Reading 13 - Technical Analysis

Question 1

What is Technical Analysis?

Answer 1

Technical analysis is a security analysis technique that involves the examination of past market trends (using data such as prices and trading volumes) to predict the future behavior of the overall market and of individual securities. It can be thought of as the study of collective investor sentiment. Technical analysis can be used in any global freely traded market (i.e., a market where buyers and sellers can trade without any external interference).

Technical analysis does not require an in depth knowledge of the security being analyzed, and can therefore be performed relatively quickly, while fundamental analysis usually takes longer. Further, technical analysis can be applied to identify short-term and long-term trends. Fundamental analysis is more time consuming so most investors with short time horizons focus on technical analysis.

Question 2

Technical analysis is based on the following:

Answer 2

• 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. 


Question 3

What are the principles and assumptions of technicians?

Answer 3

Fundamental analysts assert that markets are efficient and rational, but technicians believe that people often behave in an irrational and emotional manner, and tend to behave similarly in similar circumstances. Technicians suggest that market trends and patterns reflect irrational human behavior. Therefore, technicians study trends in the market, which they believe repeat themselves, to predict the future direction of security prices. 


Technicians believe that the market reflects collective investor knowledge and sentiment. They rely on price and volume information from the market itself to understand investor sentiment and to make investment decisions. 


While some financial instruments (e.g., stocks and bonds) have associated income streams (e.g., dividends and coupon payments), which can be used to determine their intrinsic values, others (including commodities and currencies) do not have underlying financial statements or associated income streams. Technical analysis is the only tool available to investors to forecast future prices for these asset classes. 


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. 


Question 4

Technical vs. Fundamental Analysis

Answer 4

Technical analysis uses only trading data, which includes market price and volume information. Fundamental analysis uses external information (e.g., financial reports, industry and macroeconomic analysis) and also incorporates social and political variables. 


The data used by technical analysts is more concrete and reliable. The financial statements used by fundamental analysts are subject to manipulation by management.

Fundamental analysis is more conceptual as it aims to determine the theoretical long‐term (intrinsic) value of a security. Technical analysis is more practical as it studies actual trading patterns to evaluate the market price of a security. Stated differently, fundamental analysts aim to forecast where a security should trade, while technicians focus on predicting the level at which it will trade.

Technical analysis has been in use for a longer period in investment decision‐making. Fundamental analysis is a relatively new field.

Question 5

Drawbacks of Technical Analysis

Answer 5

Technicians only study market movements and trends, which can change without warning. Further, it may take some time for a clear, identifiable trend to emerge. Technicians can therefore make incorrect investing decisions and can be late in identifying changes in trends.

Fundamental analysts demand an understanding of factors that will drive a company’s performance going forward. 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 (markets that are not freely traded) and in illiquid markets (where even a modest trade may have a relatively significant price impact).

Question 6

What are the primary tools in technical analysis?

Answer 6

Charts and indicators are the primary tools used in technical analysis.

Question 7

Technical Analysis: Charts

Answer 7

Charts are used to illustrate historical price information, which is used by technicians to infer future price behavior. A wide variety of charts are used in technical analysis. The choice of charts is governed by the purpose of the analysis.

Question 8

Technical Analysis: Line Charts

Answer 8

A line chart (see Figure 2-1) 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. Time is plotted on the horizontal axis and prices are plotted on the vertical axis. Line charts provide a broad overview of investor sentiment, and the information they provide can be analyzed quickly.

Question 9

Technical Analysis: Line chart example (explain)

Answer 9

Question 10

Technical Analysis: Bar Charts

Answer 10

While a line chart has one data point for each value of the horizontal axis (time), a bar chart presents four pieces of information—opening price, highest and lowest prices, and the closing price for each time interval (see Figure 2-2). Bar charts enable an analyst to get a better sense of the nature of trading during the period. A short bar indicates low price volatility, while a longer bar indicates high price volatility.

For each time interval, the top of the line shows the highest price, while the bottom of the line shows the lowest price. The cross‐hatch to the left indicates the opening price, while the cross‐hatch to the right indicates the closing price. (See Figure 2-3.)

Question 11

Technical Analysis: Bar Chart Notation (Example, Explain)

Answer 11

Question 12

Technical Analysis: Bar Chart Example (Explain)

Answer 12

Question 13

Candlestick Charts

Answer 13

A candlestick chart provides the same information as a bar chart (i.e., opening and closing prices, and highs and lows during the period). Further, it also clearly illustrates whether the market closed up or down. The body of the candle is shaded if the closing price was lower than the opening price, and the body is clear if the closing price was higher than the opening price. (See Figures 2-4 and 2-5.)

Question 14

Construction of a Candlestick Chart (Example, Explain)

Answer 14

Question 15

Candlestick Chart Example (Explain)

Answer 15

Question 16

Technical Analysis: Doji

Answer 16

No difference between high and low. Further, the shares opened and closed at the same price; hence the cross pattern. Such a pattern is known as a doji. A doji indicates that the market is
in balance. If it occurs after a strong uptrend or downtrend, it suggests that the trend is about to reverse.

Question 17

Technical Analysis: Point and Figure Chart

Answer 17

To construct a point and figure chart, a box size and a reversal size must first be determined. The box size 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. The vertical axis measures discrete movements in price.

To construct the chart, an “X” is plotted for an increase in price, while an “O” is plotted for a decrease in price. For example, assume that the box size is $1 and the reversal size is $3. If the price rises by $1 on the first day, the analyst puts an X. On the next day, if the price increases by $2 the analyst plots 2 further Xs on top of the X already plotted. On the third day, if the price rises by $0.50, nothing is plotted on the chart (as the price change is lower than the box size). The analyst will continue to mark Xs in the same column whenever the price increases by more than $1 on a given trading day until a reversal occurs. A reversal would occur in this case when the price falls by $3 or more. When a reversal occurs the analyst would move over to the next column and start marking Os. The first box to be filled with an O would be the one to the right and below the highest X in the previous column. (See Figure 2-6.)

Box and figure charts are useful as they highlight the prices at which trends change (when the columns change), as well as price levels at which the security most frequently trades (congestion areas). Long, sustained price movements are represented by long columns of Xs and Os.

Question 18

In Technical Analysis, point and figure charts, what is the point of having a multi-box reversal size?

Answer 18

The point of having a multi‐box reversal size is to ignore the short‐term price volatility or noise that does not alter the long‐term price trend.

Question 19

Technical Analysis: Scale

Answer 19

The vertical axis on any of the charts that we have already discussed can be constructed with a linear (arithmetic) scale or a logarithmic scale. A linear scale is more appropriate when the data fluctuate within a narrow range (see Figure 2-7). In a logarithmic scale, percentage changes are plotted on the vertical axis. They are more appropriate when the range of data is larger (see Figure 2-8). Time is plotted on the horizontal axis. The length of the time period depends on the underlying data and the purpose of the chart. Active traders typically prefer shorter time intervals.

Question 20

Technical Analysis: Describe a linear scale chart (Chart)

Answer 20

Question 21

Technical Analysis: Describe a logarithmic scale chart (Chart)

Answer 21

Question 22

Technical Analysis: Volume

Answer 22

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 (see Figure 2-9).

If a security’s price is increasing with increasing volumes, it shows that more and more investors are purchasing the stock at higher prices. This indicates that the trend is expected to continue as the two indicators “confirm” each other.

If a security’s price is rising with declining volumes (the two indicators are diverging), it suggests that the trend is losing momentum as fewer investors are willing to buy at higher prices.

Question 23

Technical Analysis: Explain a daily price chart and volume bar chart (Chart)

Answer 23

Question 24

Technical Analysis: Time Intervals

Answer 24

Charts can be constructed using any time interval. The decision regarding which interval to use varies across the nature of trading—short-term investors may create charts with intervals less than a minute long, while longer-term investors may use charts with intervals as long as one year.

Question 25

Technical Analysis: Relative Strength Analysis

Answer 25

Relative strength analysis 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. (See Figure 2-10.)

Question 26

Technical Analysis: Relative Strength Analysis: Stock X and Y vs. Benchmark Index – Example (Chart)

Answer 26

Question 27

Technical Analysis: Trend analysis

Answer 27

Trend analysis assumes that investors tend to behave in herds and that trends usually continue for an extended period of time. Stock price data may show an uptrend, a downtrend, a sideways trend, or in some cases no trend at all.

Question 28

Technical Analysis: Uptrend

Answer 28

An uptrend occurs when a security’s price makes higher highs and higher lows. Higher highs occur when each high lies above the previous high, and when the price declines (there is a retracement) each subsequent low is higher than the prior low. To illustrate an uptrend, the technician connects all the lows on the price chart with a straight line. Major retracements (that drag the security’s price significantly below the trend line) indicate that the uptrend is over and that the price may decline further.

In terms of demand and supply, during an uptrend, there are more ready buyers for a security than there are sellers and traders are willing to pay a higher price for the security over time.

Question 29

Technical Analysis: Downtrend

Answer 29

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 the downtrend. Major breakouts above the trend line may indicate that the downtrend is over and that the security’s price could rise further.

In a downtrend, sellers are willing to accept lower and lower prices for the security, which indicates negative investor sentiment regarding the asset. (See Figure 2-11.)

Question 30

Technical Analysis: Sideways trend

Answer 30

In some cases, a security may trade within a narrow range. During such a sideways trend, there is a relative balance between demand and supply. Typically, options positions are more profitable than long or short positions on the security itself during a sideways trend.

Question 31

Technical Analysis: Trend analysis graph (Explain)

Answer 31

Question 32

Technical analysis: Support and resistance levels

Answer 32

Trend analysis involves the use of support and resistance levels. A support level is 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. (See Figure 2-12.) On the other hand, a 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. Support and resistance levels may be horizontal or sloped lines.

The psychology behind the concepts of support and resistance is that investors have come to a collective consensus about the price of a security.

Question 33

Technical analysis: Change in polarity principle

Answer 33

The change in polarity principle (a key tenet of trend analysis) 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.

Question 34

Technical Analysis: Support level graph (explain)

Answer 34

Question 35

Technical Analysis: Chart patterns

Answer 35

Chart patterns are formations on price charts that look like recognizable shapes. Recurring chart patterns can be used to predict future prices because these patterns essentially represent collective investor sentiment over a given time period. Chart patterns may be categorized as reversal patterns or continuation patterns.

Question 36

Technical Analysis: Reversal patterns

Answer 36

As the name suggests, reversal patterns indicate the end of a prevailing trend.

Question 37

Technical Analysis: Head and Shoulders. A head and shoulders pattern, see Figure 2-13, follows an uptrend in the price of a security. It is composed of three parts:

Answer 37

Left shoulder

Head

Right Shoulder

Question 38

Technical Analysis: Head and Shoulders. Left Shoulder:

Answer 38

Left shoulder: The 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 rally then reverts to the same price that it started from, creating an inverted “V.”

Question 39

Technical Analysis: Head and Shoulders. Head:

Answer 39

Head: The price starts to rise again, and this time records a higher high than the one reached in the left shoulder. However, volumes in this rally are lower. The price then again falls to the level that the head started from (the same level at which the left shoulder began and ended). This price level is called the neckline.

Question 40

Technical Analysis: Head and Shoulders. Right Shoulder:

Answer 40

Right shoulder: The right shoulder is similar to the left shoulder, but with lower volumes. The price rises almost to the same level as the high of the “left shoulder,” but remains lower than the high reached during the “head.”

Question 41

Technical Analysis: Head and Shoulders. Point on formation on the price chart

Answer 41

While the formation on the price chart may not always be perfect, the head should clearly be above the two shoulders, both of which should be similar. Note that the neckline may not always be a perfectly horizontal line.

Question 42

Technical Analysis: Head and Shoulders. Note on volume

Answer 42

Volume is very important in analyzing head and shoulders patterns. The fact that the
high of the “head” is higher than the “high” of the left shoulder, but has lower volumes, indicates that investor interest is waning. When one indicator is bullish (rising price) while another is bearish (lower volumes) it is known as a divergence.

Question 43

Technical Analysis: Head and Shoulders. Note on volume

Answer 43

Volume is very important in analyzing head and shoulders patterns. The fact that the
high of the “head” is higher than the “high” of the left shoulder, but has lower volumes, indicates that investor interest is waning. When one indicator is bullish (rising price) while another is bearish (lower volumes) it is known as a divergence.

Question 44

Technical Analysis: Head and Shoulders. Filtering rules

Answer 44

Once a head and shoulders pattern has formed, prices are expected to decline (the uptrend that preceded the head and shoulders pattern is expected to reverse). Technicians use filtering rules to ensure that the neckline has been breached. An example of such a filter is the price declining to a level 3–5% below the neckline. Once the price falls below the neckline (which previously acted as a support level), it becomes the new resistance level (change in polarity principle).

Question 45

Technical analysis: head and shoulders: Graph

Answer 45

Question 46

Technical analysis: Inverse Head and Shoulders

Answer 46

A downtrend in prices precedes an inverse head and shoulders pattern. The price characteristics of each of the three segments of the head and shoulders pattern are reversed in an inverse head and shoulders pattern, but the volume characteristics are the same. For example, in the left shoulder, the slope of the price decline is greater (more negative) than that of the preceding downtrend, but volumes are heavier. Then the rally reverses (with lower volumes) toward where it originated, and forms a “V.”

Question 47

Technical analysis: Setting Price Targets with head and shoulders patterns

Answer 47

Once the neckline has been breached in the head and shoulders pattern, the price is expected to decline by an amount equal to the distance between the top of the head and
the neckline. An investor can benefit from this expected reversal by shorting the security once the price falls below the neckline and then repurchasing it (closing the position) at the (lower) target price. As shown in Figure 2-14, the price target is calculated as:

Price target = Neckline + (Head - Neckline)


Typically, the stronger the rally preceding the head and shoulders pattern, the more pronounced the expected reversal.

Question 48

Technical analysis: Calculating price target (Graph)

Answer 48

Question 49

Technical analysis: Setting price targets for inverse head and shoulders pattern

Answer 49

Inverse head and shoulders patterns are preceded by a downtrend. Therefore, prices are expected to rise or break out above the neckline after the right shoulder has been formed. (See Figure 2-15.)

Price target = Neckline + (Neckline – Head)

Question 50

Technical analysis: Calculating Price Target for Inverse Head and Shoulders Pattern (Graph)

Answer 50

Question 51

Technical analysis: double tops and bottoms

Answer 51

A double top occurs when an uptrend in prices reverses twice at approximately the same price level (two highs are recorded at roughly the same level). Usually, the first top has a higher volume.

For a double top, the price target (where the reversal will end) is established at a level that is lower than the valley (the low recorded between the two tops) by an amount that equals the distance between the tops and the valley.

The more significant the sell‐off after the first top (deeper the valley) and the longer the time period between the two tops, the more significant the formation is considered to be.

A double bottom indicates the reversal of a downtrend. It occurs when, following a recent downtrend, prices fall to a certain level, rise for a bit, then fall back to the same level and rise again. (See Figure 2-16.)

For double bottoms, the price is expected to rise above the peak between the two bottoms by approximately an amount equal to the distance between the bottoms and the peak.

Question 52

Technical analysis: Double-Bottom Pattern (Graph)

Answer 52

Question 53

Technical analysis: why are double tops and bottoms significant?

Answer 53

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. For example, with a double bottom, the suggestion is that price declines have been arrested at a similar level on two different occasions, indicating that market consensus is that the price is low enough for the security to be an attractive investment.

Question 54

Technical analysis: Triple tops and bottoms

Answer 54

A triple top consists of three peaks at roughly the same level (see Figure 2-17), while a triple bottom occurs when three troughs are formed at roughly the same price level. Triple tops and bottoms are rare, but when they occur, they indicate more significant reversals than double tops and double bottoms. Generally speaking, the greater the number of times the price reverses at a given price level, and the longer the period over which the pattern is formed, the more significant the expected reversal.

Question 55

Technical analysis: Triple tops and bottoms (Graphs)

Answer 55

Question 56

Technical Analysis: Continuation Patters

Answer 56

A continuation pattern is used to confirm the resumption of the current market trend. Also known as “healthy market corrections,” these patterns suggest that the current price trend will continue as ownership of securities changes from one group of investors to another. In an uptrend for example, while one group of investors is looking to exit, another stands ready to take a long position on the asset at approximately the same price level.

Question 57

Technical Analysis: Triangle Patterns

Answer 57

A triangle pattern is formed when the range between highs and lows over a period narrows down on the price chart. The line connecting the highs over the period eventually meets the line connecting the lows, forming a triangle.

Question 58

Technical Analysis: Ascending triangle

Answer 58

An ascending triangle is formed when the trend line connecting the highs is horizontal while the trend line connecting the lows is upward sloping (see Figure 2-18). 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 following any sign of a sell‐off. Eventually the share price is expected to rise.

Question 59

Technical Analysis: Ascending triangle Graph (Explain)

Answer 59

Question 60

Technical Analysis: Descending triangle

Answer 60

A descending triangle on the other hand, suggests that the stock price will continue to decline. The line connecting the highs is downward‐sloping, while the line connecting the lows is horizontal. (See Figure 2-19.)

Question 61

Technical Analysis: Descending triangle Graph (Explain)

Answer 61

Question 62

Technical Analysis: Symmetrical triangle

Answer 62

In a symmetrical triangle, the line connecting the highs is downward‐sloping, while
the line connecting the lows is upward sloping. The resulting triangle is somewhat symmetrical. (See Figure 2-20.) Such a formation suggests that buyers are becoming more bullish as they continue to buy at higher prices than before, but sellers are becoming increasingly bearish as they sell at successively lower prices. After these little skirmishes between buyers and sellers are over, the trend ends up in the same direction as the trend that preceded the triangle formation.

Question 63

Technical Analysis: Symmetrical triangle graph

Answer 63

Question 64

Technical Analysis: Symmetrical triangle graph – Measuring implication

Answer 64

The height of the triangle (also known as measuring implication) equals the distance between the two trend lines at the start of the formation. Once the price breaks through one of the trend lines, analysts expect the price to move further by roughly the measuring implication. Usually, the breakout from the triangle occurs between halfway and three‐ fourths of the way into the pattern; not at the end of the pattern. The longer the triangle pattern, the more significant and volatile the subsequent price movement is expected to be.

Question 65

Technical Analysis: Rectangle patterns

Answer 65

When the two trend lines (one that connects the highs and the other that connects the lows) are both horizontal, a rectangle pattern is formed (see Figure 2-21). Once a breakout occurs, the trend in prices is the same as the trend that preceded the rectangle formation.

For example, in a bullish market, the rectangle pattern shows that investors are booking profits at the resistance level, but re‐entering the stock at the support level. Once the price breaks out above the rectangle, it will continue to rise.

Question 66

Technical Analysis: Rectangle patterns graph (Explain)

Answer 66

Question 67

Technical Analysis: Flags and Pennants

Answer 67

Flags and pennants form over a much shorter time interval (usually on a daily price chart over a week) compared to triangles and rectangle patterns. A flag is formed when two trend lines are parallel to each other (similar to country flags or parallelograms). 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 (see Figure 2-22) is basically a triangle that is formed over a relatively short span of time (typically over a week).

For both flags and pennants, the expectation is that the trend that preceded the formation will continue after the pattern. The breakout beyond the trend line is expected to roughly equal the distance between the start of the trend and the flag or the pennant.

Question 68

Technical Analysis: Pennant formation graph

Answer 68

Question 69

Technical analysis: Price-Based Indicators

Answer 69

Price‐based technical indicators incorporate current and historical market price information.

Question 70

Technical analysis: Moving Average

Answer 70

A moving average is the average of the closing price over a given number of periods. Moving averages smooth out short-term price fluctuations and therefore, give a clearer picture of a market trend.

Question 71

Technical analysis: Moving Average: Simple moving average

Answer 71

A simple moving average uses the arithmetic mean, weighing each price equally in computing the average.

Question 72

Technical analysis: Moving Average: Exponential moving average

Answer 72

An exponential moving average attaches a greater weight to recent prices in computing the average.

Question 73

Technical analysis: Applications of Moving Averages

Answer 73

• Generally, a stock that is in a downtrend tends to trade below its moving average, while one in an upward trend will typically trade above its moving average. 

• Moving average trend lines can also act as support or resistance levels. When the stock price starts falling toward its moving average, investors might purchase the stock believing that it is approaching its support level. 

• When the short-term moving average intersects the long-term moving average from below, the formation is referred to as a golden cross and is a bullish sign. On the other hand, when the short-term moving average intersects the long-term moving average from above, it forms a dead cross which is a bearish signal. (See Figure 3-1.) 


Question 74

Technical analysis: Moving averages graph (Explain)

Answer 74

Question 75

Technical analysis: Bollinger Bands

Answer 75

Bollinger bands 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.

Question 76

Technical analysis: Applications of Bollinger Bands

Answer 76

• 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 the bands. 

• A long‐term investor may purchase the security once it has broken out significantly above the upper band, or short the security once it has fallen significantly below the lower band. 


Question 77

Technical analysis: Momentum Oscillators

Answer 77

Momentum oscillators are used to identify changes in market sentiment. They are calculated in such a manner that they either fluctuate within a range (usually between 0 and 100) or hover around a number (such as 0 or 100). It is easy to identify extreme highs and lows on oscillators, and these extremes indicate that market buying/selling activity is more aggressive than historical levels.

Technicians focus on whether oscillators and price data are moving in the same direction (convergence) or in different directions (divergence). For example, when the price forms a new low, but the momentum oscillator is not at its lowest, the formation is a divergence. It implies that the downtrend is weakening and is expected to end soon.

Question 78

Technical analysis: Applications of momentum oscillators

Answer 78

• The oscillator range for a security can be used to determine the strength of a trend. Oversold conditions suggest that bearish market sentiment will end soon, while overbought conditions signal that the bullish market sentiment may soon change. 

• 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. 


Question 79

Technical analysis: Momentum or Rate of Change Oscillator Equation

Answer 79

A momentum oscillator [rate of change (ROC) oscillator] is calculated as follows: 


M = (V – Vx) × 100 


where:


M = momentum oscillator value


V = last closing price


Vx = closing price x days ago, typically 10 days 


Question 80

Technical analysis: Momentum or Rate of Change Oscillator – uptrend vs. downtrend

Answer 80

When the momentum oscillator value crosses zero into positive territory in an uptrend (when prices are also rising), it is a bullish signal. When it crosses zero into negative territory in a downtrend (when prices are falling), it is a bearish signal. Crossovers that occur in the opposite direction of the trend are ignored because technicians who use oscillators first consider the general trend when making trading decisions.

Question 81

Technical analysis: The base value for an oscillator can also be set at 100. In this case, the oscillator is calculated as:

Answer 81

M = (V/V_x)x100

Question 82

Technical analysis: Relative strength index

Answer 82

A relative strength index (RSI) compares a security’s gains with its losses over a given time period (see Figure 3-3). The 14‐day RSI is the most popular one, but longer-term investors will usually use a longer time period.

Question 83

Technical analysis: The RSI is calculated using the following formula:

Answer 83

RSI = 100 – (100/(1+RS))

Where

RS = [SUM(Up changes for the period under consideration)]/[SUM(ABS(Down changes for the period under consideration))]

The RSI lies between the 0 and 100. A value above 70 typically represents an overbought situation, while a value below 30 usually indicates an oversold situation. However, bear in mind that less volatile stocks may trade in a narrower range. Further, the RSI range for any stock does not need to be symmetrical around 50.

Question 84

Technical analysis: The Relative Strength Index (RSI)³ graph

Answer 84

Question 85

Technical analysis: Stochastic oscillator

Answer 85

A stochastic oscillator 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 (see Figure 3-4). The underlying logic is that if the stock price rises during the day, but loses value near the close, the rally is not very strong, as selling pressure eventually negates the buying interest. On the other hand, if the stock price rises during the day and manages to hold on to most of its gains at the close, the signal is bullish.

Question 86

Technical Analysis: The stochastic oscillator lies between 0 and 100 and is usually calculated using 14‐day price data. It is composed of two lines, %K and %D, which are calculated as:

Answer 86

%K = 100[(C-L14)/(H14-L14)]

where:


C = last closing price


L14 = lowest price in last 14 days

H14 = highest price in last 14 days

%D (signal line) = Average of the last three %K values calculated daily.

Question 87

Technical Analysis: Warning note about the stochastic oscillator

Answer 87

The stochastic oscillator should
be used with other technical tools,
such as trend analysis or pattern analysis. If both methods suggest the same conclusion, the trader has convergence (or confirmation), but if they give conflicting signals, the trader has divergence, which is a warning signal suggesting that further analysis is necessary.

Question 88

Technical Analysis: Applications of the Stochastic Oscillators

Answer 88

• Generally speaking, when the stochastic oscillator is greater than 80, it usually indicates that the security is overbought and should be sold. A value lower than
20 indicates that the security is oversold and should be purchased. However, analysts should consider the absolute level of the two lines in light of their historical range. 

• Crossovers between the two lines can also give trading signals similar to crossovers of moving average lines. When the %K (smoothed line) crosses %D from below, it is a short‐term bullish signal, and if it crosses %D from above, it is a bearish signal. 


Question 89

Technical Analysis: Stochastic Oscillators graph

Answer 89

Question 90

Technical Analysis: Moving average convergence/divergence oscillator:

Answer 90

The moving average convergence/divergence oscillator (MACD) is the difference between the short-term and long-term moving average of a security’s price. The MACD is composed of two lines:

1) The MACD line, which is the difference between two exponentially smoothed moving average lines (typically over 12 and 26 days). 

2) The signal line, which is the exponentially smoothed moving average of the MACD line, (typically over 9 days). 


The MACD is compared with its historical levels to determine whether market sentiment regarding the security is different from what it usually is. The indicator itself moves around 0 and has no limits. (See Figure 3-5.) 


Question 91

Technical Analysis: Applications of the MACD Oscillator

Answer 91

- Crossovers of the MACD line and the signal line may indicate a change in trend (similar to crossovers of moving averages and the stochastic oscillator). 


• When MACD line moves outside its historical range, it indicates a weakening in the current trend. 

• Convergence (which suggests that the trend will continue) occurs when the MACD and price move in the same direction, while divergence (which suggests that the trend will reverse) occurs when the MACD and price move in opposite directions. 


Question 92

Technical Analysis: MACD Graph (Explain)

Answer 92

Question 93

Technical Analysis: Sentiment Indicators

Answer 93

Sentiment indicators evaluate investor activity looking for signs of bullishness or bearishness.

Question 94

Technical Analysis: Opinion Polls

Answer 94

A number of companies conduct regular polls of investors and investment professionals
to gauge market sentiment. Technicians compare the data (which is also presented graphically) with recent market highs, lows, and inflection points to establish relationships that might be useful in predicting future market direction.

Question 95

Technical Analysis: Calculated statistical indices: Put/call ratio

Answer 95

Investors who purchase put options are bearish, while those who buy call options are bullish. The put/call ratio is calculated as the volume of put options traded divided by the volume of call options traded. A high put‐call ratio indicates that the market is bearish, while a low ratio suggests that the market is bullish. 


Question 96

Technical Analysis: Calculated statistical indices: CBOE Volatility Index (VIX)

Answer 96

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. 


Question 97

Technical Analysis: Calculated statistical indices: Margin Debt Levels

Answer 97

Studies have shown that margin debt levels (loans taken by individual investors to fund stock purchases) are very strongly correlated with the movement in the market. For example, margin debt reached its peak in the summer of 2007 (when the market recorded a recent high as well). Margin debt declined sharply in the second half of 2008 when the subprime crisis hit the market. 


Question 98

Technical Analysis: Calculated statistical indices: Short interest ratio

Answer 98

Short interest refers to the number of shares sold short for a particular security. The short interest ratio is calculated as: 


Short interest ratio = Short interest / Average daily trading volume

This indicator may be interpreted in two ways. A high ratio may suggest that:

• 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.

Question 99

Technical Analysis: Flow of funds indicators

Answer 99

Technicians also look at the potential demand and supply for securities in making trading decisions. 
They include Arms index (TRIN), Margin debt, mutual fund cash position, and new equity issuance.

Question 100

Technical Analysis: Arms index

Answer 100

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 Index = [Number of advancing issues/Number of declining issues] / [Volume of advancing issues/Volume of declining issues]

When the market is in balance, the Arms index is close to 1. Values above 1 indicate that there is more activity in declining stocks, and that the market is in a selling mood. Values below 1 indicate that there is more activity in advancing stocks and that market sentiment is currently bullish. 


Question 101

Technical Analysis: Margin Debt

Answer 101

Margin loans may increase stock purchases, while declining margin balances may force the selling of stocks.

Question 102

Technical Analysis: Mutual fund cash positions

Answer 102

Mutual funds typically hold a proportion of their portfolios in the form of cash to fund redemptions and to pay for miscellaneous expenses. Contrarian technicians believe that low mutual funds cash positions mean that mutual funds have already invested in the market, while high cash positions show that mutual funds are relatively liquid, and security prices will rise once they enter the market. Therefore, contrarians buy when mutual funds’ cash positions are high and sell when their cash positions are low. The average cash percentage of mutual funds has historically hovered around 6.8%.

Question 103

Technical Analysis: New equity issuance

Answer 103

Issuers of new securities try to time the offer such that it coincides with a period during which investor appetite for new issues is high and when the market is bullish so that they can obtain premium prices. Premium prices occur near market peaks. Therefore, when the new equity issuance indicator is high, the market is usually near its peak and is likely to decline in the future.

Question 104

Technical Analysis: Secondary offerings

Answer 104

Technicians also observe secondary offerings of shares. While these offerings do not increase the number of shares outstanding, they do increase the number of shares available for trading (the free float). Therefore, secondary offerings affect the supply of shares just like IPOs.

Question 105

Technical Analysis: Cycles

Answer 105

Over time, technicians have observed recurring cycles in the markets, only some of which can be logically explained. By identifying different cycles, technicians look to predict the market’s future direction.

Question 106

Technical Analysis: Kondratieff Waves

Answer 106

Nikolai Kondratieff suggested that economies went through a 54‐year economic cycle. His theory was mainly derived from economic cycles and commodity prices, but similar cycles have also been seen in equity prices during the time of his work.

Question 107

Technical Analysis: 18-Year Cycle

Answer 107

The 18‐year cycle is usually mentioned in real estate markets though it can also be observed in equities and other markets.

Question 108

Technical Analysis: Decennial Pattern

Answer 108

The decennial pattern traces the average annual stock returns (based on the DJIA) according to the last digit of the year. The DJIA has historically performed poorly in years ending with a 0, while the best ones have been years that end with a 5.

Question 109

Technical Analysis: Presidential Cycle

Answer 109

Historically, it has been observed that the third year (of the four‐year U.S. Presidential term) boasts the best stock market performance. The stock market has done reasonably well in the fourth year as well. One explanation for this is that politicians up for re‐election inject stimuli into the economy to increase their popularity.

Question 110

Technical Analysis: Elliott wave theory

Answer 110

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) in the following pattern: 1 = up, 2 = down, 3 = up, 4 = down, and 5 = up. The impulse wave is followed by a corrective wave that has three components: a = down, b = up, and c = down. The same pattern is reversed in a bear market. (See Figure 4-1.)

Elliott also proposed that each wave can be broken into smaller waves. Starting with the largest “grand supercycle,” which takes place over centuries, waves can be broken down into supercycles, cycles, and subcycles which take place over shorter and shorter intervals.

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 reverse prices by a factor of a Fibonacci number to the next number. He also described the characteristics of each wave.

Question 111

Technical analysis: Fibonacci sequence

Answer 111

The Fibonacci Sequence starts with the numbers 0, 1, 1, and then each subsequent number in the sequence is the sum of the two preceding numbers: 0, 1, 1, 2, 3, 5, 8, 13, …

Question 112

Technical analysis: Elliott wave theory advantage

Answer 112

Elliott Wave Theory is used along with Dow Theory, trend analysis, pattern analysis, and oscillator analysis to forecast market movements. Its biggest advantage is that it can be applied in short‐term trading as well as long‐term economic analysis.

Question 113

Technical analysis: Elliott wave theory graph (Explain)

Answer 113

Question 114

Technical analysis: Intermarket Analysis

Answer 114

Intermarket analysis refers to the technique of combining analysis of different markets to identify trends and reversals of trends. It is based on the principle that markets for different categories of securities (stocks, bonds, currencies, commodities, etc.) are interrelated and influence each other, and asserts that these relationships are strengthening with increasing globalization.

Question 115

Technical analysis: Intermarket Analysis: Some of the relationships that have been observed between different asset classes are:

Answer 115

• 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. (See Figure 4-2.) 


Question 116

Technical analysis: Intermarket Analysis: Inflection points

Answer 116

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. 


Question 117

Technical analysis: Intermarket Analysis: Inflection points graph – Relative strength of 10-Year T-Bonds vs. S&P 500

Answer 117

Question 118

Technical analysis: Intermarket Analysis: Inflection points graph – S&P 500 Index vs. Commodity Price

Answer 118

Question 119

Technical Analysis: Give an example where relative strength analysis can be used.

Answer 119

Given technical observations regarding the business cycle at any time, relative strength analysis can be used to identify potentially lucrative investments from within the equity market. For example, sectors like utilities and financials tend to perform well during the beginning of an economic cycle, while retailers and consumer durables do well once an economic recovery is well underway.

Question 120

Technical Analysis: Give an example where Intermarket analysis can be used.

Answer 120

Intermarket analysis can also be used to identify which countries one should invest in. Countries like Australia, Canada, and South Africa are driven by commodity markets, while others like India and China are primarily reliant on exports, which are driven by GDP growth in the rest of the world.

Question 121

Technical analysis

Answer 121

Technical analysis is a form of security analysis that uses price and volume market data, often graphically displayed.

Question 122

When can technical analysis be used?

Answer 122

Technical analysis can be used for any freely traded security in the global market and is used on a wide range of financial instruments, such as equities, bonds, commodity futures, and currency futures.

Question 123

What is technical analysis the study of?

Answer 123

Technical analysis is the study of market trends or patterns and relies on recognition of patterns that have worked in the past in an attempt to predict future security prices. Technicians believe that market trends and patterns repeat themselves and are somewhat predictable because human behavior tends to repeat itself and is somewhat predictable.

Question 124

Give a tenant of technical analysis

Answer 124

Another tenet of technical analysis is that the market brings together the collective wisdom of multiple participants, weights it according to the size of the trades they make, and allows analysts to understand this collective sentiment. Technical analysis relies on knowledgeable market participants putting this knowledge to work in the market and thereby influencing prices and volume.

Question 125

Technical analysis vs fundamental analysis

Answer 125

Technical analysis and fundamental analysis are equally useful and valid, but they approach the market in different ways. Technical analysis focuses solely on analyzing markets and the trading of financial instruments, whereas fundamental analysis is a much wider ranging field encompassing financial and economic analysis as well as analysis of societal and political trends.

Question 126

Main difference between technical and fundamental analysis

Answer 126

Technical analysis relies primarily on information gathered from market participants that is expressed through the interaction of price and volume. Fundamental analysis relies on information that is external to the market (e.g., economic data, company financial information) in an attempt to evaluate a security’s value relative to its current price.

Question 127

How is the usefulness of technical analysis diminished?

Answer 127

The usefulness of technical analysis is diminished by any constraints on the security being freely traded, by large outside manipulation of the market, and in illiquid markets.

Question 128

In technical analysis, what do charts provide?

Answer 128

Charts provide information about past price behavior and provide a basis for inferences about likely future price behavior. Various types of charts can be useful in studying the markets: line charts, bar charts, candlestick charts, and point and figure charts.

Question 129

In technical analysis, describe relative strength analysis

Answer 129

Relative strength analysis is based on the ratio of the prices of a security to a benchmark and is used to compare the performance of one asset with the performance of another asset.

Question 130

In technical analysis, why is volume information deemed important by technicians?

Answer 130

Many technicians consider volume information to be very important and watch for the confirmation in volume of a price trend or the divergence of volume from a price trend.

Question 131

In technical analysis, describe trends, including up trend and downtrend.

Answer 131

The concept of trend is perhaps the most important aspect of technical analysis. An uptrend is defined as a security making higher highs and higher lows. To draw an uptrend line, a technician draws a line connecting the lows of the price chart. A downtrend is defined as a security making lower highs and lower lows. To draw a downtrend line, a technician draws a line connecting the highs of the price chart.

Question 132

Technical analysis, define support and resistance.

Answer 132

Support is defined as a low price range in which the price stops declining because of buying activity. It is the opposite of resistance, which is a price range in which price stops rising because of selling activity.

Question 133

In technical analysis, define chart patterns.

Answer 133

Chart patterns are formations appearing in price charts that create some type of recognizable shape.

Question 134

In technical analysis, define reversal patterns.

Answer 134

Reversal patterns signal the end of a trend. Common reversal patterns are the head and shoulders, the inverse head and shoulders, double tops and bottoms, and triple tops and bottoms.

Question 135

In technical analysis, define continuation patterns.

Answer 135

Continuation patterns indicate that a market trend in place prior to the pattern formation will continue once the pattern is completed. Common continuation patterns are triangles, rectangles, flags, and pennants.

Question 136

In technical analysis, define price-based indicators.

Answer 136

Price-based indicators incorporate information contained in market prices. Common price-based indicators are the moving average and Bollinger Bands.

Question 137

In technical analysis, define momentum oscillator indicators.

Answer 137

Momentum oscillator indicators are constructed from price data, but they are calculated so that they fluctuate either between a high and low, typically 0 and 100, or around 0 or 100. Some examples are momentum (or rate of change) oscillators, the RSI, stochastic measures, and MACD.

Question 138

In technical analysis, define sentiment indicators.

Answer 138

Sentiment indicators attempt to gauge investor activity for signs of increasing bullishness or bearishness. Sentiment indicators come in two forms—investor polls and calculated statistical indices. Opinion polls to gauge investors’ sentiment toward the equity market are conducted by a variety of services. Commonly used calculated statistical indices are the put/call ratio, the VIX, margin debt, and the short interest ratio.

Question 139

In technical analysis, define flow-of-funds indicators.

Answer 139

Flow-of-funds indicators help technicians gauge potential changes in supply and demand for securities. Some commonly used indicators are the ARMS Index (also called the TRIN), margin debt (also a sentiment indicator), mutual fund cash positions, new equity issuance, and secondary equity offerings.

Question 140

In technical analysis, define cycles and types.

Answer 140

Many technicians use various observed cycles to predict future movements in security prices; these cycles include Kondratieff waves, decennial patterns, and the US presidential cycle.

Question 141

In technical analysis, define Elliot Wave Theory.

Answer 141

Elliott Wave Theory is an approach to market forecasting that assumes that markets form repetitive wave patterns, which are themselves composed of smaller and smaller subwaves. The relationships among wave heights are frequently Fibonacci ratios.

Question 142

In technical analysis, define intermarket analysis

Answer 142

Intermarket analysis is based on the principle that all markets are interrelated and influence each other. This approach involves the use of relative strength analysis for different groups of securities (e.g., stocks versus bonds, sectors in an economy, and securities from different countries) to make allocation decisions.

Question 143

Elliott Wave Theory: The major cycles are:

Answer 143

Grand supercycle

Supercycle

Cycle

Primary

Intermediate

Minor

Minute

Minuette

Subminuette