Reading 12 LOS's Flashcards
LOS 12a: Explain principles of technical analysis, its applications, and its underlying assumptions
Technical analysis is a security analysis technique that involves the examination of past market trends to predict the future behavior of the overall market and of individual securities. It is based on the following:
- Supply and demand determine prices in real time
- Changes in supply and demand cause changes in prices
- Prices can be projected with charts and other technical tools
Principles and Assumptions
Technicians believe that people often behave in an irrational and emotional manner, and tend to behave similarly in similar circumstances. They suggest that market trends and patterns reflect irrational human behavior and therefore study trends in the market
They rely on price and volume information from the market itself to understand investor sentiment and to make investment decisions
Technicians believe that security price movements occur before fundamental developments occur or are reported. An important tenet of technical analysis is that the equity market moves roughly six months ahead of crucial turning points in the broader economy
Technical vs Fundamental Analysis
technical uses only trading data which includes market price and volume information. Fundamental analysis uses external information (financial reports) and also include social variables.
The data used by technical is more concrete and reliable, whereas fundamental data can be manipulated by management
Fundamental analysis aims to state what a security should trade at, while technical analysis aims to state where a security will trade at.
Technical analysis has been used for a much longer period of time, as fundamental analysis is relatively new.
Drawbacks of Technical Analysis
Technicians only study market movements and trends, which can change without warning. It can also take some time for a clear, identifiable trend to emerge. Technicians expect trends to repeat themselves, so a change in investor psychology may be missed by them.
Application of technical analysis is limited in markets that are subject to significant outside manipulation and in illiquid markets
LOS 12b: Describe the construction of different types of technical analysis charts and interpret them
Charts are used to illustrate historical price information, which is used by technicians to infer future price behavior. A wide variety is used and follows.
Line Charts
A line chart is a simple graphical display of prices over time. Usually the chart plots closing prices as data points and has a line connecting these points. They provide a broad overview of investor sentiment and can be analyzed quickly.
Bar Charts
A bar chart presents four pieces of information - opening price, highest and lowest prices, and closing price for each time interval. Bar charts enable an analysts to get a better sense of the nature of trading during the period.
For each interval, the top of the line represents the highest price, the bottome the lowest, the left hatch is opening price, and the right hatch closing price. The shorter the vertical line, the less price movement, thus less volatility.
Candlestick Charts
Provides same information as bar chart, but it more clearly shows if the market finished up or down for the day, by leaving the box open if market finished up and by shading it in if the market finished down.
Point and Figure Chart
To construct a point and figure chart, a box size and a reversal size must first be determined. The box refers to the minimum change in price that will be represented by a box on the chart, while the reversal size determines when a new column will be created on the chart. The reversal size is typically a multiple of the box size. A reversal size of three means that an analyst will move to the next column when the price reverses, or changes direction by three or more boxes.
To construct the chart, an “X” is plotted for an increase in price and an “O” for a decrease in price. For example assume that box size is $1 and reversal is $3. If price rises by $1, then an X gets marked down. If increases by $.50 the next day, nothing is marked. A reversal would happen if the price fell by $3 or more. If it did then the analysts would move over to the next column and start making Os.
Scale
The vertical axis can be constructed with a linear scale or a logarithmic scale. A linear scale is more appropriate when the data fluctuate within a narrow range. In a logarithmic scale, percentage changes are plotted on the vertical axis, and are more appropriate when the range of data is larger.
Volume
Volume is used by technicians as a barometer of the strength of a trend. Volume-related information is typically included at the bottom of most charts.
If a security’s price increases with increasing volumes, that means more and more people are buying at higher prices, and thus we have a confirmed trend. When volumes start to die out, its a sign the trend is fading.
Time Intervals
Charts can be constructed using any time interval. Intervals can be from minutes to years, it all depends on what the analyst is looking for.
Relative Strength Analysis
This is used to evaluate the relative performance of a security compared to a stated benchmark by plotting the ratio of the security’s price to the benchmark index over time. An upward-sloping line indicates outperformance, while a downward-sloping line suggests underperformance
LOS 12c: Explain uses of trend, support, resistance lines, and change in polarity
Trend analysis assumes that investors tend to behave in herds and that trends usually continue for an extended period of time.
An uptrend occurs when a security’s price makes higher highs and higher lows. To illustrate an uptrend, a technician will connect all the lows on the price chart with a straight line that should be increasing. More demand than supply
A downtrend is indicated by lower highs and lower lows on the price chart. A technician connects all the highs on the chart to illustrate downtrend. More supply than demand.
A sideways trend happens when a security trades within a narrow range, due to supply and demand being equal.
Trend analysis involves the use of support and resistance levels.
- Support levels are defined as the price at which there is sufficient buying interest in the stock to arrest the price decline. At this level, investors believe that the security is an attractive investment despite the recent price decline.
- Resistance Level is the price at which enough selling activity is generated to prevent any further increase in price. at the resistance level, investors believe that the security is overpriced.
These lines can be either sloped or horizontal
The change in polarity principle asserts that once the price rises above the resistance level, it becomes the new support level. Similarly, once the price falls below a support level, it becomes the new resistance level.
LOS 12d: Identify and interpret common chart patterns
Reversal Patterns (indicate the end of a prevailing trend)
Head and Shoulders
A head and shoulder pattern follows an uptrend in the price of a security and is composed of three parts:
- Left shoulder- consists of a strong rally with high volumes, with an upward trend that has a slope that is steeper than that of the preceding uptrend. The really then reverts to the same price it started from, creating an inverted “V”
- Head- The price starts to rise again and this time records a higher high than the one reached in the left shoulder. However, volumes are lower in this rally. The price then again falls to the level that the head started from. This price level is called the neckline
- Right Shoulder Is similar to the left, but with lower volumes. High almost reaches same high as left shoulder, but does not come near high of head.
The formation might not always be perfect, but what we need is the head to be higher than the shoulders, with less volume than the left shoulder, showing investor inerest is waning.
When one indicator is bullish while another indicator is bearish, we call this divergence.
Once the price breaks the neckline, the trend is confirmed and prices are expected to drop
Inverse Head and Shoulders
Reverse the price pattern of a regular head and shoulers to represent a downtrend, but volume pattern stays the same
Setting Price Targets with Head and Shoulders Patterns
Once the neckline has been breached in the head and shoulers pattern, the price is expected to decline by an amount equal to the distance between the top of the head and the neckline. In forumla:
- Price Target = Neckline - (head -Neckline)
Or for inverse Head and shoulders
- Price Target = Neckline + (Neckline - Head)
Double Tops and Bottoms
A double top occurs when an uptrend in prices reverses twice at approximately the same price level. Usually the first top will have a higher volume. For a double top, the price target is established at a level that is lower than the valley (low between two tops) by an amount that equals the distance from the tops to the valley.
A double bottom indicates the reversal of a downtrend. Same thing at double bottoms, just use terms of bottoms and peaks.
Double tops and bottoms are significant because they indicate that at a particular price level, investors are ready to step up and reverse the prevailing trend ( good indication for what prices are floors and ceilings for securities).
Triple Tops and Bottoms
A triple top consists of three peaks at roughly the same level, while a triple bottom occurs when three troughs are formed at roughly the same price level. These are very rare, but obviously indicate more significant reversals than double tops or bottoms.
Continuation Patterns (used to confirm the resumption of the current market trend)
Triangle Patterns
A triangle pattern is formed when the range between highs and lows over a period narrows down on the price chart.
An ascending triangle is formed when the trend line connecting the highs is horizontal while the trend line connecting the lows is upward sloping. Ascending triangles formed during an uptrend indicate that investors are selling the stock at a particular price level, but buyers are willing to purchase the stock at higher and higher prices. Eventually the price is expected to rise
A descending triangle suggests that the stock price will continue to decline (highs are downward sloping, while lows are horizontal)
In a symmetrical triangle, the line connecting the highs is downward-sloping, while the line connecting the lows is upward sloping, resulting in a somewhat symmetrical triangle. After the buyers and sellers duke it out, the trend will end up in the same direction that it was prior to the stagnation.
Rectangle Patterns
When the two trend lines are both horizontal, a rectangle pattern is formed. Once a breakout occurs, the trend in prices is the same as the trend that preceded the rectangle formation.
Flags and Pennants
These form over a much shorter time interval compared to triangles and rectangle patterns. A flag is formed when two trend lines are parallel to each other. Typically, the slope of the trend lines is opposite to that of the prevailing trend. For example, in an uptrend, the trend lines comprising the flag slope down.
A pennant is basically a triangle that is formed over a relatively short span of time.
For both, the expectation is that the trend that preceded the formation will continue after the pattern.
LOS 12e: Describe common technical analysis indicators: price-based
Price-based technical indicators incorporate current and historical market price information
Moving Average
A moving average is the average of the closing price over a given number of periods. Moving averages smooth out short-term price fluctuaions and therefore, give a clearer picture of a market trend.
- A simple moving average uses the arithmetic mean, weighing each price equally in computing the average
- An exponential moving average attaches a greater weight to recent prices in computing the average
Applications of Moving Averages
- Generally a stock in a downtrend will trade below its moving average and vice versa
- Moving average trend lines can act as support or resistance levels
- When short term moving average intersects long-term moving average from below, the formation is referred to as a golden cross(bullish sign).
- When the short-term intersects the long-term from above, it forms a dead cross (bearish sign).
Bollinger Bands
These consist of a simple moving average plus upper and lower bands that are calculated by adding and subtracting a specific number of standard deviations from the moving average
Applications of Bollinger Bands
- A contrarian technical strategy based on Bollinger bands aims to sell the security when it reaches the upper band and purchase the security when it touches the lower band. The assumption here is that the security will continue to trade within these bands
- A long-term investor may purchase the security once it has broken out significantly above the upper band, or short it, if broken the lower band.
LOS 12e: Describe common technical analysis indicators: momentum oscillators
mometum oscillators are used to identify changes in market sentiment. They are calculated in such a manner that they either fluctuate within a range or hover around a number. Technicians focus on whether oscillators and price data are moving in the same direction (convergence), or in different directions (divergence)
Applications of Momentum Oscillators
- The oscillator range for a security can be used to determine the strength of a trend
- They may signal a trend reversal when they reach historical highs or lows
- They can be used to make short-term trading decisions in nontrending markets
Momentum or Rate of Change Oscillator
A ROC oscillator is calculated as:
- M = (V - Vx) x 100
- M = momentum oscillator value
- V= last closing price
- Vx= closing price x days agao, typically 10
When positive and an in uptrend, its bullish and vice versa. When it is opposite of trend it is ignored.
The base value for an oscillator can also be set at 100. In this case it can be calculated as:
- M = (V / Vx) x 100
Relative Strength Index
A RSI compares a security;s gains with its losses over a given time period, and is calculated as:
- RSI = 100 - ( 100/ 1 + RS)
- where RS = Sum of up changes for the period divided by absolute sum of down changes for the period
The RSI lies between 0 and 100, with a value of 70 being overbought (bullish) and a value of 30 being oversold (bearish). Keep in mind that less volatile stocks will trade in a narrower range.
Stochastic Oscillator
This is based on the assumption that in an uptrend, the stock price tends to close near the high of its recent range, while in a downtrend it tends to close around its recent low. The logic is that if price increases during the day but then loses value by close, the rally is not strong, whereas if it maintained value at close, it would be strong.
It is calculated as:
- %K = 100 [(C - L14) / (H14 - L14)]
- C = last closing price
- L14= lowest price in last 14 days
- H14= highest in 14 days
- %D (signal line) = Average of the last three %K values calculated daily
Applications of Stochastic Oscillators
- Generally when it is over 80, it usually indicates the security is overbought and should be sold. When it is under 20, it is oversold and should be purchased
- When %K crosses %D from below, it is a short-term bullish signal, and if it crosses from above it is a bearish signal
Moving Average Convergence/Divergence Oscillator
The MACD is the difference between short-term and long-term moving average of a security’s price and is composed of two lines:
- The MACD line, which is the difference between two exponentially smoothed moving average lines (typically over 12 and 26 days)
- The signal line, which is the exponentially smoothed moving average of the MACD line ( typically over 9 days)
Applications of the MACD Oscillator
- Crossovers of the MACD line and the signal line may indicate a change in trend
- When it moves outside its historical range, it indicates a weakening trend
- Convergence occurs when the MACD and price move in the same direction, while divergence is when they move in opposite directions
LOS 12e: Describe common technical analysis indicators: sentiment
Sentiment Indicators evaluate investor activity looking for signs of bullishness or bearishness
Opinion Polls
A number of companies conduct regular polls of investors and investment professionals to gauge market sentiment.
Calculated Statistical Indices
- Investors who purchase put options are bearish, while those who buy call options are bullish. The put/call ratio can determine the market sentiment; a high ratio indicates bearish, while a low ratio indicates bullish
- the CBOE Volatility Index (VIX) measures short-term market volatility and is calculated from the prices of options on stocks in the S&P 500. The VIX rises when the market fears a market decline
- Studies have shown that margin debt levels are very strongly correlated with the movement in the market
- Short interest refers to the numbe of shares sold short for a particular security. The short interest ratio is calculated as:
- Short interes ratio = Short Interest / Average daily trading volume
- This indicator may be interpreted in 2 ways:
- There is overall a negative outlook on the security and one should expect the price to decline
- The effect of short sales has already been factored into the current market price. When these short sellers cover their positions, the price of the stock will rise.
LOS 12e: Describe common technical analysis indicators: flow of funds
Technicians also look at the potential demand and supply for securities in making trading decisions
Arms Index
Also called the short term trading index (TRIN), the Arms index is a common flow of funds indicator that looks at how much money is flowing into and out of leading stocks
- Arms = (number of advancing issues/ number of declining issues ) /
- (volume of advancing issues / volume of decreasing issues)
Values above 1 indicate that there is more activity in declining stocks, thus bearish. Values below 1 indicate more activity in advancing, thus bullish.
Margin Debt
Margin loans may increase stock purchases, while declining margin balances may force the selling of stocks
Mutual Fund Cash Positions
Technicians believe that low mutual funds cash positions mean that mutual funds have already invested in the market, while high cash positions show they still have to enter the market. The idea is that once they do enter, prices will rise
New Equity Issuance
When the new equity issuance indicator is high, the market is usually near its peak and is likely to decline in the future
Secondary Offerings
Secondary offerings affect the supply of shares just like IPOs
LOS 12f: Explain how technical analysts uses cycles
Over time, technicians have observed recurring cycles in the markets, only some of which can be explained. They use these cycles to predict market’s future direction
Kondratieff
Nikolai Kondratieff suggested that economies went through a 54-year economic cycle. His theory was mainly on commodity prices, but can also be seen in equities
18-year cycle
The 18-year cycle is mentioned in real estate markets though it can be observed in equities and other markets
Decennial Pattern
This pattern traces the annual stock returns based on the DJIA according to the last digit of the year. DJIA has historically performed bad in years ending in 0 and good in years ending in 5
Presidential Cycle
It has been observed that the third year or a presidents 4 year term, boasts the best stock market performance
LOS 12g: Describe the key tenets of Elliott Wave Theory and the importance of Fibonacci numbers
In 1938 R.N. Elliott proposed that the market moves in regular cycles or waves. In a bull market, the market moves up in five waves ( called impulse waves) and the simply go up, down, up, down, up, and then are followed by 3 corrective waves, down, up, down.
Elliott discovered that market waves followed patterns that were ratios of numbers in a Fibonacci Sequence. Positive price movements would take prices up by a factor equal to the ratio of a Fibonacci number to its preceding number, while negative price movements would be a factor of a Fibonacci number to the next number
LOS 12h: Describe intermarket analysis as it relates to technical analysis and asset allocation
Intermarket Analysis refers to the technique of combining analysis of different market to identify trends and reversals of trends. It is based on the principle that markets for different categories of securities are interrelated and influence each other, and asserts that these relationships are strengthening with increasing globalization. Some relationships observed are:
- Stock prices and bond prices tend to move in the same direction. Therefore. rising bond prices are a positive for stocks
- Declining bond prices are a signal of commodity prices possibly rising
- A strong dollar usually results in lower commodity prices
Technicians often use relative strength analysis to identify inflection points in a particular market and then look for a change in trend in a related market
