8-behavoral finance and technical analysis

8/19/2019 8-Behavoral Finance and Technical Analysis

1/36

Comm 324 --- W. SuoSlide 1Slide 1

Behavioral finance and

technical analysis


2/36


Behavioral Finance

Limit of arbitrage

Psychology

Investors do not always process information correctly Investors often make Inconsistent or systematically

suboptimal decisions

11-211-2


3/36


!" Prices reflect value !ispricing will be corrected by arbitrageurs

Limit of #rbitrage $trategies may not be arbitrage Problems entering positions%

&orrect '( no free lunch

)o free lunch '(correct prices

Implementing costs

&ommission Bid-ask spread Price impact $hort sale costs

Fees

*olume constraints

Legal constraints

Limit of #rbitrage vs !arket fficiency


4/36


+win shares ,oyal utch ./0 and $hell .30

4nly risk is noise traders 5e should have P.,'1678P.$

vidence $upporting Limits to

#rbitrage

Inde9 inclusions $tock price :umps permanently

;67 average 9planation%


5/36


Internet carve-outs

;&4m sells 7 of Palm in IP4< and will spin off theremainder in = months

1 share of ;&om will own 167 shares of Palm P.Palm '>=7

;&om should be at least >132 But P.;&om'>?1

5hich implies ;&om e9cluding Palm ' ->/06

vidence $upporting Limits to

#rbitrage 666


6/36

Comm 324 --- W. SuoSlide 6 Slide 6

5hy% *ery few shares of Palm available to short

#rbitrage was limited

!ispricing persisted

vidence $upporting Limits to #rbitrage 666


7/36Comm 324 --- W. SuoSlide 7 Slide 7

"erding

Beliefs 4verconfidence @4ptimismA5ishful thinking

nrealistic view of personal abilitiesAprospects g6 =0 of drivers claim above average driving skill

== of freshman claim superior intelligence

,epresentativeness Law of small numbers

CamblerDs fallacy

Belief perseverance

$earch for contradictory evidence +reatment of contradictory evidence

#nchoring Initial arbitrary value and make ad:ustments

#vailability biases ,ecent or salient events

E

Psychology


8/36Comm 324 --- W. SuoSlide 8Slide 8

BarberA4dean .F< 2000 have a huge database from 1==1 to 1==/ of individual

trading #verage returns of individuals is below all sorts of benchmarks such asG portfolio they

had in the beginning of the year< market portfolio< P! benchmark< ; factor model

benchmark6 +his in net returns .H after transaction costs6 )o strong underperformance in gross

returns6 +he more you trade the worse you do .gross is higher than $@P700 the net is lower6

Excessive Trading



#nnual portfolio turnover

Excessive Trading



People avoid actions that create regret and seek

actions that cause pride

isposition effect this cause investors to be predisposed to selling winners

too early and riding losers too long

Pride and ,egret



"ouse money effect

,isk aversion and .or snake-bite effect

+rying to break even effect &oval and $humway studied the activities of proprietary traders at &B4+ in 1==? .32/ traders< and found that

they are more likely to increase their level of risk in the afternoon when they suffer losses in the morning6

ndowment effect $tatus uo

!emory and decision Cive more weight to recent memory 9ampleG

Investor buys a share in biotechnology and a share in pharmaceutical< both worth >1006 +hroughout thefollowing year< bio stock slowly declines to >J7< while the pharmaceutical stock stays at 100 and drops to

>?0 at the end of the year

$imilarly< 100 -( 127 gradually vs 100 -( 120 at the end

&ognitive dissonance Investors seek to reduce psychological pain by ad:usting their beliefs about the success of past investment choices People want to believe that their investment decisions are good6 In the face evidence of the contrary< the brainDs

defense mechanisms filter the contradictory information and alter the recollection of the decision6

&onsidering the Past



#n attempt to e9ploit recurring and predictable patterns in stock prices

+echniciansD beliefsG $hifts in market fundamentals can be discerned before their impact is fully

reflected in prices !arket fundamentals can be perturbed by irrational factors

+hese presumptions are in contradiction with the weak form of the!"

Basic termsG

*olatility Fluctuations 72-week high A low Price A trading range 4pen A closing price

+echnical #nalysis



+he ow +heory

4riginated by &harles ow Founder of the ow ones &ompany and editor of Wall Street Journal

ow +heory presumes market moves in persistent bull and bear trends 4ften used for market as a whole< but used for individual securities also

+ypes of movements defined by ow theorists Primary trends .bull or bear market $econdary trends .corrections

!arket collapses or upward surges lasting a few weeks or months +ertiary moves .little daily fluctuations

!eaningless random wiggles but should be studied to determine if relate to a primary trend

!ost ow theorists do not think a

new primary trend has been

confirmed until pattern of ascending

or descending tops occur in both

industrial and transportation

averages6



"ead and $houlders Formation

# series of reversals $upposed to signal that a securityDs price has reached a ceiling and

is e9pected to decline in the future

Left shoulderKheavy

buying increases priceto a peak before lull in

trading pushes price

downward6

&onfirmation

.breakoutKthe

price falls

below the

neckline which

is a sell signal6

"eadKa spurt of

buying activity

increases price to new

high6 +hen a lull in

trading decreases

prices to below top of

left shoulder6

,ight shoulderKa

moderate rally

increases price but not

to a new level eual to

the top of the head6



&harts !aps price performance

$heds light on supply and

demand

investment roadmapM

Price A volumerelationship important



&hart +ypes

Line &harts !ost basic of all charts

ust a line that connects the closing pricesover a time frame )o trading range

Bar &hart *ertical line represents highsAlows of the

day "oriNontal line represents closing price ,ed ' down BlueABlack ' up



&hart +ypes

&andlestick &harts *ertical line represents the trading

range

5ide bar represents open and close 5hite bar O p and closes above

opening price

,ed Bar O down Black bar O up< but closes below the

opening price



&hart Basics O +ime $cale

+ime $cale ates along bottom of chart .varies from seconds to decades

&ommon +ypesG intraday< daily< weekly< monthly

$ubtle differences between different time scales

Weekly ChartDaily Chart



*olume

#mount of shares that trade

hands between seller and

buyers Price movements more

significant when volume is

above average

Price and *olume



+rends are your Friends

+rendG general direction of stock

ptrendG higher highs< higher lows



$ometimes< trends difficult to see



+rendlines

$imply put< a line drawn on a

chart to represent the overall

trend pward trendline< connecting the

lows< represents support +wo parallel trend lines that act as areas of

support and resistance .more later

#ny break through the channel is a break ofthe trend< otherwise the price should stay in

range


23/36


$upport and ,esistance Levels

$upport level Price at which Buyers ( $ellers Floor .trough below which stock price is not e9pected to drop

emand of security is e9pected to increase

,esistance level Price at which Buyers $ellers &eiling .peak above which stock price is not e9pected to go

$upply of security is e9pected to increase

&ongestion #reas Price fluctuates

Price fluctuates in first

congestion area for a while6

Price rises through >70 resistance level

Kold resistance level becomes new

support level6


24/36

#!Q) 9ample of $upports

AMZN retraces from amonstrous rally to $60

AMZN stops tanking at$60. NOT A

COINCIDNC.


25/36

C44C $upport Psychology

!OO! skyrockets from A"#OM earnings %ut

s&oul' I %uy it((((

$)*0. I s&oul' &a+e %oug&t !OO!

O,. I-m not gonnamiss out again./ 1 $2)3

$$$$$44

CA/TION5 #upportscan %reak'on.


26/36

+! O ,esistance Psychology

I s&oul' &a+e sol'&en TM as $*7844

9inally4 $*78. I %ettersell t&is time.

#&oul' I sell(( Na I-ll

take my c&ances.


27/36

+C+ ,esistance Breakout

,$I$+#)& B&4!$

$PP4,+

B,#R4+HH


28/36


!oving #verage #nalysis

!oving averages are used to provide a smooth reference point for Individual securities !arket indices &ommodity prices Interest rates Foreign e9change rates

&ommon choicesG 70< 100< 170< 200-day moving average &hanges each day

!ost recent day is added and oldest day is dropped Following calculation is performed

70 !#t ' .1A70.*aluet S *aluet-1 S E *aluet-3=


29/36


!oving #verage #nalysis

!oving average analysts recommend buyingAselling stock ifstock price and its moving average cross path


30/36


!oving #verages .!# or 5!#

!ost popular are 70-day and 200-day

$hows the average price of the last T days and plots it on a line

4ften acts as areas of support andAor resistance


31/36


5I, O $upport U 10 5!#


32/36


&P# O $upport at 20 @ 70 !#


33/36


&P# O $upport at 20 @ 70 !#

20 !# and 70 !# becomes points of

support for this stock


34/36


$oE

&harts are fundamental to technical analysis

Important to understand what is shown on a chart

and the information it conveys

4ther technical analysis methods lliot wave

Bollinger band #nd many more


35/36


+echnical Indicators

$entiment indicators 4dd-Lot trading &onfidence Inde9 PutA&all ratio !utual fund cash position

Flow of funds indicators $hort interest O total number of shares of stock currently sold short in the market $ome technicians interpret high levels of short interest as bullish< some as bearish &redit balances in brokerage accounts

!arket structure indicators !oving averages Breadth

+he most common measure O the spread between the number of stocks that advance

and decline in price ,elative strength

+he ratio of the price of the security to a price inde9 for the industry


36/36

Folklore

9amples Buy on good news< sell on bad

Buy on rumor< sell on news Buy a stock :ust after a split to earn abnormal returns Firms wholes earning decreased relative to the market E

price fell in years preceding

Low priced stocks< low PA stocks outperform high prices< high PA stocks

8-behavoral finance and technical analysis

Documents