Chapter 7 - Analysis of Equity Securities III: Technical Analysis - 4.75% Flashcards
What are the basics of Technical Analysis?
Technical analysis is based on three assumptions:
- All influences on market action are automatically accounted for or discounted in price activity.
- Prices move in trends and those trends tend to persist for relatively long periods of time.
- The future can be found in the past.
What is the difference between Technical and Fundamental Analysis?
The basic difference between technical and fundamental analysis is that the technical analyst studies the effects of changing fundamentals – that is, price and volume over time – while the fundamental analyst studies the causes of price movements.
What is Chart Analysis?
Technical analysis is practised under four disciplines: chart analysis, statistical analysis, sentiment analysis and intramarket analysis. Chart analysis, the most commonly used of the four, is the study of price movements of a security over a specific period of time, which technical analysts believe can then be used to forecast where prices are headed. The basic tool of chart analysis is the price chart.
What are the types of Price Charts?
- Bar Charts:
The bar chart plots price on the vertical axis and time on the horizontal axis. The activity in each period (hour, day, week, month, etc.) is represented on a vertical bar, with the top of the bar representing the highest price for that period and the bottom representing the lowest price.
The bar chart is also known as an open, high, low, close (OHLC) chart. In addition to the high and low for the period represented, the opening price is represented by a short horizontal line to the left of the vertical bar, and the close by a line to the right. - Line Charts:
Line charts track a single value only, usually the closing price, rather than the four values contained in the standard bar chart. Since most technicians want to know all four pieces of information, line charts are rarely used to track primary price data. They are used, however, to chart statistical indicators such as moving averages and a wide variety of oscillators. - Candlestick Charts:
Candlestick charts use one of the oldest known charting techniques, which originated in Japan in the early 17th century. Like bar charts, candlestick charts record the open, high, low, and closing price for each period. The main difference between the two is that the candlestick for each period has a real body, that is, a box that visually represents the difference between the period’s opening and closing prices. When the closing price is higher than the opening price, the real body is white or empty; when the closing price is lower than the opening price, the real body is black or filled in. The colour of the real body plays an important role in interpreting candlestick charts.
What are Chart Patterns?
- Trendlines
One of the principles of technical analysis is that prices move in long-term, intermediate, or short-term trends. The trendline is used to determine trends. A trendline is a line connecting a series of ascending lows (an up trendline) or descending highs (a down trendline). Although it can be drawn by connecting just two points, a third point is needed to confirm that the trend is valid.
Once a trendline assumes a certain slope, that slope tends to persist. Therefore when technicians notice an up trend, for example, they may consider a price decline to, or near, the trendline as a buying opportunity. If a stock trades below an up trendline or above a down trendline – a situation referred to as a break (or violation) of the trendline – it may signal an end to the trend. There are two reasons that it is not a certainty that a break or violation signals an end. - Support and Resistance
A support level is the price at which the majority of investors sense value and are willing to buy more than the holders of the stock (or short sellers) are willing to sell. As demand outstrips supply, prices tend to rise from support levels.
A resistance level is the price at which investors believe the stock is fully valued or possibly even overvalued. At this point, perceived return potential is limited and many holders of the stock (or short sellers) are willing to sell. Because of the limited return potential, potential buyers are unwilling to buy. Prices tend to fall as supply overwhelms demand. - Reversal Formations
Reversal formations are price or chart patterns that help confirm whether a trend reversal has taken place. We discuss three of the more significant reversal formations in this section. - Head-and-shoulders Formation
Some reversal formations take weeks or even months to develop. One such formation, the head-and-shoulders (H&S) formation, gets its name from its similarity to a human head and shoulders silhouette. When this formation appears at the end of a bull market, it is called a head-and-shoulders top. When it takes place at the end of a bear market, it is known as a head- and-shoulders bottom or inverse head and shoulders. - Key Reversal
A key reversal occurs after a long move either up or down has taken place. It typically follows several days, or even weeks, of sharp price movements in the direction of the prevailing trend. At the start of a key reversal, prices continue to move strongly in the direction of the trend, reaching a new high (in the case of an uptrend) or a new low (in the case of a down trend). By the end of the day, however, the price has closed lower (in the case of an up trend) or higher (in the case of
a downtrend) than the previous day’s close. If prices close lower than the previous day’s low (in the case of an uptrend) or higher than the previous day’s high (in the case of a downtrend), the reversal has even more significance and would be called an outside day. Volume on a key reversal day is normally very heavy, as buying or selling power is finally exhausted. - Continuation Pattern
Continuation patterns are an extension of the second assumption of technical analysis: prices tend to move in trends that persist for relatively long periods. It is usually a mistake (often an expensive one) to anticipate a reversal of the trend without significant technical corroboration.
Continuation patterns represent a pause on a price chart, typically in the form of sideways trading, before the prevailing trend continues. These patterns are also referred to as a consolidation of an existing trend. They are quite normal and are considered healthy in a trending market. If a trend continues too far too quickly without a pause, it usually experiences a sharp, even violent reversal.
At which RSI level is a market considered to be in a downtrend if the market stays below this level for a considerable amount of time? A. 60 B. 50 C. 40 D. 30
B is correct.
The market is considered to be in a downtrend if the RSI stays lower than 50 for a significant time.
What is a down trendline?
A. A down trendline is a line connecting series of descending highs.
B. A down trendline is a line connecting series of ascending highs.
C. A down trendline is a line connecting series of descending lows.
D. A down trendline is a line connecting series of ascending lows.
A is correct.
One of the principles of technical analysis is that prices move in long-term, intermediate, or short-term trends. The trendline is used to determine trends. A trendline is a line connecting a series of ascending lows (an up trendline) or descending highs (a down trendline). Although it can be drawn by connecting just two points, a third point is needed to confirm that the trend is valid.
Jerry is a wealth manager who uses technical analysis in the management of his clients’ portfolios. Currently, the TSX has gained 1000 points in 3 months and is approaching the 13,000 point level. Basic economic fundamentals are still favourable for growth. Four years ago, the TSX briefly crossed the 13,000 point level before retreating all the way back to the 9,000 level in less than a year. In this most recent rally, trading volume is declining as the 13,000 level comes closer. The TSX 200 day moving average is at 12,100. Jerry’s clients read all the newspaper headlines and clamour for him to buy the rally before it gets away from him. According to technical analysis, what action should Jerry take with regard to his clients’ portfolios?
A. Jerry should fully invest any excess client funds into equities.
B. Jerry should resist the temptation to chase the rally and wait for a pull back.
C. Jerry should shift equity exposure in client portfolios down to 50% equities and 50% bonds.
D. Jerry should increase foreign equity exposure.
B is correct.
Resistance is at the old highs. Volume is declining as the old high is approached. There likely is not enough strength in the rally to get beyond the old highs. Support lies at the 200 day moving average.
If put/call ratios are normally around 60%, at what put/call ratio could an investor step into the market and buy stocks? A. 85% B. 55% C. 45% D. 30%
A is correct.
At 85%, the ratio is high enough to signal a “buy”.
Select the stochastic period on a daily chart that is likely to capture the most market movement. A. 20 B. 15 C. 10 D. 5
A is correct.
The longer period would capture more significant moves.
Select the oscillator that has fixed upper and lower bounds.
I. MACD
II. RSI
III. Stochastic
II and III.
The RSI and stochastic oscillators are bound between two fixed values.
What do sentiment indicators focus on?
A. The relationship between bonds and gold.
B. The moving averages and trend direction of a stock.
C. The expectations of investors.
D. The breakout level of a chart.
C is correct.
Sentiment indicators focus on investor expectations, or their degree of bullishness or bearishness about a particular stock or stock index.
Which refers to a violation of a trendline?
A. If a stock trades below a down trendline.
B. If a stock trades above an up trendline.
C. If a stock trades on the trendline.
D. If a stock trades below an up trendline.
D is correct.
Once a trendline assumes a certain slope, that slope tends to persist. Therefore when technicians notice an up trend, for example, they may consider a price decline to, or near, the trendline as a buying opportunity. If a stock trades below an up trendline or above a down trendline, it is referred to as a break or violation of the trendline.
Which of the following refers to the point at which investors believe the stock is fully valued on a stock price chart? A. Breakthrough level. B. Support level. C. Extreme level. D. Resistance level.
D is correct.
Support and resistance levels are the most noticeable and recurring patterns on a price chart. The most common are the highs and lows of trading ranges. These levels are known as horizontal support and horizontal resistance levels. A resistance level is the price at which investors believe the stock is fully valued or possibly even overvalued. A support level is the price at which the majority of investors sense value.
If the Moving Average Convergence-Divergence Indicator (MACD) is positive and increasing over time, which statement(s) is/are true?
I.The stock price is increasing.
II.The stock price is decreasing.
III.Rate of previous price gains is greater than the rate of recent price gains.
I is correct only.
The MACD indicator is equal to the difference between a short-term and longer-term exponential moving average. It is a measure of momentum. If, the MACD is positive and increasing over time, it implies positive price momentum. That is, the stock price is rising and that the rate of recent price gains is greater than the rate of previous price gains.
