Post on 25-Dec-2015
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Technical AnalysisTechnical Analysis
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An attempt to exploit recurring and predictable patterns in stock prices
Technicians’ beliefs: Shifts in market fundamentals can be discerned before
their impact is fully reflected in prices Market fundamentals can be perturbed by irrational
factors These presumptions are in contradiction with the
weak form of the EMH
Technical Analysis
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The Dow Theory
Originated by Charles Dow Founder of the Dow Jones Company and editor of Wall Street Journal
Dow Theory presumes market moves in persistent bull and bear trends Often used for market as a whole, but used for individual securities also
Types of movements defined by Dow theorists Primary trends (bull or bear market) Secondary trends (corrections)
Market collapses or upward surges lasting a few weeks or months Tertiary moves (little daily fluctuations)
Meaningless random wiggles but should be studied to determine if relate to a primary trend
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The Dow Theory
Most Dow theorists do not think a new primary trend has been confirmed until pattern of ascending or descending tops occur in both industrial and transportation averages.
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Head and Shoulders Formation
A series of reversals Supposed to signal that a security’s price has reached a ceiling and
is expected to decline in the future
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Head and Shoulders Formation
Left shoulder—heavy buying
increases price to a peak before lull in trading pushes price downward.
Head—a spurt of buying activity
increases price to new high. Then a
lull in trading decreases prices to below top of left shoulder.
Right shoulder—a moderate rally increases price
but not to a new level equal to the top of the head.
Confirmation (breakout)—the price falls below
the neckline which is a sell
signal.
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Other Patterns
Numerous patterns have been described by technicians, such as
Triangles Pennants Flags Channels Rectangles Double tops Triple tops Wedge formations Diamonds See http://www.marketscreen.com/help/chartpatterns/
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Triangles
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Flags Pennants
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Rectangles
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Wedge
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Charting Volume of Shares Traded
Technicians argue volume measures the intensity of investor’s feelings
Volume is studied in conjunction with prices Technicians analyze resistance and support levels
along with volume
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Support and Resistance Levels
Resistance level Ceiling (peak) above which stock price is
not expected to go Supply of security is expected to increase
Support level Floor (trough) below which stock price is
not expected to drop Demand of security is expected to
increase
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Support and Resistance Levels
Suppose the following occurred Moderate surge in trading volume at Point A Larger surge in trading volume at Point B
3 times greater than surge at Point A May surmise that some bullish new information
caused buying pressure at Point B which overcame the previous resistance at Point A
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Congestion Areas
Technicians are unable to offer reasons for price actions like this
Penetrating support line means sell Penetrating resistance line means buy
Studies examining trading range breakouts find that, after deducting commissions, return was slightly larger than riskless interest rate
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Congestion Areas
Price fluctuates in first congestion area for a while.
Price rises through $50 resistance level—old resistance level
becomes new support level.
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Selling Climaxes and Speculative Blowoffs
When supply and demand are out of balance (price is moving) volume is watched closely
Market is bullish when high volume is combined with a rising price Market is bearish with high volume and falling prices
Falling prices and high volume are considered bullish if a selling climax occurs
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Selling Climaxes and Speculative Blowoffs
If one believes the end of bear market is near and high volume occurs
Means last of bearish investors are liquidating their holdings Clears the way for bullish investors to start bidding up price
A speculative blowoff marks the end of a bull market High volume pushes prices to peak
Exhausts bullish speculators enthusiasm, enabling bearish market to begin
A bull dies with a bang, not a whimper
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Point and figure charts The figure has no time dimension It traces significant upward or downward moves in
stock prices
Candlestick charts Used to summarize price data Aid in identification of trends
Other Charting Techniques
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Sentiment indicators Flow of funds indicators Market structure indicators
Technical Indicators
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Trin statistic
Sentiment indicators
or:
Number advancing/Number decliningTrin=
Volume advancing/Volume declining
Volume declining/Number decliningTrin=
Volume advancing/Number advancing
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Odd-Lot trading Confidence Index Put/Call ratio Mutual fund cash position
Sentiment Indicators (cont’d)
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Short interest – total number of shares of stock currently sold short in the market Some technicians interpret high levels of short interest
as bullish, some as bearish
Credit balances in brokerage accounts
Flow of Funds Indicators
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Moving averages Breadth
The most common measure – the spread between the number of stocks that advance and decline in price
Relative strength The ratio of the price of the security to a price index for
the industry
Market Structure Indicators
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Moving Average Analysis
Moving averages are used to provide a smooth reference point for
Individual securities Market indices Commodity prices Interest rates Foreign exchange rates
Some use a 150-day (30 week) moving average Changes each day
Most recent day is added and oldest day is dropped Following calculation is performed
M150DAPt = (1/150)(Valuet + Valuet-1 + … Valuet-149)
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Moving Average Analysis
Moving averages computed over short time frames follow daily prices more closely
Technicians analyze difference between daily price and moving average If daily prices penetrate moving average line it is a signal to take action
If daily price moves down through a moving average, price fails to rise for many months
Sell signal If daily prices are above moving average but difference is narrowing
Signals end of bull market may be near
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Moving Average Analysis
Moving average analysts recommend buying stock if Moving average line flattens and stock price moves up
through moving average line Price of stock falls (temporarily) below moving average
line that is rising Stock price is above moving average line, falls, turns
around and rises again without penetrating moving average line
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Moving Average Analysis
Moving average analysts recommend selling stock if Moving average line flattens and stock price drops down through
moving average line Stock price temporarily rises above a declining moving average line Stock price falls through moving average line and turns around only
to fall again without penetrating above moving average line Strategy is more successful if moving average is calculated
over a longer time frame
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Self-destructing patterns Once a useful technical rule is discovered, it ought to
be invalidated once the mass of traders attempts to exploit it
A new view of technical analysis Brown and Jennings propose a more complex
framework than the EMH They envision an economy where many investors have
private information regarding the value of a stock
Can Technical Analysis Work?
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Folklore Examples
Buy on good news, sell on bad Buy on rumor, sell on news Buy a stock just after a split to earn abnormal returns Firms wholes earning decreased relative to the market …
price fell in years preceding Low priced stocks, low P/E stocks outperform high
prices, high P/E stocks