Reading 13: Technical Analysis Flashcards
Technical Analysis (Definition)
- Study of collective market sentiment
- Price effected by supply and demand
- Price/volume reflect the collective behavior of buyers and sellers (as only those who trade in the asset determine the price)
Technical Analysis (Assumptions)
- Rational and Irrational consumers (i.e. refute of efficient market hypothesis)
- Trends and patterns repeat over time and can be identified and forecasted
Technical Analysis cf. to fundamental analysis
Fundamental analysis looks at the intrinsic value of an asset
FA uses financial statements whereas TA uses price and volume i.e. not why people buy and sell, only what actually happened
Technical Analysis (Advantages)
- Uses actual data and is not subject to restatement
- Can forecast price of assets with no future cash flows
- May detect financial fraud before it comes up in financial statements
Technical Analysis (Limitations)
- Markets where the price may not truly reflect supply / demand e.g. illiquid markets or currencies (where central bank and intervene)
- Short covering can obscure true supply / demand (e.g. buying back stock to close a short position)
What are the different types of charts used in technical analysis:
- Line
- Bar
- Candlestick
- Point Figure
- Volume
Line Chart
Shows the closing price over a period
Bar Chart
High / Low price with closing and opening price shown by dashes on the right and left side of the chart
Candlestick Chart
Opening and Closing price.
Clear indicates closing price higher than opening price. Filled indicates closing price lower than opening price
Point and Figure Chart
Helpful in identifying changes in price movements
Boxes indicate a movement by a specified price increment
Usually 3 x price increment change will result in a reversed column
Volume Chart
Displayed below price charts
Relative Strength Analysis
The price of an asset relative to a benchmark. An increase will represent outperformance (positive relative strength)
Uptrend
Higher highs and higher lows
Demand > Supply
Downtrend
Lower lows and lower highs
Supply > Demand
Trendline (Please state connections for uptrends and downtrends)
Connects higher lows on an uptrend and lower highs on a downtrend
Breakout
Price > trend line in downturn
Breakdown
Price < trend line in upturn
Support Level
Price Floor (represented by trendline and indicates buying power restricting further losses)
Resistance Level
Price Ceiling (represented by the trendline and indicates selling power restricting further price increases)
Change in polarity
Breached support levels become resistance levels and breached resistance levels become support levels
Reversal Patterns
Head and Shoulders
Double / Triple Top
Inverse Head and Shoulders and Double / Triple Bottom
Head and Shoulders
Indicates waning demand
Difference between top of head and bottom of left shoulder (neckline) indicates the the extent of the price decline
Double / Trip Top/Bottom
Indicates weakening in buying / selling pressure as the price approaches a resistance / support level
Continuance Patterns
Triangles
Rectangles
Flags
Pennants
Price Based Indicators
Moving Average Lines
Bollinger Lines
Oscillators
Moving Average Lines
Mean of the last closing prices
In an uptrend, the price will be higher than the moving average and vice versa
Golden Cross
When the short term moving average line is greater than the long term moving average. This indicates a time to buy
Dead Cross
Short term moving average line is lower than the long term moving average. Indicates a time to sell
Dougy Bollinger Bands
Standard deviations of closing prices over the last n periods.
Usually two standard deviations each side
More volatility results in them moving away from each other and vice versa
Top of the band indicates an overbought market and the bottom of the bank indicates an oversold marketplace
Contrarian Trading Strategy
Do the opposite of what the trading signals say e.g. buy at the lower end of the bollinger band
Oscillator is a…
tool to identify when the market may be overbought / oversold
Convergence
When an oscillator mimic’s the price curve
Divergence
When the oscillator does not mimic the price curve and may indicate a change in trend
Oscillator examples
Relative Strength Index
Rate of Change Oscillator (Momentum Oscillator)
MACD (Moving Average Convergence / Divergence)
Stochastic Index
Rate of Change (Momentum Oscillator)
Formula + Interpretation
100 * (Last Closing Price - Closing Price n periods ago)
Positive = Buy Negative = Sell
Relative Strength Index
Ratio of total price increases to total price decreases over a selected number of periods
Higher values = overbought
Lower values = oversold
Moving Average Convergence / Divergence (MACD)
Exponentially smoothed moving averages that take greater account of recent movements
MACD line is the difference between two exponentially smoothed moving averages of the price
A Signal line is the exponentially smoothed moving average of the MACD line
MACD Interpretation
When the MACD line goes above theSignal line, this indicates a buy signal and vice versa
Stochastic Oscillator
Calculated by looking at the latest closing price relative to the highest / lowest price during a specified period
Consists of two lines:
- %K = difference between the latest closing price and a recent low as a % of the difference between high / low prices over a period
- %D = 3 period average of the %K
Stochastic Oscillator Interpreation
Similar to the MACD line, a buy signal is when the %K crosses the %D and vice versa
Non-Price Based Indicators
Put / Call Ratio
Volatility Index
Margin Debt
Short Interest Ratio
Put / Call Ratio
Put Options increase in value when the price of an asset drops
Call Options increase when the price of an assets increase
Thus when the the Put / Call ratio drops, the price is likely to decrease and vice versa.
Often viewed from a contrarian standpoint through so an increase in the put / call ratio would be an indication to buy
Volatility Index (VIX)
Run by the Chicago Board Options Exchange and measures the volatility of options in the S&P500
A high VIX indicates that investors anticipate declines in the stock market
Usually interpreted from a contrarian standpoint e.g. low VIX indicates a time to sell
Margin Debt
Increased margin debt = increased prices
Decreased margin debt = decreased prices
Short Interest Ratio
Indicates strong negative sentiment
However investors are split about its interpretation as a high ratio might also indicate more buying as short sellers have to close out their short positions
Flow of Funds Indicators
Arms Ratio / Short Term Trading Index (TRIM)
Margin Debt
Mutual Fund Cash Position
New Equity Issuance
Arms Ratio / TRIM
Measure of funds flowing into advancing and declining stocks
1 = even flow \+1 = more in declining stocks -1 = more in advancing stocks
Margin Debt (Flow of Funds Application)
Indicates increased willingness to buy stocks
Mutual Fund Cash Position
More Cash indicates that mutual funds have a bearish outlook.
Usually a contrarian indicator though more cash is an indication to buy
New Equity Issuance (IPO’s)
Indicates peak of the market
Common Cycles
4-year Presidential Term
10-year Decennial Pattern
54-year Kondratieff Wave
Elliot Wave Theory
Based on the belief that market prices can be explained by a set of interconnected cycles
“Waves”
Chart patterns that occur in relation with the Elliot Wave Theory
Each big movement consists of 5 waves up/down then reversal in the trend will be indicated by a new 3 wave movement
Size of the waves are said to correspond with the Fibonacci Numbers
Fibonacci Ratio
Starting with 0 and 1, the next number is the sum of the previous two numbers
The number can be used to predict the size of the next wave e.g. a down leg can be 1/2 the size of an up leg
Fibonacci Ratio Convergence
0.618 and 1.618 as the numbers in the sequence get larger
Intermarket Analysis
Analysis of the interrelationships among the market values of major asset classes e.g. stocks/bonds/commodities
Relative Strength Ratios (e.g. increases / decreases) indicate which asset classes are outperforming others
Useful for comparing the relative performance of equity market sectors or industries and of various international markets
