Test 3
Chapter 15: Technical Analysis
Technical analysis: a method of evaluating securities by analyzing statistics generated by market
activity. Analysts develop technical trading rules from observations of past price movements of the stock
market and individual stocks. “CNBC is 60% technical analysis”, “trend is my friend”.
-How it differs:
• Is in sharp contrast to the efficient market hypothesis, which contends that past performance has
no influence on future performance or market values.
• Whereas fundamental analysts use economic data that are usually separate from the stock or bond
market, technical analysts use date from the market itself (prices and volume), because they
contend that the market is its own best predictor.
o Technicians also believe that a change in the price trend may predict a forthcoming change
in some fundamental variables such as earnings and risk before the change is perceived by
most fundamental analysts.
Covered in this chapter:
-First examine basis philosophy underlying technical analysis
-Next consider advantages and potential problems with the technical approach
-Finally present alternative technical trading rules applicable to US and foreign markets.
Underlying Assumptions of Technical Analysis:
1) The market value of any good or service is determined solely by the interaction of supply and
demand.
2) Supply and demand are governed by numerous rational and irrational factors. The market
weights all factors continually and automatically.
3) Disregarding minor fluctuations, the prices for individual securities and the overall value of the
market tend to move in trends, which persist for appreciable lengths of time.
4) Prevailing trends change in reaction to shifts in supply and demand relationships.
Advantages of Technical Analysis:
• Major advantage is that it is not heavily dependent on financial accounting statements—the major
source of information about the past performance of a firm or industry. Technicians contend there
are several major problems with accounting statements.
• Technicians only need to quickly recognize a movement to a new equilibrium value for whatever
reason, whereas a fundamental analyst must process new information correctly and quickly to
derive a new intrinsic value for the stock or bond before other investors.
• Because most technicians do not invest until the move to the new equilibrium is underway, they
contend that they are more likely than a fundamental analyst to experience ideal timing.
Challenges to Technical Trading Rules
• Obvious challenge is that the past price patterns or relationships between specific market
variables and stock prices may not be repeated.
• Critics contend that many price patterns become self-fulfilling prophecies.
• The success of a particular trading rule will encourage many other investors to adopt it. The
resulting popularity and competition will eventually neutralize the technique.
• Most trading rules require a great deal of subjective judgement.
Technical Trading Rules and Indicators
,-Page 530 provides a good walk through of how a stock/market goes through rising and declining trend
channels.
-Analysts watch many alternative rules and decide on a buy or sell decision based on a consensus of the
signals, because complete agreement of all the rules is rare.
-Rules divided into 4 groups based on the attitudes of technical analysts.
Contrary-Opinion Rules: Determine when the majority of investors is either strongly bullish or bearish
and then trade in the opposite direction.
Mutual fund cash positions: the amount of cash that mutual fund managers are holding. These amounts
are low in a bull market because the cash is being invested, and high in a bear market because the
manager wants to increase the fund’s defensive cash position. (Text disagrees)
Credit balances in brokerage accounts: result when investors sell stocks and leave the proceeds with
their brokers, expecting to reinvest them shortly. These amounts are low in a bullish market, and high in
a bearish market for similar reasons mentioned above. (Text disagrees)
Chicago Board of Options Exchange (CBOE) put-call ratio: put options, which give the holder the
holder the right to sell stock at a specified price for a given time period, as signals of a bearish attitude.
Low put- call ratio is bullish, high is bearish.
-Directly related to the VIX, because the VIX is directly constructed by puts and calls. VIX is a fear index,
weighted average that hovers between 12-50. Low is bullish.
Follow the Smart Money: set of indicators and corresponding rules that analysts believe indicate the
behavior of smart, sophisticated investors.
Confidence Index: the ratio of the average yield on high grade bonds (Barron’s “Best grade bonds”) to the
average yield of medium grade bonds (Dow Jones “Intermediate Grade bonds”). Index measures the yield
spread over time, and should approach 100 as the spread between the two sets of bonds gets smaller
because yields on high grade bonds always should be lower than those on intermediate grade bonds.
• Because during periods of high confidence investors are willing to invest in lower-quality bonds
for added yield, which causes a decrease in the yield spreads between intermediate and high
grade bonds. Therefore the ratio of the yields, the CI, will increase, which is a bullish signal. Signal
is bearish if the ratio is falling.
• Remember: as demand increases, yields decline, prices increases. As demand declines, yield
increases, and price declines.
T-bill-Eurodollar Yield Curve (Spread): measure of investor attitude/confidence is spread between t-bill
yields and Eurodollar rates measures as a ratio of T-bill/Eurodollar yields.
• During times of international crisis, the spread widens as the smart money flows to safe-haven US
T-bills, which causes a decline in the ratio.
• Ascending or high ratio means bullish. Descending or low ratio means bearish.
Momentum Indicators: several popular indicators of overall market momentum used to make aggregate
market decisions.
Breadth of Market: measures the number of issues that have increased each day and the number of
issues that have declined. It helps explain what caused a change in direction in a composite market such
as the S&P 500 Index.
, • Important to consider that most stock-market indexes are heavily influenced by the stocks of large
firms because the indexes are value weighted. So the index can experience an overall increase
while the majority of the individual stocks are not participating in the risking market. Such a
divergence can be detected by examining the advance-decline figures for all stocks on the
exchange, along with the overall market index.
• The advance decline index is typically a cumulative index of net advances or net declines
• Advances: x = A – D Declines: E(x) = A – D = 0
1. Harlen Intermediate Index: 20 day moving average of x stock.
• Bullish signal: index > 0 Bearish signal: index < 0
2. Arms Index: looks at the number of advances/declines and the volume of advances/declines.
• Formula: (A/D) / (Volume of A / Volume of D) ex: (50/50) / (2000/1000) = 1
• Bullish signal < 1 Bearish signal > 1
Stock Price and Volume Techniques: important to consider hypothetical stock price chart on page 530.
While price patterns alone are important, most technical trading rules consider both stock price and
corresponding volume movements.
Dow Theory: stock prices moving in trends analogous to the movement of water.
-History:
• 1902 Dow said that stock prices could be used to forecast business conditions
• 1922 Hamilton extends this, saying stock prices could be used to forecast the movement of the
stock market
• 1932 Rhea extends this, saying stock prices could be used to forecast stock prices themselves. Now
we see Dow Theory “through the lens of Rhea”.
-Dow Theory: 3 types of market movements, can
1. Primary or major trend, may last years (tides)
2. Intermediate or secondary trend, may last weeks or months (waves)
3. Short run or minor trend, may last days or weeks (ripples)
-Things to consider from text:
• Theory is an attempt to detect the direction of the major price trend (tide), recognizing that
intermediate movements (waves) may occasionally move in the opposite direction.
• Major market advance does not go straight up, but rather includes small price declines as some
investors decide to take profits. See Exhibit 15.5
• Price change alone does not indicate the breadth of the excess demand or supply. Price
increase/decrease on heavy volume relative to the stock’s normal volume is considered
bullish/bearish.
-Things to consider from notes:
• Look for conformation in volume, technicians look for every recovery to reach a new peak above
the prior peak, and this price rise should be accompanied by heavy trading volume. Relatively
light trading volume during profit-taking reversals.
• Look for confirmation in other indices for signals.
• Feel that when market is moving sideways that eventual move will be big up or down.
Chapter 15: Technical Analysis
Technical analysis: a method of evaluating securities by analyzing statistics generated by market
activity. Analysts develop technical trading rules from observations of past price movements of the stock
market and individual stocks. “CNBC is 60% technical analysis”, “trend is my friend”.
-How it differs:
• Is in sharp contrast to the efficient market hypothesis, which contends that past performance has
no influence on future performance or market values.
• Whereas fundamental analysts use economic data that are usually separate from the stock or bond
market, technical analysts use date from the market itself (prices and volume), because they
contend that the market is its own best predictor.
o Technicians also believe that a change in the price trend may predict a forthcoming change
in some fundamental variables such as earnings and risk before the change is perceived by
most fundamental analysts.
Covered in this chapter:
-First examine basis philosophy underlying technical analysis
-Next consider advantages and potential problems with the technical approach
-Finally present alternative technical trading rules applicable to US and foreign markets.
Underlying Assumptions of Technical Analysis:
1) The market value of any good or service is determined solely by the interaction of supply and
demand.
2) Supply and demand are governed by numerous rational and irrational factors. The market
weights all factors continually and automatically.
3) Disregarding minor fluctuations, the prices for individual securities and the overall value of the
market tend to move in trends, which persist for appreciable lengths of time.
4) Prevailing trends change in reaction to shifts in supply and demand relationships.
Advantages of Technical Analysis:
• Major advantage is that it is not heavily dependent on financial accounting statements—the major
source of information about the past performance of a firm or industry. Technicians contend there
are several major problems with accounting statements.
• Technicians only need to quickly recognize a movement to a new equilibrium value for whatever
reason, whereas a fundamental analyst must process new information correctly and quickly to
derive a new intrinsic value for the stock or bond before other investors.
• Because most technicians do not invest until the move to the new equilibrium is underway, they
contend that they are more likely than a fundamental analyst to experience ideal timing.
Challenges to Technical Trading Rules
• Obvious challenge is that the past price patterns or relationships between specific market
variables and stock prices may not be repeated.
• Critics contend that many price patterns become self-fulfilling prophecies.
• The success of a particular trading rule will encourage many other investors to adopt it. The
resulting popularity and competition will eventually neutralize the technique.
• Most trading rules require a great deal of subjective judgement.
Technical Trading Rules and Indicators
,-Page 530 provides a good walk through of how a stock/market goes through rising and declining trend
channels.
-Analysts watch many alternative rules and decide on a buy or sell decision based on a consensus of the
signals, because complete agreement of all the rules is rare.
-Rules divided into 4 groups based on the attitudes of technical analysts.
Contrary-Opinion Rules: Determine when the majority of investors is either strongly bullish or bearish
and then trade in the opposite direction.
Mutual fund cash positions: the amount of cash that mutual fund managers are holding. These amounts
are low in a bull market because the cash is being invested, and high in a bear market because the
manager wants to increase the fund’s defensive cash position. (Text disagrees)
Credit balances in brokerage accounts: result when investors sell stocks and leave the proceeds with
their brokers, expecting to reinvest them shortly. These amounts are low in a bullish market, and high in
a bearish market for similar reasons mentioned above. (Text disagrees)
Chicago Board of Options Exchange (CBOE) put-call ratio: put options, which give the holder the
holder the right to sell stock at a specified price for a given time period, as signals of a bearish attitude.
Low put- call ratio is bullish, high is bearish.
-Directly related to the VIX, because the VIX is directly constructed by puts and calls. VIX is a fear index,
weighted average that hovers between 12-50. Low is bullish.
Follow the Smart Money: set of indicators and corresponding rules that analysts believe indicate the
behavior of smart, sophisticated investors.
Confidence Index: the ratio of the average yield on high grade bonds (Barron’s “Best grade bonds”) to the
average yield of medium grade bonds (Dow Jones “Intermediate Grade bonds”). Index measures the yield
spread over time, and should approach 100 as the spread between the two sets of bonds gets smaller
because yields on high grade bonds always should be lower than those on intermediate grade bonds.
• Because during periods of high confidence investors are willing to invest in lower-quality bonds
for added yield, which causes a decrease in the yield spreads between intermediate and high
grade bonds. Therefore the ratio of the yields, the CI, will increase, which is a bullish signal. Signal
is bearish if the ratio is falling.
• Remember: as demand increases, yields decline, prices increases. As demand declines, yield
increases, and price declines.
T-bill-Eurodollar Yield Curve (Spread): measure of investor attitude/confidence is spread between t-bill
yields and Eurodollar rates measures as a ratio of T-bill/Eurodollar yields.
• During times of international crisis, the spread widens as the smart money flows to safe-haven US
T-bills, which causes a decline in the ratio.
• Ascending or high ratio means bullish. Descending or low ratio means bearish.
Momentum Indicators: several popular indicators of overall market momentum used to make aggregate
market decisions.
Breadth of Market: measures the number of issues that have increased each day and the number of
issues that have declined. It helps explain what caused a change in direction in a composite market such
as the S&P 500 Index.
, • Important to consider that most stock-market indexes are heavily influenced by the stocks of large
firms because the indexes are value weighted. So the index can experience an overall increase
while the majority of the individual stocks are not participating in the risking market. Such a
divergence can be detected by examining the advance-decline figures for all stocks on the
exchange, along with the overall market index.
• The advance decline index is typically a cumulative index of net advances or net declines
• Advances: x = A – D Declines: E(x) = A – D = 0
1. Harlen Intermediate Index: 20 day moving average of x stock.
• Bullish signal: index > 0 Bearish signal: index < 0
2. Arms Index: looks at the number of advances/declines and the volume of advances/declines.
• Formula: (A/D) / (Volume of A / Volume of D) ex: (50/50) / (2000/1000) = 1
• Bullish signal < 1 Bearish signal > 1
Stock Price and Volume Techniques: important to consider hypothetical stock price chart on page 530.
While price patterns alone are important, most technical trading rules consider both stock price and
corresponding volume movements.
Dow Theory: stock prices moving in trends analogous to the movement of water.
-History:
• 1902 Dow said that stock prices could be used to forecast business conditions
• 1922 Hamilton extends this, saying stock prices could be used to forecast the movement of the
stock market
• 1932 Rhea extends this, saying stock prices could be used to forecast stock prices themselves. Now
we see Dow Theory “through the lens of Rhea”.
-Dow Theory: 3 types of market movements, can
1. Primary or major trend, may last years (tides)
2. Intermediate or secondary trend, may last weeks or months (waves)
3. Short run or minor trend, may last days or weeks (ripples)
-Things to consider from text:
• Theory is an attempt to detect the direction of the major price trend (tide), recognizing that
intermediate movements (waves) may occasionally move in the opposite direction.
• Major market advance does not go straight up, but rather includes small price declines as some
investors decide to take profits. See Exhibit 15.5
• Price change alone does not indicate the breadth of the excess demand or supply. Price
increase/decrease on heavy volume relative to the stock’s normal volume is considered
bullish/bearish.
-Things to consider from notes:
• Look for conformation in volume, technicians look for every recovery to reach a new peak above
the prior peak, and this price rise should be accompanied by heavy trading volume. Relatively
light trading volume during profit-taking reversals.
• Look for confirmation in other indices for signals.
• Feel that when market is moving sideways that eventual move will be big up or down.
