technical analysis

Quantitative Methods

Technical Analysis

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA

Institute. Reproduced and republished with permission from CFA Institute.

All rights reserved.

Contents

1. Introduction

2. Technical Analysis: Definition and Scope

3. Technical Analysis Tools

4. Elliot Wave Theory

5. Intermarket Analysis

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1. Introduction

• Technical analysis has historically been used by analysts and traders; now has also gained acceptance among regulators and the academic community

• We will study the main tools used in technical analysis

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2. Technical Analysis: Definition and Scope

Technical analysis is a form of security analysis

• Uses price and volume data which is often graphically displayed

• Does not require detailed knowledge of underlying instrument

• Objective is to make a buy/sell/hold decision

Technical data means price and volume trends

Underlying logic of technical analysis

• Supply and demand determine prices

• Changes in supply and demand cause changes in prices

• Prices can be projected with charts and other technical tools

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2.1 Principles and Assumptions

• Technical analysis can be thought of as the study of collective investor psychology or sentiment

• Human behavior is driven by emotion not always rational

• Market trends reflect irrational behavior not necessarily efficient

• Technicians rely on patterns/trends to predict future security prices

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Graphical Depiction

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Knowledge and Sentiment of:• Investors• Hedgers• Insiders• Other Stakeholders

Trades Price and Volume

Study data to gauge sentiment

Predict the trend/pattern

Make a decision

Technical and Fundamental Analysis

Technical Analysis

• Analyze markets and trading of financial instruments

• Well defined price and volume data

• Practical

• Limited to studying market trends and ignore other predictive analytical methods

• Identify market moves only after they are underway

Fundamental Analysis

• Much broader field covering all factors which might impact security prices

• Large amounts of objective and subjective information

• Theoretical

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Both methods are useful but approach markets in different ways

3. Technical Analysis Tools

• Charts

• Trend

• Chart Patterns

• Technical Indicators

• Cycles

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3.1 Charts

• Types of Charts:

Line

Bar

Candle stick

Point and figure

• Relative Strength Analysis

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Line Chart

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Simple graphical display of price trends over timeOne data point per time interval

Bar Chart


A bar has chart four data points in each entry:1. Opening Price2. Closing Price3. High Price4. Low Price

Source: forex-trade-strategies.com

Time

Pri

ce

http://forex-trade-strategies.com/

Candle Stick Chart


Each candle has two elements: body and wick/shadowWhite body means market closed UPClose > OpenDark body means market closed DOWNClose < Open

Source: TradeStation

Price moves more visible compared to bar chart faster analysis

Point and Figure Chart


X-axis: number of changes in direction

Time and volume are not presentedFocus is on price changes

x = increase in price

o = decrease in price

Box size = $1

Reversal size = $3 (new column only if there is a reversal of 3 or more)

Price

20

15

Relative Strength Analysis


Price

Time

Used to compare performance of a particular asset with that of a benchmark

Stock A/S&P500

Stock B/S&P500

3.2 Trend


Market participants often display a ‘herd mentality’ trends stay in place for some time

Uptrend: reaching higher highs and retracing to higher lows

Trend line for uptrend: touches the lows

Downtrend: lower highs and lower lows

Trend line for downtrend: touches the highs

http://www.getaforexlife.com

Trends: Support, Resistance and Polarity


• Support: low price range in which buying activity is sufficient to stop the decline in price

• Resistance: high price range in which selling activity is sufficient to

• Change in polarity: once support level is breached it becomes a resistance level;once resistance level is breached it becomes support level Time

Pri

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3.3 Chart PatternsChart patterns are formations that create a recognizable shape; common patterns appear repeatedly and lead to similar subsequent price movements

• Reversal Patterns Head and Shoulders

Inverse Head and Shoulders

Double Tops and Bottoms

Triple Tops and Bottoms

• Continuation Patterns Triangles

Rectangles

Flags and Pennants


Head and Shoulders Pattern


Price target = Neckline – (Head - Neckline)

Time

Pri

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Neckline

Shoulder Shoulder

Head

Inverse Head and Shoulders Pattern


Price target = Neckline + (Neckline - Head)

Time

Pri

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Neckline

Shoulder Shoulder

Head

Double/Triple Tops and Bottoms


Double bottom pattern

Triple top pattern

Pri

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Time

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Time

Continuation PatternsContinuation pattern is used to predict the resumption of a market trend that was in place prior to the formation of a pattern

Supply/demand: change in ownership from one group to another

• Triangles

• Rectangles

Flags and pennants are minor continuation patterns because they form over short periods of time – on a daily price chart typically over a week


Triangle Patterns


Pri

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Time

Pri

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Time

Pri

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Time

Ascending Triangle

Descending TriangleSymmetric Triangle

Rectangle Patterns


Pri

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Time

Pri

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Time

Bullish Rectangle Bearish Rectangle

3.4 Technical Indicators

• Price Based Indicators

Moving average lines

Bollinger bands

• Momentum Oscillators

Momentum or Rate of Change Oscillator

Relative Strength Index

Stochastic Oscillator

Moving-Average Convergence Divergence (MACD) Oscillator


• Sentiment Indicators

Opinion Polls

Calculated Statistical Indices

• Flow-of-Funds Indicators

Arms Index

Margin Debt

Mutual Fund Cash Position

New Equity Issuance

Secondary Offerings

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Price-Based Indicators: Moving Average


Price-based indicators incorporate information contained in current and past history of market prices.A moving average is the average of the closing price of a security over a specified number of periods

Source: finance.yahoo.com

Golden cross: short-term moving average crosses from underneath a longer term moving average. Bullish sign.

Dead cross: short-term moving average crosses from above a longer-term moving average. Bearish sign.

Price-Based Indicators: Bollinger Bands


Bollinger Bands consist of a moving average plus a higher line representing a set number of standard deviations and lower line representing a set number of standard deviations

Source: support2.dundas.com

High stock volatility leads to a wider band

Bollinger Bands can be used to create trading strategies such as a contrarian strategy

Contrarian strategy: Sell at upper band and buy at lower band

http://support2.dundas.com/onlinedocumentation/winchart2003/Bollinger.html

Momentum Oscillators• Momentum oscillators help determine whether change in market sentiment

is out of the ordinary

• Oscillators are indicators based on market prices; oscillate around a given value or between two values

• Convergence: oscillator shows same pattern as prices; suggests price trend will continue

• Divergence: oscillator shows different pattern from price; implies change in price trend

• There are many types of oscillators: Rate of Change Oscillator (ROC)

Relative Strength Index (RSI)

Stochastic Oscillator

Moving-Average Convergence/Divergence Oscillator (MACD)


Momentum or Rate of Change (ROC) Oscillator


M = 100 * (V – Vx)

where

M = momentum oscillator (ROC) valueV = last closing priceVx = closing price x days ago, typically 10 days

If ROC oscillator crosses into positive territory during an uptrend this is a buy signalIf ROC oscillator crosses into negative territory during an downtrend this is a sell signal

Alternate method: M = 100 * (V / Vx)ROC value oscillates around 100 (instead of 0)

Source: Investopedia.com

Momentum Oscillator: Relative Strength Index (RSI)


RSI should not be confused with the charting method called “relative strength analysis” RSI is computed over a rolling time period and graphically compares a security’s gains with its losses over the set period. Recommend period is 14 days.

RSI = 100 - 100/(1 + RS)

where

RS = Summation of up changes for the period / Summation of down changes for the period

RSI is always between 0 and 100Mostly stays between 30 and 7030 oversold line70 overbought line

Source: www.onlinetradingconcepts.com

Momentum Oscillator: Stochastic Oscillator


The stochastic oscillator is based on the observation that in uptrends, prices tend to close at or near the high end of their range and in downtrends, they tend to close near the low end. The stochastic oscillator oscillates between 0 and 100

Source: www.forex-central.net

Oscillates between 0 and 100Default setting is a 14-day periodComposed of 2 lines: %K and %D

%K = 100 * (C – L14) / (H14 – L14)

%D = Average of last 3 daily %Ks(like a long-term moving average)

80 Oversold20 Overbought

http://www.forex-central.net/stochastic-oscillator.php

Moving Average Convergence/Divergence Oscillator


The MACD is constructed by calculating two lines: the MACD line (difference between two exponentially smoothed moving averages, generally 12 and 26 days) and the signal line (exponentially smoothed average of MACD line, generally 9 days)

Source: stockcharts.com

Oscillates around 0; no overbought-oversold range

Crossover change in trend

Convergence: oscillator shows same pattern as prices; suggests price trend will continue

Divergence: oscillator shows different pattern from price; implies change in price trend

http://stockcharts.com/education/IndicatorAnalysis/indic_MACD1.html

Sentiment IndicatorsSentiment indicators gauge investor activity for signs of increasing bullishness or bearishness

• Opinion polls

• Put/call ratio If very low then market sentiment is overly positive and a correction is likely

• VIX Based volatility of options on S&P500 stocks; high volatility suggests investors fear

a decline

• Margin debt

• Short interest ratio Short interest/Average daily trading volume

High means investors expect short term decline… but shares will have to be repurchased later


Flow of Fund Indicators


Look at fund flows to gauge potential supply and demand for equities

• Arms Index (next slide)

• Margin Debt Margin loans increase purchase of stocks

Declining margin balances may force selling of stocks

Negative margin balance means that money is owed to the brokerage firm

• Mutual Fund Cash Position When the cash position is low fund managers have bought, and effects of purchases are

reflected in security prices

• New Equity Issuance Increases supply of shares available to investors

Can be viewed as a bearish factor

• Secondary Offerings Can impact supply/demand equation similar to new equity issuance

Number of advancing issues ÷ Number of declining issuesVolume of advancing issues ÷ Volume of declining Issues

Arms IndexArms Index is also called the TRIN for “short-term trading index”. It is applied to a broad market (such as the S&P 500) to measure the relative extent to which money is moving into or out of rising and declining stocks. The index is a ratio of two ratios:


Index = 1 market is in balance

Index > 1 more money in declining stocks market in a selling mood

Index < 1 more money in rising stocks market in a buying mood

Example: Calculate the Arms Index and evaluate the market mood.

Advancing issues = 500

Volume = 4,000,000

Declining issues = 200

Volume = 1,000,000

Answer: Arms Index = TRIN Indicator = 0.625. Market is in a buying mood.

3.5 Cycles

Technicians use various cycles to predict future movements in security prices; even cycles in fields such as astronomy and climate can influence the economy and hence capital markets. Commonly referenced cycles include:

• Kondratieff (K) Wave Western economies have a 54-year cycle

• 18-Year Cycle Three 18-year cycles make up the 54-year cycle

Generally mentioned in real estate prices, but also found in equities and other markets

• Decennial Patterns This pattern connects average stock market returns with the last digit of the year

Years ending in 0 have shown poor performance, years ending in 5 have shown good performance

• U.S. Presidential Cycle Third year following an election shows the best performance


4. Elliot Wave TheoryMarket moves in regular, repeated waves or cycles. Pattern of five waves as shown below. Each wave can be broken into smaller and smaller sub-waves.


Source: ww.diamondslice.com

Market waves follow patterns that are ratios of numbers in the Fibonacci sequence:

0, 1, 1, 2, 3, 5, 8 …

Ratio of size of subsequent waves is generally a Fibonacci ratio:

1/2, 2/3, 3/5, 5/8, 8/13

5. Intermarket Analysis

Intermarket analysis is based on the principle that all markets are interrelated and influence each other.

Look for inflection point in one market as a warning sign for a change in another

Use of relative strength analysis for different groups of securities to make asset allocation decisions

• stocks versus bonds

• sectors in an economy

• securities from different countries


Summary


Conclusion

• Review learning objectives

• Examples and practice problems from the curriculum

• Practice questions from other sources


technical analysis

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