Topic 5 - Technical analysis

Question 1

Technical analysis - Concept

Answer 1

• technical analysis is the study of historical prices for the purpose of predicting prices in the future
• technical analysis frequently utilizes charts of past prices to identify historical price patterns
• these price patterns are then used to forecast prices in the future

Role of technical analysis:
* identify and predict changes in direction of price trends
* determine the timing of action - entry and exit decisions

Question 2

Technical analysis and efficiency

Answer 2

• a basic belief of technical analysists is that market prices themselves contain useful and timely information
• …but in efficient markets prices quickly reflect all available fundamental information, as well as other information, such as traders’ expectations and the psychology of the market
• there is not much room for technical analysis in highly efficient markets except in the case of very short term changes

Question 3

The Dow theory

Answer 3

• The Dow theory is the main antedencent of what we define today as technical analysis
• It is based on six main tenets

Question 4

1.The market has three movements

Answer 4

1. The primary movement may last from less than a year to several years.
2. The secondary reaction, which may last from ten days to three months (generally retraces from 33% to 66% of the primary price change)
3. The “short swing” or minor movement varies with opinion from hours to a month or more

Question 5

2.Market trends have three phases

Answer 5

1. The accumulation phase (phase 1): when investors “in the know” are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority demanding (absorbing) stock that the market at large is supplying (releasing)
2. The public participation phase (phase 2): The market catches on to these astute investors and a rapid price change occurs. This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs
3. The distribution phase (phase 3): At this point, the astute investors begin to distribute their holdings to the market

Question 6

3.Stock market averages must confirm each other

Answer 6

There is a connection between the evolution of the industrial and transportation indices

If manufacturers’ profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship their output to market, the railroads

Question 7

4.Trends are confirmed by volume

Answer 7

Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations. For example, it could be caused by an overly aggressive seller

But when price movements are accompanied by high volume, Dow believed this represented the “true” market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. This was a signal that a trend was developing

Question 8

Types of charts used in technical analysis

Answer 8

1. bar charts
2. line charts
3. candlestick charts
4. point-and-figure charts

Question 9

Candlestick charts

Answer 9

• hollow candlesticks form when the close is higher than the open price, indicate buying pressure
• filled (solid) candlesticks form when the close is lower than the open, indicate selling pressure

Question 10

White vs Black Marubozus

Answer 10

• A White Marubozu forms when the open equals the low and the close equals the high
• A black Marubozu forms when the open equals the high and the close equals the low

Question 11

Doji

Answer 11

Doji form when a security’s open and close are virtually equal.

Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level. The result is a standoff. Neither were able to gain control and a turning point could be developing.

Doji indicate that the forces of supply and demand are becoming more evenly matched and a change in trend may be near. Doji alone are not enough to mark a reversal and further confirmation may be warranted.