Chapter 13 Technical Analysis 6520211999 SouthWestern College Publishing

Chapter 13 Technical Analysis ® 6/5/20211999 South-Western College Publishing 1

Technical Analysis As An Art • Prices are Determined by Investors’ Attitudes – Prices move in trends • Changing Attitude Toward – Economic forces – Monetary forces – Political forces – Psychological forces ® 6/5/20211999 South-Western College Publishing 2

Technical Analysis As A Science • Study of the Action of the Market • Science of Recording in Graphic Form – Price changes, volume, highs and lows, … – The averages of above • Deducing the Probable Future Trend ® 6/5/20211999 South-Western College Publishing 3

Is Technical Analysis An Art Or Science? • Art – Martin J. Pring • Science – Robert D. Edwards and John Magee ® 6/5/20211999 South-Western College Publishing 4

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 factors, both rational and irrational ® 6/5/20211999 South-Western College Publishing 5

Underlying Assumptions of Technical Analysis 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 and these shifts can be detected in the action of the market ® 6/5/20211999 South-Western College Publishing 6

Advantages of Technical Analysis • Not heavily dependent on financial accounting statements – Problems with accounting statements: 1. Lack information needed by security analysts 2. GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms 3. Nonquantifiable factors do not show up in financial statements ® 6/5/20211999 South-Western College Publishing 7

Advantages of Technical Analysis • Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium • Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly ® 6/5/20211999 South-Western College Publishing 8

Challenges to Technical Analysis • Trading rules – The past may not be repeated – Patterns may become self-fulfilling prophecies – A successful rule will gain followers and become less successful – Rules all require subjective judgment • Assumptions - Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends 9 ® 6/5/20211999 South-Western College Publishing

Is There Any Empirical Evidence To Support Technical Analysis (TA)? • Patterns in Security Prices – Fall one week, bounce back next week – Monthly returns over a long time – Seasonal patterns • January effect (Chapter 12) • Resent Research Merits TA ® 6/5/20211999 South-Western College Publishing 10

Charting • Bar Charts – Illustrates each days • High, low, and closing price – Looks at stock price behavior over time • Point-and-Figure Charts – Identifies stock price reversals – Does not consider time • Candlestick Charts – Illustrates each days • Opening, high, low, and closing price ® 6/5/20211999 South-Western College Publishing 11

Bar Charts • Trendline – Drawn on chart to identify trend • Channel – Pattern formed by 2 trendlines • Resistance – Downward price movement • Support – Upward price movement ® 6/5/20211999 South-Western College Publishing 12

Typical Stock Market Cycle Stock Price ® 6/5/20211999 South-Western College Publishing Figure 21. 2 13

Typical Stock Market Cycle Stock Price Figure 21. 2 Declining Trend Channel Peak Flat Trend Channel Sell Point Rising Trend Channel Declining Buy Point Trend Trough ® 6/5/20211999 South-Western College Publishing Channel Trough Buy Point 14

Point-And-Figure Charts • A Series of Xs and Os • Same as Bar Charts • Popular Tool ® 6/5/20211999 South-Western College Publishing 15

Candlestick Chart • Candlestick Line – Real body • Difference between opening and closing price – Shadow • Vertical line identifying the high and low price – Can be constructed with Different Time Data • Intraday • Weekly ® 6/5/20211999 South-Western College Publishing 16

Summary Of Charts ® 6/5/20211999 South-Western College Publishing 17

Contrary-Opinion • Many analysts rely on rules developed from the premise that the majority of investors are wrong as the market approaches peaks and troughs • Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction • These positions have various indicators ® 6/5/20211999 South-Western College Publishing 18

Contrary-Opinion Rules • • • Mutual fund cash positions Credit balances in brokerage accounts Investment advisory opinions OTC versus NYSE volume Chicago Board Options Exchange (CBOE) put/call ratio • Futures traders bullish on stock index futures ® 6/5/20211999 South-Western College Publishing 19

Follow the Smart Money • Indicators showing behavior of sophisticated investors • The Barron’s Confidence Index • T-Bill - Eurodollar yield spread • Short sales by specialists • Debit balances in brokerage accounts (margin debt) ® 6/5/20211999 South-Western College Publishing 20

Other Market Indicators • Breadth of market – Advance-decline – Diffusion index • Short interest • Stocks above their 200 -day moving average • Block uptick-downtick ratio ® 6/5/20211999 South-Western College Publishing 21

Theoretical Basis Of TA • Dow Theory – Trends • Moving Averages – 5 -day – 200 -day • Relative Strength – RSI ® 6/5/20211999 South-Western College Publishing 22

Dow Theory • Primary Trend - “Tides” – Cycle in years • Intermediate Trend - “waves” – 3 Weeks to 6 months • Short-Term Trend - “ripples” – Volatile and erratic • Basic Tenets next slide ® 6/5/20211999 South-Western College Publishing 23

Basic Tenets Of Dow Theory • Requires Data on Stock Indexes – No additional information • Types of Financial Market Movements – Primary – Intermediate – Short-term • Positive Relationship Between – Trend – Volume of shares traded ® 6/5/20211999 South-Western College Publishing 24

RSI • Range From 0% to 100% • High – Industry stock prices outperform the market – Indicate a sell signal? Buy signal? • Low The trend is your friend! – Market outperforming the industry stock – Indicates a buy signal? Sell signal? ® 6/5/20211999 South-Western College Publishing 25

Stock Price and Volume Techniques • Relative-strength (RS) ratios – For individual stocks and industry groups • Bar charting • Multiple indicator charts • Point-and-figure charts • Overall feel from a consensus of numerous technical indicators ® 6/5/20211999 South-Western College Publishing 26

Technical Indicators • Breadth Indicators – Advance-decline (ADL) – Volume – New high/new low • Sentiment Indicators – Stock market newsletter – Odd-lot trading – Put/call trading – Specialists short selling ® 6/5/20211999 South-Western College Publishing 27

Advance-Decline Line ADLt = At - Dt + ADLt - 1 ® 6/5/20211999 South-Western College Publishing 28