Chapter 11 - Technical Analysis of Equity Markets (Done)

Question 1

What is the advance/decline line?

Answer 1

The cumulative total of the number of
stocks that have increased in value each day
minus the number that have decreased.

Question 2

What is “breadth” in the markets?

Answer 2

A measure of the extent or broadness of a
market trend; provides a way to measure
how many stocks are following the stock
market’s general trend.

Question 3

What is the CONSENSUS Index of Bullish Market Opinion?

Answer 3

A survey, published by CONSENSUS Inc.,
of major professional brokers and advisors,
showing the percentage that are bullish on
each futures market.

Question 4

What is the cumulative volume index (CVI)?

Answer 4

A cumulative total of the volume of
advancing stocks minus the volume of
declining stocks; a measure of whether
money is flowing into or out of the stock
market.

Question 5

What is the public short ratio?

Answer 5

The number of short sales made by
non-member traders (public short sales)
divided by the total number of short sales;
used as a contrarian indicator, a high ratio
suggests that the market is oversold and a
low ratio suggests that the market is
overbought.

Question 6

What is RELATIVE STRENGTH (not to be confused with relative strength index - RSI)?

Answer 6

The ratio between two financial
instruments (markets, sectors, industry
groups, commodities, stocks, etc.), it is one
value divided by another, normally shown
as a line chart.

Question 7

Explain the concept of market breadth and the different ways of measuring it.

Answer 7

• Finding the breadth of a market is an attempt to gauge the extent to which stocks are
  participating in a trend.
• The most popular way of measuring the breadth of a market is with an advance/decline
  (A/D) line.
• An A/D line is formed by summing the net number of stocks rising each day.
• Another technique used to measure breadth is the percentage of stocks trading above
  their 200-day moving average.
• A final technique used to measure breadth is the daily net number of stocks reaching
  new highs.

Question 8

What is the importance of volume in conjunction with price movements, and how is the cumulative volume index (CVI) measured?

Answer 8

• Volume is used to confirm market moves.
• Breakouts, especially to the upside, should be accompanied by rising volumes;
  breakouts on declining volumes should be viewed cautiously.
• Volume can also be broken down by those stocks moving up and those stocks moving
  down.
• The Cumulative Volume Index (CVI) is the daily net volume of rising stocks, which
  is calculated by subtracting the volume of declining stocks from the volume of rising
  stocks.

Question 9

What is the function of momentum indicators in confirming market moves?

Answer 9

• The MACD and ROC are the most popular indicators used to measure momentum
  (see Chapter 7).
• Momentum indicators are used to confirm market moves, and any divergence between
  the market and a momentum indicator may be an early reversal warning signal.

Question 10

What are the techniques that are used to measure market sentiment?

Answer 10

• The CBOE put/call ratio measures the number of puts traded on individual stocks
  relative to the number of calls traded.
• The ratio tends to be used as a contrarian indicator, with high (low) levels of put option
  trading relative to call option trading being a bullish (bearish) signal.
• Volatility indices measure the “nervousness” of the market and are useful at extreme
  values.
• Each week stock exchanges publish short sale data broken down by members and non-
  members (i.e., the public).
• The public short ratio is calculated by dividing the number of public short sales by the
  total number of short sales.
• Like the put/call ratio, the public short ratio is used as a contrarian indicator, with a
  large number being viewed as positive and a small number being viewed as negative.
• Another contrarian indicator of stock market sentiment is the CONSENSUS Index of
  Bullish Market Opinion for S&P 500 Index futures.
• This index is a survey of market participants and a reading over 75% is interpreted as
  bearish, while a reading under 25% is considered bullish.

Question 11

Explain the concept of relative strength as it applies to group rotation within equity markets.

Answer 11

• Relative strength is the ratio between two securities (dividing one by another).
• Finding which sectors within the market will outperform others is an important step in
  finding stocks that will outperform.
• Once the strongest sectors have been determined, stock selection can be made.

Question 12

What is a bearish divergence?

Answer 12

A bearish divergence is the pattern that occurs when the price reaches higher highs, while the technical indicator makes lower highs. Although there is a bullish attitude on the market, the discrepancy means that the momentum is slowing. Therefore it is likely that there will be a rapid decline in price.

Question 13

What is a bullish divergence?

Answer 13

A bullish divergence occurs when prices fall to a new low while an oscillator fails to reach a new low. This situation demonstrates that bears are losing power, and that bulls are ready to control the market again—often a bullish divergence marks the end of a downtrend.

Question 14

How do averages “smooth things out?”

Answer 14

Averages smooth things out by reducing fluctuations and highlighting overall trends. By combining multiple values and computing their mean, individual variations or extreme values are less prominent, leading to a more stable, general representation of the data set. This smoothing effect helps in identifying the underlying patterns more clearly, as it minimizes the impact of outliers or irregularities.

Question 15

What is the NH-NL technical indicator?

Answer 15

The New Highs - New Lows indicator (NH-NL) displays the daily difference between the number of stocks reaching new 52-week highs and the number of stocks reaching new 52-week lows.

Question 16

What is the rationale behind contrarian investing?

Answer 16

Contrarian investing is an investment strategy that involves bucking against existing market trends to generate profits. The idea is that markets are subject to herding behavior augmented by fear and greed, making markets periodically over- and underpriced.

Question 17

With a top-down approach, what techniques are used to determine the health of the overall market?

Answer 17

• trend
• breadth
• volume
• momentum
• sentiment

Question 18

What is the put/call ratio?

Answer 18

One of the most popular tools used to measure stock market sentiment is the put/call ratio. There
are several methods of calculating this. Some technicians compare the average premium paid for
puts versus calls; others calculate a ratio based on open interest or the dollar amount traded. The
most popular calculation shows the relationship between the volume of puts traded to the volume
of calls traded daily on the Chicago Board Options Exchange (CBOE).
Options are generally traded by short-term investors who are looking to earn large profits with
little capital outlay. The actions of these investors ironically often provide excellent contrarian
signals for market tops and bottoms. A high put/call ratio is an indication that these investors
are overly bearish and thus the market is ready to move higher, according to the contrarian view.
A low put put/call ratio is a bearish indicator.
For many years, the ratio remained for the most part within a range of 0.35 to 0.80. A reading
under 0.35 was considered bearish (a low number of puts per calls), while a reading over 0.80 was
considered bullish (a high number of puts per calls). In recent years, the range has been 0.45 to
0.85. In Figure 11.7, notice in the first half of 2011 the extreme shift in sentiment.

Question 19

What are volatility indices?

Answer 19

Another options-related method for gauging sentiment is to look at volatility. Since options are
priced partially on the expected volatility of the underlying asset in the future, an index of this
volatility will measure the market’s expected “nervousness.”
Several volatility indices exist, which reflect the specific volatility of different market indexes.
The VIX (Volatility Index), remains the most widely followed and reflects the volatility of 30-day
options on the S&P 500 Index traded on the CBOE. As with any volatility index, the VIX
increases with investor anxiety and is commonly referred to as the “fear index.” Other volatility
indices are based on the NASDAQ 100 (VXN), the Dow Jones Industrial Average (VXD) and
the Russell 2000 (RVX). In Canada, the Montreal Exchange introduced the MVX, a volatility
index calculated from current prices of options on the iShares CDN S&P/TSX 60 Fund (XIU).
Since the value of XIU mirrors the S&P/TSX 60, MVX is a good proxy of investor sentiment for
the Canadian equity market.
Although there is some correlation with actual index and stock prices, volatility indices are
most useful when they are at extreme values. A high value indicates fear and uncertainty,
suggesting a market bottom may be imminent (i.e., a trend change is imminent and a rally may
be forthcoming). A low value indicates complacency, suggesting a market may be topping and
setting up for a correction.

Question 20

What is the public short ratio?

Answer 20

Each week, exchanges publish a breakdown of round lot short sales between those made by
exchange members and those made by non-members (known as public short sales). The public
short ratio is calculated by taking the number of public short sales and dividing this figure by
total short sales. Since this is a contrarian indicator (quite similar to the put/call ratio), a high
public short ratio is considered bullish, meaning that a majority of public investors are bearish,
which is why they are shorting. When the ratio is low, it is considered bearish, meaning that a
majority of public investors are bullish.
The public short ratio is generally smoothed using a moving average of 10 weeks. Generally,
a public short ratio under 25% is considered bearish, while a reading over 40% is considered
bullish.
As with all the indicators discussed in this chapter, the public short ratio cannot be considered
in isolation. If it is used, it should be viewed only as one indicator within a basket of indicators,
helping build a case for a bullish, bearish or neutral market call.