Lokanandha Reddy Irala / Technical Analysis 1 Technical Analysis Two Main approaches to valuing...

Lokanandha Reddy Irala / Technical Analysis 11

Technical AnalysisTechnical Analysis

Two Main approaches to valuing stocks include– Fundamental analysis– Technical analysis

Some use only technical analysis while others use both fundamental and technical analysis

Technicians focus on charts of market prices and transactions statistics– Think that these statistics will reveal all

Technicians study patterns in security prices


Theoretical FoundationTheoretical Foundation Edwards & Magee (1997) state the basic

assumptions of technical analysis– A security’s market value is based on supply and

demand– Supply and demand are based on both rational

and irrational factors– Security prices tend to move in persistent trends– Changes in trends occur due to shifts in supply

and demand– Shifts in supply and demand can be detected

using charts of market transactions– Some chart patterns tend to repeat themselves


Theoretical FoundationTheoretical Foundation

Technicians believe past patterns will recur– Therefore can be predicted

Technical analysts estimate prices– Whereas fundamental analysts estimate

value

Technicians tend to ignore issues such as a firm’s riskiness and earnings growth– Instead focus on barometers of supply and

demand


Theoretical FoundationTheoretical Foundation

Technicians claim technical analysis is– Easier– Faster– Can be applied simultaneously to more stocks than

fundamental analysis

But, does technical analysis work? Technicians argue that when using

fundamental analysis– Must wait until market realizes a stock is undervalued– Must rely on inadequate accounting statements – It is hard work– Must use ambiguous estimates of growth


The Dow TheoryThe 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


The Dow TheoryThe Dow Theory


Bar ChartsBar Charts

Represent price (high, low, close) of security over time

Each bar spans the distance from the day’s highest price to the day’s lowest price, and a small cross on each bar marking that day’s closing price


Sample Bar ChartSample Bar Chart

High

Low

Close

PricePrice

DaysDays


Bar ChartsBar Charts

S&P CNX NIFTY May 01, 2003 - Aug31, 2003

900925950975

10001025105010751100112511501175120012251250127513001325135013751400


Support and Resistance Support and Resistance LevelsLevels

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


Contrarian logic : Short Interest Contrarian logic : Short Interest

Short Interest - total number of shares that are sold short

When short sales are high : – Market is going to be Bullish

Logic : – when stock is sold short, it must be

repurchased to close out position. When short interest is high, there will be buying pressure when shorts close out their positions

Bearish market is not ruled out though – Large short sales indicate widespread

belief that stock prices will fall


Breadth of the MarketBreadth of the Market

It is possible that an index would still be raising for some time after the market for the majority of lesser known stocks have already turned down

Measuring the number of advances and declines

Net advances = # advances - # declines



Day # Adv# Dec Net BreadthMon 800 680 120 120Tue 850 720 130 250Wed 750 785 -35 215Thu 600 880 -280 -65Fri 690 756 -66 -131



Breadth statistic may become negative during a bear market

However, it is arbitrary and depends on the date the cumulative breadth series began

Only the direction and not the level of the statistic is important



B-O-M-S is compared with the Market Index

The breadth and the market Index normally move in tandem

TAs watch for the trend in breadth to diverge from the trend in Index


Relative Strength AnalysisRelative Strength Analysis

Some securities exhibit relative strength – The prices of these securities rise

relatively faster in a bull market or decline relatively more slower in a bear market

Watching the price of the security in relation to– Industry– Market



Year Security* Industry** Market***2001 300 170 21002002 360 180 25002003 720 200 2850

* Avg. Price of the security in the year **Industry Average for the year *** Avg. of the Market index for the year



Year Sec/ Ind Sec/ Mkt Ind / Mkt2001 1.76 0.14 0.082002 2.00 0.14 0.072003 3.60 0.25 0.07



Sec / Mkt

Ind / Mkt

Sec / Ind


Charting Volume of Charting Volume of Shares TradedShares 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


Charting Volume of Shares Traded Charting Volume of Shares Traded

Selling ClimaxesSelling Climaxes 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


Charting Volume of Shares Traded Charting Volume of Shares Traded

Speculative BlowoffsSpeculative 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


Moving Average AnalysisMoving 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

» M150 Pt = (1/150)(Valuet + Valuet-1 + … Valuet-149)


Moving Average AnalysisMoving Average Analysis

Moving averages computed over short time frames follow daily prices more closely– More volatile than longer-term moving averages

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


Moving Average Analysis – Moving Average Analysis – Buy Buy SignalsSignals

Moving average analysts recommend buying stock if 1. Moving average line flattens and stock

price moves up through moving average line

2. Price of stock falls (temporarily) below moving average line that is rising

3. Stock price is above moving average line, falls, turns around and rises again without penetrating moving average line


Moving Average Analysis – Moving Average Analysis – Sell Sell SignalsSignals

Moving average analysts recommend selling stock if1. Moving average line flattens and stock price

drops down through moving average line2. Stock price temporarily rises above a declining

moving average line3. 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


Moving Average AnalysisMoving Average AnalysisNIFTY 200 DAY MA :OCT 01, 2002 - AUG 31, 2003

800

900

1000

1100

1200

1300

1400

1-Sep-02 21-Oct-02 10-Dec-02 29-Jan-03 20-Mar-03 9-May-03 28-Jun-03 17-Aug-03 6-Oct-03

Closing

200 Day MASell Signal

Buy Signal

B1

B1

B3

S1S1


The Bottom LineThe Bottom Line

Technical tools are used to detect price patterns Technical analysis assumes shifts in supply and

demand occur gradually over time Price change pattern is extrapolated to predict

future price changes Many financial economists believe technical

analysis cannot predict market prices– Believe security prices are a random walk

• Occur in reaction to random arrival of new information

– Believe a series of similar independent changes in prices are coincidence

Lokanandha Reddy Irala / Technical Analysis 1 Technical Analysis Two Main approaches to valuing...

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