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
Follow the Smart Money
Indicators showing behavior of sophisticated investors
The Barrons Confidence Index
T-Bill - Eurodollar yield spread
Short sales by specialists
Debit balances in brokerage accounts (margin debt)
Other Market Indicators
Breadth of market
Advance-decline
Diffusion index
Short interest
Stocks above their 200-day moving average
Block uptick-downtick ratio
Stock Price and Volume Techniques
The Dow theory oldest technical trading rule
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
Stock Price and Volume Techniques
Relative-strength (RS) ratios
For individual stocks and industry groups
Bar charting
Multiple indicator charts
Point-and-figure charts
Overall feel from a consensus of numerous technical
indicators
Technical Analysis of Foreign Markets
When analyzing non U.S. markets many techniques are
limited to price and volume data rather than the more
detailed U.S. market information because the more
detailed information that is more available on the U.S.
market through the SEC, stock exchange, the Nasdaq
system and various investment services is not always
available in other countries.
Foreign Stock Market Series
Technical analysts prepared separate publications for
individual countries such as Japan, Germany and the UK
as well as a summary of all world markets and
commented used on various term for those markets.
Technical Analysis of Foreign Exchange
Rate
On numerous reasons we have discuss the important of
changes in foreign exchange rates on the rates of return
on foreign securities.
Technical Analysis of Bond Markets
Technical analysis of bonds are the same as for the stock, and many
of the same trading rules are used. A major difference is that it is
generally not possible to consider the volume of trading of bonds
because most bonds are traded OTC, where volume is not reported.
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