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Chapter 9

Chapter 9. A Basic View of Technical Analysis. Objective. Understand the difference between fundamental and technical analysis Appreciate how technical analysis is related to patterns of stock price movement Explain the types of charting that are used in technical analysis

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Chapter 9

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  1. Chapter 9 A Basic View of Technical Analysis

  2. Objective • Understand the difference between fundamental and technical analysis • Appreciate how technical analysis is related to patterns of stock price movement • Explain the types of charting that are used in technical analysis • Describe the use of key indicator series in attempting to track the direction of the market

  3. A Basic View of Technical Analysis • Technical Analysis: The Use of Charting • Key Indicator Series

  4. Technical Analysis • Examines prior price and volume data and other market-related indicators to determine past trends believing they may help to forecast future trends • Emphasis on charts and graphs of internal market data • Less emphasis on fundamental factors • Timing considerations and market imperfections

  5. Technical AnalysisBasic Assumptions • Market value determined solely by interaction of demand and supply • Although there are minor fluctuations in the market, stock prices tend to move in trends that persist for long periods • Reversals of trends are caused by shifts in demand and supply • Shifts in demand and supply can be detected sooner or later in charts • Many chart patterns tend to repeat themselves

  6. Technical AnalysisMost Significant Assumptions: The lag between the time a technical analyst perceives a change in the value of a security and when the investing public ultimately assesses this change provides a profit opportunity to the chartist

  7. The Use of Charting • Often linked to development of theDow Theoryin the late 1890s by Charles Dow • Generally believed successful in signaling the market crash of 1929

  8. Essential Elements of the Dow Theory • 3 major movements in the market: • Daily fluctuations 2. Secondary movements • two weeks to a month 3. Primary trends • long term • May be bullish or bearish in nature

  9. Presentation of the Dow Theory:Example of use to analyze a trend • Chart shows positive primary trend despite two secondary downward trends • Bullish primary trend is confirmed by the increases in the levels of secondary lows and highs • Pattern assumed to persist long term but ultimately to end

  10. Presentation of the Dow Theory:Market reversal and confirmation Ultimate end of a bullish trend detected by a new pattern: • Recovery fails to exceed previous high (Abortive recovery) + • New low penetrates a previous low + • New pattern confirmed by subsequent movement in Dow Jones Transportation Average

  11. Support and Resistance Levels Chartists attempt to define trading levels where price movements might face a challenge or barrier This assumes the existence of • Support levels (lower ends of trading ranges) and • Resistance levels (upper ends of trading ranges)

  12. Support and Resistance Levels • A breakout above a resistance level or below a support level is assumed to be significant • suggests that stock is now trading in new range • suggests higher or lower trading values outside the previous range may be expected

  13. Support and Resistance Levels • Support may develop each time stock price falls to lower level as investors who previously passed up buying opportunity now act • Resistance may develop when stock price rises to high side of normal trading range as investors take profit or try to get even after having bought at previous high

  14. Support and Resistance Levels • Support– at a sufficiently low price, the quantity demanded of a security increases keeping the price from falling further • Resistance– at a sufficiently high price, the quantity supplied of a security increases keeping the price from rising further Note that the analyst is looking just at the patterns here and is not really concerned with any fundamentals behind them

  15. Support and Resistance Levels • Breakout– the security price moves out of the previous trading range (breaching the resistance or support level) suggesting a new consensus and new trading levels

  16. Volume The volume of trading supporting a given market movement is considered significant • A stock price making a new high on heavytrading volume is viewed as bullish • A stock price making a new low on heavy trading volume is viewed as very bearish

  17. Volume The volume of trading supporting a given market movement is considered significant cont. • A stock price making a new high or low on lighttrading volume may indicate a temporary move likely to be reversed

  18. Types of Charts • Line charts • Bar charts • Point and figure charts

  19. Types of Charts: Bar Charts On November 12th, this stock traded between a high of $41 and a low of $38 and closed at $40 a share Bar chart showing the high and low prices of a stock during trading days in November with a horizontal dash along the line to indicate the closing price

  20. Bar Chart of Market Average

  21. Chart Evaluations Market technicians carefully evaluate charts – looking for what they perceive to be significant patterns of movement

  22. Chart Evaluations Chart Representation of a Market Bottom Thus in the Figure 9-4 bar chart, the pattern might be interpreted as the “head-and-shoulders” one (note the head in the middle) with a lower penetration of the neckline to the right indicating a sell signal

  23. Chart Representations

  24. Chart Representations

  25. Types of Charts: Point and Figure Chart (PFC) • Emphasizes significant price changes and the reversal of significant price changes • Has no time dimension • Chartists carefully read PFCs to observe market patterns: support, resistance, breakouts, congestion, etc.

  26. Types of Charts: Point and Figure Chart In Figure 9-7, assume stock price starts at $30. Only moves of $2 or more are plotted Advances  x Declines  o Reversals from advance to a decline & vice versa calls for a shift in columns

  27. Types of Charts: Point and Figure Chart Thus: The stock price initially goes from $30 to $42 and then shifts columns in its subsequent decline to $36 before moving up again in column 3. A similar pattern persists throughout the chart.

  28. Charts • Trendline, published through a division of Standard & Poor’s • Provides excellent charting information on a variety of securities traded on the major exchanges • Is available at many libraries and brokerage houses

  29. Charts • The problem in reading charts: • Analyzing patterns in such a fashion that they truly predict stock market movements before they unfold.

  30. Key Indicator Series A number of technical indicator series may be watched for bearish ( )and bullish ( ) trends • Contrary opinion rules • Smart money rules • Overall market indicators

  31. Contrary Opinion Rules Observe unsuccessful market behavior and choose a contrary position: • Odd-lot Theory • Short Sales Position • Investment Advisory Recommendations • Put-Call Ratio

  32. Contrary Opinion Rules:Odd-Lot Theory • Odd-lot trade • Less than 100 shares • Small investors • Theory suggests watching what small investor is doing, then do opposite • Barron’sreports odd-lot trading in • “Market Laboratory – Stocks” section • Construct a ratio of odd-lot purchases to odd-lot sales

  33. Contrary Opinion Rules:Odd-Lot Theory Cont. As shown in Figure 9-8, the odd-lot trader is on the correct path as the market is going up (net selling position) but becomes a net buyer preceding a fall in the market

  34. Contrary Opinion Rules:Odd-Lot Theory Cont. • The odd-lot trader is also presumed to be a strong seller right before the bottom of a bear market • Odd-lot trades on Mondays are particularly suspect

  35. Contrary Opinion Rules:Short Sales Position A rule based on the volume of short sales in the market A short sale represents the selling of a security you do not own with the anticipation of purchasing the security in the future at a lower price

  36. Contrary Opinion Rules:Short Sales Position • Short seller are sometimes emotional and may overreact to the market • Built-in demand for stocks that have been sold short by investors • They have to repurchase shares to cover their short positions

  37. Contrary Opinion Rules:Short Sales Position Cont. • Short sale totals reported in the Wall Street Journal • When the number of short sellers is large (i.e., they are bearish), this is thought to be a bullish signal

  38. Contrary Opinion Rules:Short Sales Position Cont. • Compute the ratio of total short sales positions on an exchange to average daily exchange volume for the month • Normal ratio is between 2.0 and 3.0 • A ratio of 2.5 indicates current short sales are equal to 2 ½ times the day’s average trading volume

  39. Contrary Opinion Rules:Short Sales Position Cont. • As the ratio (called the short interest ratio) approaches the higher end of the normal range, this would be considered bullish • Use of ratio has produced mixed results

  40. Contrary Opinion Rules:Investment Advisory Recommendations Watch the predictions of investment advisory services and do the opposite • Investors Intelligence has formalized this into an Index of Bearish Sentiment:

  41. Contrary Opinion Rules:Investment Advisory Recommendations Cont. In Figure 9-9, a summary of bullish and bearish sentiments from the “Market Laboratory—Economic Indicators” section of Barron’s, the AAII Index (American Assoc. of Individual Investors Index) shows the percentage of bears in the 15% range suggesting a possible sell under contrary opinion rules

  42. Contrary Opinion Rules: Put-Call Ratio Watch the “put-call” ratio and do the opposite of what option traders are doing • Puts and calls represent options to buy or sell stock over a specified period of time at a given price: • A put is an option to sell • A call is an option to buy

  43. Contrary Opinion Rules: Put-Call Ratio Cont. • The ratio of put (sell) to call (buy) options • Normally about 0.60 • Fewer traders of put options than call options • When ratio gets up to 0.65 to 0.70 or higher • Indicates increasing pessimism by option traders and contrary rules suggests a buy signal

  44. Contrary Opinion Rules: Put-Call Ratio Cont. • When the ratio goes down to 0.40 • decreasing pessimism (increasing optimism) may indicate that it is time to sell • The put-call ratio has a better than average record for calling market turns. • Put-call ratio data is found in the “Market Week – Options” section of Barron’s

  45. Smart Money Rules • Some investors attempt to track the pattern of sophisticated traders • They might provide unusual insight into the future

  46. Smart Money Rules:Barron’s Confidence Index • Used to observe trading pattern of investors in the bond market • Bond traders may be more sophisticated than stock traders • They may pick up trends more quickly • The theory suggests that a person who can figure out what bond traders are doing today may be able to determine what stock market investors will be doing in the near future

  47. Smart Money Rules:Barron’s Confidence Index Cont. • Computed by taking yield on 10 top-grade corporate bonds, dividing by yield on 40 intermediate-grade bonds and multiplying by 100: Barron’s Confidence Index Published weekly in the “Market Laboratory – Bonds” section of Barron’s

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