PRICEPATTERNS,CHARTSANDTECHNICALANALYSIS:TECHNICALANALYSIS

AswathDamodaran

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FoundationsofTechnicalAnalysis:Whataretheassumptions?

1. Priceisdeterminedsolelybytheinteractionofsupply&demand.

2. Supplyanddemandaregovernedbynumerousfactors,bothrationalandirrational.Themarketcontinuallyandautomaticallyweighsallthesefactors.

3. Disregardingminorfluctuationsinthemarket,stockpricestendtomoveintrendswhichpersistforanappreciablelengthoftime

4. Changesintrendarecausedbyshiftsindemandandsupply.Theseshiftsnomatterwhytheyoccur,canbedetectedsoonerorlaterintheactionofthemarketitself.

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TechnicalIndicators

¨ Therearehundreds(perhapsthousands)ofchartpatternsandtechnicalindicatorsthatinvestorsclaimworksatmakingthemmoney.

¨ Ratherthantrytodealwiththemindividually,wewillarguethatalltechnicalindicatorsarebuiltonthepresumptionofinvestorirrationalityonaglobalscaleandthattheycanthereforebeclassifiedonthatbasis.

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I.Marketsoverreact:TheContrarianIndicators

Basis:Researchinexperimentalpsychologysuggeststhatpeopletendtooverreacttounexpectedanddramaticnewsevents.Inrevisingtheirbeliefs,individualstendtooverweightrecentinformationandunderweightpriordata.Empiricalevidence:

(1)Extrememovementsinstockpriceswillbefollowedbysubsequentpricemovementsintheoppositedirection.(2)Themoreextremethepriceadjustment,thegreaterwillbethesubsequentadjustment

Issues:(1) Why,ifthisistrue,isisthatcontrarianinvestorsaresofewin

numberormarketpowerthattheoverreactiontonewinformationisallowedtocontinueforsolong?

(2) Isthemarketmoreefficientaboutincorporatingsometypesofinformationthanothers?

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Technicaltradingrules:ContrarianOpinion

1. Odd-lottrading:Theodd-lotrulegivesusanindicationofwhatthemanonthestreetthinksaboutthestock(Ashegetsmoreenthusiasticaboutastockthisratiowillincrease).

2. MutualFundCashpositions:Historically,theargumentgoes,mutualfundcashpositionshavebeengreatestatthebottomofabearmarketandlowestatthepeakofabullmarket.Henceinvestingagainstthisstatisticmaybeprofitable.

3. InvestmentAdvisoryopinion:Thisistheratioofadvisoryservicesthatarebearish.Whenthisratioreachesthethreshold(eg 60%)thecontrarianstartsbuying.

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II.DetectingshiftsinDemand&Supply:TheLessonsinPricePatterns

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ShiftIndicators

1. Breadthofthemarket:Thisisameasureofthenumberofstocksinthemarketwhichhaveadvancedrelativetothosethathavedeclined.Amarketadvancewithlessbreadthisanindicationofademandshift(down).

2. Support&ResistanceLines:Ifeitherisbroken,themarketispoisedforamajormove.

3. Movingaverages:Amovingaveragelinesmooths outfluctuationsandenablesthechartisttoseetrendsinthestockprice.Howthattrendisinterpretedthendependsuponthechartist.

4. Volumeshifts:Sometechnicalanalystsbelievethatthereisinformationaboutfuturepricechangesintradingvolumeshifts.

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PriceFeedbackloops

¨ Whilethenotionofsupport/resistancelinesorpriceleveltargets(baseduponthepastorarbitraryroundnumbers)seemsfarfetched,thereisanargumenttobemadethathittingtheselevelscanhavefeedbackeffects,whichcanbepositiveornegative:¤ Thepositive:Itispossiblethathittingthespecifiedpricelevelcanaddtothemomentumonthestock,causingupward(downward)movingstockstomoveup(down)evenmore.

¤ Thenegative:Inanalternatestory,hittingthespecifiedpricelevelcanleadinvestorstoreassessthecompany’svalue,andcorrectoverreach,pushingpricesbackdown(up),iftheyhavewanderedwayabove(below)value.

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III.Marketlearnslowly:TheMomentumInvestors

¨ Basis:Theargumenthereisthatmarketslearnslowly.Thus,investorswhoarealittlequickerthanthemarketinassimilatingandunderstandinginformationwillearnexcessreturns.Inaddition,ifmarketslearnslowly,therewillbepricedrifts(i.e.,priceswillmoveupordownoverextendedperiods)andtechnicalanalysiscandetectthesedriftsandtakeadvantageofthem.

¨ TheEvidence:Thereisevidence,albeitmild,thatpricesdodriftaftersignificantnewsannouncements.Forinstance,followinguponpricechangesafterlargeearningssurprisesprovidesthefollowingevidence.

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MomentumIndicators

1. RelativeStrength:Therelativestrengthofastockistheratioofitscurrentpricetoitsaverageoveralongerperiod(eg.sixmonths).Therulesuggestsbuyingstockswhichhavethehighestrelativestrength(whichwillalsobethestocksthathavegoneupthemostinthatperiod).

2. TrendLines:Youlookpasttheday-to-daymovementsinstockpricesattheunderlyinglong-termtrends.Thesimplestmeasureoftrendisatrendline.

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TradingVolume:Thetechnicalanalyst’ssecretweapon

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IV.FollowingtheSmartInvestors:TheFollowers

• Thisapproachistheflipsideofthecontrarianapproach.Insteadofassumingthatinvestors,onaverage,arelikelytobebewrong,youassumethattheyareright.

• Tomakethisassumptionmorepalatable,youdonotlookatallinvestorsbutonlyatthesmartestinvestors,whopresumablyknowmorethantherestofus.

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SmartInvestorIndicators

1. Specialistshortsales:Theassumptionisthatspecialistshavemoreinformationaboutfuturepricemovementsthanotherinvestors.Investorswhousethisindicatorwilloftensellstockswhenspecialistsdo,andbuywhentheydo.

2. Insiderbuying/selling:Theratioofinsiderbuyingtosellingisoftentrackedforstockswiththeideathatinsiderswhoarebuyingmusthavepositiveinformationaboutastockwhereasinsiderswhoaresellingarelikelytohavenegativeinformation.

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V.Marketsarecontrolledbyexternalforces:TheMystics

¨ TheElliotWave:Elliot'stheoryisthatthemarketmovesinwavesofvarioussizes,fromthoseencompassingonlyindividualtradestothoselastingcenturies,perhapslonger."Byclassifyingthesewavesandcountingthevariousclassificationsitispossibletodeterminetherelativepositionsofthemarketatalltimes"."Therecanbenobullofbearmarketsofone,sevenorninewaves,forexample.

¨ TheDowTheory:"Themarketisalwaysconsideredashavingthreemovements,allgoingatthesametime.Thefirstisthenarrowmovement(dailyfluctuations)fromdaytoday.Thesecondistheshortswing(secondarymovements)runningfromtwoweekstoamonthandthethirdisthemainmovement(primarytrends)coveringatleastfouryearsinitsduration.

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DeterminantsofSuccessatTechnicalAnalysis

1. Behavioralbasis:Ifyoudecidetouseachartingpatternortechnicalindicator,youneedtobeawareoftheinvestorbehaviorthatgivesrisetoitssuccess.Youcanmodifyorabandontheindicatoriftheunderlyingbehaviorchanges.

2. Don’ttrust,verify:Itisimportantthatyouback-testyourindicatortoensurethatitdeliversthereturnsthatarepromised.Inrunningthesetests,youshouldpayparticularattentiontothevolatilityinperformanceovertimeandhowsensitivethereturnsaretoholdingperiods.

3. Timelytrading:Theexcessreturnsonmanyofthestrategiesthatwedescribedinthischapterseemtodependupontimelytrading.Tosucceedatsomeofthesestrategies,youmayneedtomonitorpricescontinuously,lookingforthepatternsthatwouldtriggertrading.

4. Goldilockstimehorizons:Buildingonthethemeoftimehorizons,successatchartingcanbeverysensitivetohowlongyouholdaninvestment.

5. Controltradingcosts:Thestrategiesthatcomefromtechnicalindicatorsaregenerallyshort-termstrategiesthatrequirefrequentandtimelytrading.Notsurprisingly,thesestrategiesalsogeneratelargetradingcoststhatcanveryquicklyeatintoanyexcessreturnsyoumayhave.