Part 10. Technical Analysis

Question 1

Technical analysis

Answer 1

A form of security analysis that uses price and volume data often graphically displayed in decision making.

This allows us to see a battle between buyers and sellers, along with subtle clues as to which side may be winning.

Question 2

Underlying logical of technical analysis:

Answer 2

• Supply and demand determine prices.
• Changes in supply and demand - in price level and volume can cause changes in prices.
• Past price action can be used to anticipate and project potential future prices with charts and other technical tools.

Question 3

3 main principles in technical analysis:

Answer 3

• The market discounts everything - assumes price already reflects known factors impacting financial instrument.
• Prices move in trends and counter trends - assumes prices follow trends, which move directionally.
• Price action creates certain patterns that tend to reoccur and may be cyclical - due to market psychology.

Question 4

Beliefs:

Answer 4

• Irrational behaviour drive market volatility as a reaction to greed and/or fear.
• Since trend and patterns repeat themselves they are often identifiable and predictable.
• By studying market technical data, price and volume trends, the technicians seeking to understand investor sentiment and detect any fundamental change transpiring behind the scenes or may shortly transpire.
• If a time lag occurs between market activities and analyst conclusions, technicians ay be ahead of fundamental analysts in their positioning.
• Valuation models cannot be used to derive fundamental intrinsic values.

Question 5

Market microstructure

Answer 5

This deals with issues of market structure and design, price formation, price discovery, transactions and timing costs, information and disclosure and investor behaviour.

e.g. minimum tick increments, algorithmic execution interfaces.

Aims to establish connections between activity over fast moving ST and properties that emerge over longer time frames.

Question 6

Technical analysis vs fundamental

Answer 6

• Technicians solely focus on analysing markets and trading of financial instruments, but fundamental is a much wider field, encompassing financial and economic analysis, as well as analysis of societal and political trends.
• Technicians analyse market prices, solely from price and volume data, but fundamentals study a company, incorporate external market data, an use analysis to predict security price movements.
• Technician has more concrete data, but fundamentals use numerous estimates and assumptions from a financial statement combined to use various line items.
• T seek to project level at which financial instruments will trad, but F seek to predict where it should trade.

Question 7

Interpreting technical analysis

Answer 7

• Best and most easily applied to liquid and deep markets.
• Can be applied to different asset classes such as equities etc.
• Impacted by market participation, i.e. retail investors tend to have less in depth info, being more momentum-centric than institutional investors.
• Institutional investors have enough float/liquidity in given stock to participate in scale.

Question 8

Backtesting

Answer 8

This is a method of assessing the viability of a trading strategy by showing how the strategy would play out using historical data.

Question 9

Line charts

Answer 9

x axis = time
y axis = price level

• the most effective tool for analysing price action because they show the closing price of the day, week or month.
• closing price is regarded by traders and investors as the most important data point, as it reflects the final decision for that periods transactions.

Question 10

Bar chart

Answer 10

• This has 4 bits of data in each entry, the high and low prices encountered during the time interval, plus opening and closing prices.
• Vertical line connects the high and low prices of the day.
• Cross hatch the the right indicates the closing price.
• Cross hatch to the left indicates the opening price.
• this chart is most useful in ST trading, as spikes on upside and downside forming support and resistance levels can be visibly seen.

Question 11

Candlestick chart

Answer 11

This provides 4 prices per data point, the opening and closing prices, and high and low prices during the period.

Vertical line (wick/shadow) = this represents the range through which he security price travelled during the time period.

Body of candle is white/clear = if opening price was lower than closing price.

Body of candle is dark = if the opening price was higher than the closing price.

Question 12

Advantage of candlestick chart over bar chart

Answer 12

• The price fluctuations are much more visible which allows for better analysis.
• The bar chart indicates market volatility by the height of each bar, but candlestick shows the difference between opening and closing prices, and relationship to highs and lows of the day are clearly apparent.

Question 13

Candlestick chart: doji

Answer 13

• This signifies that after a full day of trading, the positive price influences of buyers, and negative price influence of sellers exactly counteract each other – market under analysis is in balance.
• If occurs at end of long uptrend or downtrend, it signals trend will probably reverse.

Question 14

Linear scale

Answer 14

There are equal vertical distances on the chart corresponding to equal unit change.

Better suited for shorter term price charts.

Question 15

Logarithmic scale

Answer 15

This equals vertical distances on the chart that corresponds to equal percentage change.

More appropriate when working on longer time frames – appropriate when data moves through a range of values representing several orders of magnitude.

Question 16

Breakdown signal - linear vs logarithmic scale

Answer 16

• the upward sloping logarithmic trendlines are broken sooner than linear trendline, the opposite for downward trends.
• a breakdown occurs when the price of an asset moves below a support level.

Question 17

Volume

Answer 17

This is used to assess the strength or conviction of buyers and sellers in determining a security’s price.

e.g. a daily price chart, a bar chart below the price section will show the volume traded for that day.

volume info is crucial:

• if volume increases during time frame in which price also increases, the combo is considered positive, and 2 indicators are said to confirm each other.
• signal means that over time more and more investors are buying the financial instruments, and doing so at higher and higher prices. (positive technical development).
• conversely a breakout can take place with low volume.

Question 18

Time intervals

Answer 18

• using longer time intervals containing fewer data points, so longer time frame can be presented on the chart.
• computerised and high frequency trading has resulted in frequent false and distorted signals in ST analysis. (randomness in intra-day trading)

Question 19

Relative strength analysis

Answer 19

Widely used to compare performance of a particular asset such as common stock, with that of some benchmark, FTSE 100, or performance of another security.

The intent to show outperformance or underperformance of individual issue relative to some other index or asset.

asset = numerator
benchmark = denominator

• so y axis is the ratio function of relative prices of assets under consideration.
• rising line shows asset is performing better than benchmark, and vice versa.

Question 20

Trend

Answer 20

A long term pattern of movement in a particular direction.

Question 21

Consolidation

Answer 21

When a security is not trending, no LT pattern of movement in a particular direction.

• Offers an opportunity for traders who buy/sell between well-defined ranges.
• for position traders and investors, this is a time at assess the strength of the stock.

Question 22

Uptrend

Answer 22

• When the price goes to higher highs and higher lows, the forces of demand are greater than forces of supply.
• So traders are willing to pay higher and higher prices for the same asset over time.

retracement = a reversal in movement of security’s price, it must stop at a higher low than the prior lows in trend period.

• the longer the security price stays below the trendline, the more meaningful the breakdown is considered to be.

Question 23

Downtrend

Answer 23

• A security makes lower lows and lower highs, as price of security moves down, each subsequent new high must be lower than prior high.
• Each time there is a retracement, the price must stop at lower low that prior lows in trend period.
• Major breakouts above the downtrend line indicates the downward trend is over, and rise in security price may occur.
• Supply overwhelms demand, as overtime sellers are willing to accept lower and lower prices to exit long positions or enter new short positions.
• Indicates deteriorating investor sentiment about the asset.

Question 24

Chartist

Answer 24

An individual who uses charts or graphs of securities historical prices or levels to forecast its future trends.

Question 25

2 concepts of trend:

Answer 25

Support = a low price range in which buying activity is sufficient to stop decline in price.

Resistance = a high price range in which selling activity is sufficient to stop the rise in price.

Question 26

Change in polarity principle:

Answer 26

A key tenet regarding support and resistance as part of technical analysis.

This states that once support level is breached, it becomes a resistance level, and vice versa.

Support indicates at some price level, investors consider a security to be an attractive investments, and are willing to buy, even in wake of sharp decline.

Resistance indicates at some level, investors are not willing to buy, even in an uptrend.

Question 27

Reversal pattern

Answer 27

This signals the end of a trend , a change in direction for the financial instrument’s price.

1. Head and shoulders pattern = consists of 3 segments, with volume being an important consideration in interpreting this pattern.

Question 28

3 elements key for head should pattern:

Answer 28

1. Neckline - connecting beginning of left should and end of right shoulder at both low points.
2. Volume - volume during advance of left shoulder should be higher than during advance of head.
   - fall in volume into new high of head serves an initial warning sign.
   - next warning sign comes when volume increases on decline from peak of head, and notably decreases during advance of right shoulder.
   - final confirmation comes when volume increases once again during decline from right shoulder.
3. Price target - after price breaks from neckline support, the projected price decline is found by measuring distance from neckline to reach price target.

Question 29

Divergence

Answer 29

When one indicator is making a new high (or low) but another is not.

Question 30

Inverse head and shoulders

Answer 30

A reversal pattern for a preceding downtrend, known as head and shoulders bottom.

Question 31

Price target

Answer 31

When attempting to profit from head and shoulders pattern, a technician will often use the price difference between head and neckline to set price target.

The price target is the price at which technician anticipates closing the investment position.

Question 32

Double top

Answer 32

This is formed when an uptrend reverses x2 at roughly the same high price level.

Typically, volume is lower on 2nd high than on 1st, signalling diminishing of demand.

The longer time between 2 tops, the deeper the sell off after 1st top, the more significant the pattern is considered to be.

Question 33

Double bottom

Answer 33

This is formed when the price reaches a low, rebounds and then declines again to first low level.

Used to predict a change from downtrend to uptrend in security prices.