09.technical analysis

8/10/2019 09.Technical Analysis

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Technical Analysis and Profit

Advantages

Dr. Rahul Singh


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Background

Main approaches to valuing stocks include Risk-return analysis

Fundamental analysis

Technical analysis

Some technicians use only technical analysiswhile others use both fundamental and technicalanalysis

Technicians (chartists) focus on charts of market

prices and transactions statistics Think that these statistics will reveal all

Technicians study patterns in security prices


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Theoretical Foundation

Edwards & Magee (1997) state the basic assumptions of technicalanalysis A securitys 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 markettransactions

Some chart patterns tend to repeat themselves

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 firms riskiness and

earnings growth Instead focus on barometers of supply and demand


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Dow Theory

Originated by Charles Dow Founder of the Dow Jones Company and founder of Wall Street

Journal

Dow Theory presumes market moves in persistent bulland 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 ifrelate to a primary trend


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Continued

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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Testing the DOW Theory

Results indicate forecasts based on 4discernable patterns Recent downward trends in index are sell signals

index falls from recent peaks are sell signals

Recent upward trends in index are buy signals

Recoveries from recent declines in index are buysignals

When a buy or neutral signal was detected, ahypothetical portfolio is fully invested in index

When a sell signal was detected, a hypotheticalportfolio is fully invested in cash


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Support and Resistance Levels

Resistance level

Ceiling (peak) above which stockprice is not expected to go

Supply of security is expected toincrease

Support level

Floor (trough) below which stock priceis not expected to drop

Demand of security is expected toincrease

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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Support is the price level at which demand is thought tobe strong enough to prevent the price from decliningfurther. Support levels are usually below the currentprice.

Resistance is the price level at which selling is thought tobe strong enough to prevent the price from rising further.


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Congestion Area 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 riskfree interest rate

Price fluctuates in

first congestion

area for a while.

Price rises through 50 resistancelevelold resistance level

becomes new support level.


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Relative Strength Index (RSI)

The RSI compares the magnitude of a stock's recent gainsto the magnitude of its recent losses and turns thatinformation into a number that ranges from 0 to 100

Stocks which score high on the relative strength

measure are considered good investments. Wilder recommended using 70 and 30 and overbought and

oversold levels respectively. Generally, if the RSI risesabove 30 it is considered bullish for the underlying stock.Conversely, if the RSI falls below 70, it is a bearish signal.

Some traders identify the long-term trend and then useextreme readings for entry points. If the long-term trend isbullish, then oversold readings could mark potential entrypoints.


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Formulae


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It is important to remember that the Average Gain and Average Loss are not

true averages! Instead of dividing by the number of gaining (losing) periods,

total gains (losses) are always divided by the specified number of time periods -

14 in this case.


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Moving Average Analysis

Moving averages are used to provide a smoothreference 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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Continued

Moving averages computed over short timeframes 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


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Continued

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 risesagain without penetrating moving average line

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 alonger time frame


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Serial Correlation

Serial correlation measures the correlation betweenprice changes in consecutive time periods

Measure of how much price change in any perioddepends upon price change over prior time period.

0: imply that price changes in consecutive time periods areuncorrelated with each other

>0: evidence of price momentum in markets (buying afterperiods with positive returns and selling after periods withnegative returns )


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Continued Serial correlations in most markets is small,it is unlikely that

there is enough correlation to generate excess returns.

The serial correlation in short period returns is also affected byprice measurement issuesand the market micro-structurecharacteristics. Non-tradingin some of the components of the index can create a

carry-over effectfrom the prior time period, this can result in positiveserial correlationin the index returns.

The bid-ask spreadcreates a bias in the opposite direction, iftransactions prices are used to compute returns, since prices have aequal chance of ending up at the bid or the ask price. The bounce thatthis induces in prices will result in negative serial correlationsinreturns.

Bid-Ask Spread = Square root of (Serial Covariance in returns)

(where the serial covariance in returns measures the covariance betweenreturn changes in consecutive time periods)


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Filter Rule

In a filter rule, an investor buys an investmentif the price rises X% from a previous low andholds the investment until the price dropsX% from a previous high.

The magnitude of the change (X%) that triggersthe trades can vary from filter rule to filter rule.

with smaller changes resulting in moretransactions per period and higher transactionscosts.


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Illustration of Filter Rule

price changes are seriallycorrelated and that there is

price momentum


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January Effect

Returns in January are significantly higher thanreturns in any other month of the year.

The January effect is much more accentuated

for small firmsthan for larger firms.


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Week End Effect

Monday effect is really a weekend effectsince the bulk of the negativereturns is manifested in the Friday close to Monday open returns.The returns from intraday returns on Monday are not the culprits increating the negative returns.

Monday effect is worse for small stocksthan for larger stocks.

Monday effect is no worse following three-day weekendsthan two-day weekends.


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New of the Today's

Artificial Intelligence: Software systems thatattempt to replicate aspects of humanintelligence.

Expert System: Computerized decision-making

technique that embodies knowledge gleanedfrom experts.

Neural Network: Tries to mimic human brainprocessesand learns from mistakesit makes.

Chaos Theory: Holds that seemingly randomevent s actually have patternsthat computerscan detect.

09.technical analysis

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