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Technical Analysis
Introduction

   Technical analysis is the attempt to forecast
    stock prices on the basis of market-derived data.
   Technicians (also known as quantitative analysts
    or chartists) usually look at price, volume and
    psychological indicators over time.
   They are looking for trends and patterns in the
    data that indicate future price movements.
The Potential Rewards

   This chart, from Norman Fosbeck, shows how market
    timing can benefit your returns. The only problem is that
    you have to be very good at it.




            Alternative Market Strategies (1964 to 1984)
     Strategy                        Avg. Annual Gain   $10,000 Grows To
     Buy and Hold                         11.46%        $          87,500
     Avoid Bear Markets                   21.48%        $         489,700
     Long and Short Major Swings          27.99%        $       1,391,200
     Long and Short Every 5% Swing        93.18%        $ 5,240,000,000
The Potential Rewards

   This chart, from Barron’s, shows the benefit of being
    smart enough to miss the worst 5 days of the year
    between Feb 1966 and Oct 2001.




                Source: “The Truth About Timing,” by Jacqueline Doherty,
                Barron’s (November 5, 2001)
Agenda

   Charting Stocks
       Bar Charts and Japanese Candlestick Charts
       Point and Figure Charts
   Major Chart Patterns
   Price-based Indicators
   Volume-based Indicators
   Dow Theory
   Elliot Wave
Charting the Market

   Chartists use bar charts, candlestick, or point and
    figure charts to look for patterns which may
    indicate future price movements.
   They also analyze volume and other
    psychological indicators (breadth, % of bulls vs
    % of bears, put/call ratio, etc.).
   Strict chartists don’t care about fundamentals at
    all.
Drawing Bar (OHLC) Charts

   Each bar is composed of 4
    elements:
       Open
       High                                High                                High
       Low                                        Close                 Open
       Close
   Note that the candlestick body
    is empty (white) on up
    days, and filled (some color)    Open                                              Close
    on down days                            Low                                 Low
   Note: You should print the       Standard              Japanese      Standard              Japanese
                                     Bar Chart             Candlestick   Bar Chart             Candlestick
    example charts (next two
    slides) to see them more
    clearly
Types of Charts: Bar Charts

   This is a bar (open, high, low, close or OHLC) chart of
    AMAT from early July to mid October 2001.
Types of Charts: Japanese Candlesticks

   This is a Japanese Candlestick (open, high, low, close)
    chart of AMAT from early July to mid October 2001
Drawing Point & Figure Charts

   Point & Figure charts are
    independent of time.
   An X represents an up move.
   An O represents a down
    move.
   The Box Size is the number of
    points needed to make an X or
    O.                                 X
   The Reversal is the price          X
    change needed to recognize a     X XO
                                     X XO
    change in direction.             XO O
   Typically, P&F charts use a 1-   XO O
                                     X
    point box and a 3-point
    reversal.
Chart Types: Point & Figure Charts

   This is a Point & Figure chart of AMAT from early July
    to mid October 2001.
Basic Technical Tools

   Trend Lines
   Moving Averages
   Price Patterns
   Indicators
   Cycles
Trend Lines

   There are three basic
    kinds of trends:
       An Up trend where prices
        are generally increasing.
       A Down trend where
        prices are generally
        decreasing.
       A Trading Range.
Support & Resistance

   Support and resistance lines
    indicate likely ends of trends.
   Resistance results from the
                                                Breakout
    inability to surpass prior
    highs.
   Support results from the
    inability to break below to
    prior lows.
   What was support becomes
    resistance, and vice-versa.
                                      Support   Resistance
Simple Moving Averages

   A moving average is simply
    the average price (usually the
    closing price) over the last N                                   MSFT Daily Prices with 10-day MA
                                                                               9/23/93 to 9/21/94

                                             60

    periods.
                                             55

   They are used to smooth out
    fluctuations of less than N
                                             50




    periods.


                                     Price
                                             45




   This chart shows MSFT with               40




    a 10-day moving average.                 35




    Note how the moving average              30
                                                  1   21   41   61    81     101       121          141   161   181   201   221   241


    shows much less volatility                                                           Date




    than the daily stock price.
Price Patterns

   Technicians look for many patterns in the
    historical time series of prices.
   These patterns are reputed to provide
    information regarding the size and timing of
    subsequent price moves.
   But don’t forget that the EMH says these
    patterns are illusions, and have no real meaning.
    In fact, they can be seen in a randomly generated
    price series.
Head and Shoulders
                                                 H&S Top
   This formation is                               Head
    characterized by two
    small peaks on either       Left Shoulder                Right Shoulder

    side of a larger peak.
   This is a reversal                            Neckline

    pattern, meaning that it
                                                H&S Bottom
    signifies a change in the
                                                  Neckline
    trend.
                                Left Shoulder                Right Shoulder



                                                    Head
Head & Shoulders Example




                       Sell Signal




                Minimum Target Price
                Based on measurement rule
Double Tops and Bottoms
                                Double Top
   These formations are
    similar to the H&S
    formations, but there is
    no head.
   These are reversal                Target
    patterns with the same            Target

    measuring implications
    as the H&S.


                               Double Bottom
Double Bottom Example
Triangles

   Triangles are
    continuation formations.
   Three flavors:              Ascending
       Ascending
       Descending                           Symmetrical
       Symmetrical
   Typically, triangles                     Symmetrical
    should break out about
    half to three-quarters of
                                Descending
    the way through the
    formation.
Rounded Tops & Bottoms

   Rounding formations are     Rounding
    characterized by a slow     Bottom
    reversal of trend.



                              Rounding Top
Rounded Bottom Chart Example
Broadening Formations

   These formations are like
    reverse triangles.          Broadening Bottoms
   These formations usually
    signal a reversal of the
    trend.



                                  Broadening Tops
DJIA Oct 2000 to Oct 2001 Example




What could you have known,
and when could you have known it?
DJIA Oct 2000 to Oct 2001 Example




  Nov to Mar
  Trading range
                                  Descending
                                  triangles



                                               Gap, should get
                  Double bottom
                                               filled
Technical Indicators

   There are, literally, hundreds of technical indicators used
    to generate buy and sell signals.
   We will look at just a few that I use:
       Moving Average Convergence/Divergence (MACD)
       Relative Strength Index (RSI)
       On Balance Volume
       Bollinger Bands
   For information on other indicators see my Investments
    Class Links page under the heading “Technical Analysis
    Links.”
    (http://clem.mscd.edu/~mayest/FIN3600/FIN3600_Links.htm)
MACD

   MACD was developed by Gerald Appel as a way to keep
    track of a moving average crossover system.
   Appel defined MACD as the difference between a 12-
    day and 26-day moving average. A 9-day moving
    average of this difference is used to generate signals.
   When this signal line goes from negative to positive, a
    buy signal is generated.
   When the signal line goes from positive to negative, a
    sell signal is generated.
   MACD is best used in choppy (trendless) markets, and is
    subject to whipsaws (in and out rapidly with little or no
    profit).
MACD Example Chart
Relative Strength Index (RSI)

   RSI was developed by Welles Wilder as an oscillator to
    gauge overbought/oversold levels.
   RSI is a rescaled measure of the ratio of average price
    changes on up days to average price changes on down
    days.
   The most important thing to understand about RSI is that
    a level above 70 indicates a stock is overbought, and a
    level below 30 indicates that it is oversold (it can range
    from 0 to 100).
   Also, realize that stocks can remain overbought or
    oversold for long periods of time, so RSI alone isn’t
    always a great timing tool.
RSI

   a technical analysis tool that is banded between
    two extreme values and built with the results
    from a trend indicator for discovering short term
    overbought and over sold conditions. As the
    value of the oscillator approach the upper
    extreme value the asset is seem to be over
    brought and as it is approaches to be lower
    extreme as it seems to be over sold.
RSI Example Chart
          Overbought   Oversold
On Balance Volume

   On Balance Volume was developed by Joseph
    Granville, one of the most famous technicians of the
    1960’s and 1970’s.
   OBV is calculated by adding volume on up days, and
    subtracting volume on down days. A running total is
    kept.
   Granville believed that “volume leads price.”
   To use OBV, you generally look for OBV to show a
    change in trend (a divergence from the price trend).
   If the stock is in an uptrend, but OBV turns down, that is
    a signal that the price trend may soon reverse.
OBV Example Chart



                        Divergence, OBV failed


         OBV confirms
         trend change
         but doesn’t
         lead
Bollinger Bands

   Bollinger bands were created by John Bollinger (former FNN
    technical analyst, and regular guest on CNBC).
   Bollinger Bands are based on a moving average of the closing price.
   They are two standard deviations above and below the moving
    average.
   A buy signal is given when the stock price closes below the lower
    band, and a sell signal is given when the stock price closes above the
    upper band.
   When the bands contract, that is a signal that a big move is
    coming, but it is impossible to say if it will be up or down.
   In my experience, the buy signals are far more reliable than the sell
    signals.
Bollinger Bands Example Chart
         Sell signal




           Buy signals


                         Sometimes, the buy
                         signals just keep coming and
                         you can go broke!
Dow Theory

   This theory was first stated by Charles Dow in a
    series of columns in the WSJ between 1900 and
    1902.
   Dow (and later Hamilton and Rhea) believed that
    market trends forecast trends in the economy.
   A change in the trend of the DJIA must be
    confirmed by a trend change in the DJTA in
    order to generate a valid signal.
Dow Theory Trends (1)

   Primary Trend
       Called “the tide” by Dow, this is the trend that
        defines the long-term direction (up to several years).
        Others have called this a “secular” bull or bear
        market.
   Secondary Trend
       Called “the waves” by Dow, this is shorter-term
        departures from the primary trend (weeks to months)
   Day to day fluctuations
       Not significant in Dow Theory
Dow Theory Trends (2)
Does Dow Theory Work?

   According to Martin Pring, if you had invested
    $44 in 1897 and followed all buy and sell
    signals, by 1981 you would have accumulated
    about $18,000.
   If you had simply invested $44 and held that
    portfolio, by 1981 you would have accumulated
    about $960.
Elliot Wave Principle (1)

   R.N. Elliot formulated this idea in a series of articles in
    Financial World in 1939.
   Elliot believed that the market has a rhythmic regularity
    that can be used to predict future prices.
   The Elliot Wave Principle is based on a repeating 8-wave
    cycle, and each cycle is made up of similar shorter-term
    cycles (“Big fleas have little fleas upon their backs to
    bite 'em - little fleas have smaller fleas and so on ad
    infinitem”).
   Elliot Wave adherents also make extensive use of the
    Fibonacci series.
The Elliot Wave Principle (2)


                              5

                                      B
                                  A
                                          C
                      3

                          4
              1

                  2
Fibonacci Numbers

   Fibonacci numbers are a series where each succeeding number is the
    sum of the two preceding numbers.
   The first two Fibonacci numbers are defined to be 1, and then the
    series continues as follows: 1, 1, 2, 3, 5, 8, 13, 21…
   As the numbers get larger, the ratio of adjacent numbers approaches
    the Golden Mean: 1.618:1.
   This ratio is found extensively in nature, and has been used in
    architecture since the ancient Greeks (who believed that a rectangle
    whose sides had the ratio of 1.618:1 was the most aesthetically
    pleasing).
   Technical analysts use this ratio and its inverse, 0.618, extensively to
    provide projections of price moves.
Does Elliot Wave Work?

   Who knows? One of the biggest problems with Elliot
    Wave is that no two practitioners seem to agree on the
    wave count, and therefore on the prediction of what’s to
    come.
   Robert Prechter (the most famous EW practitioner) made
    several astoundingly correct predictions in the
    1980’s, but hasn’t been so prescient since (he no longer
    gets much press attention).
   For example, in 1985 he predicted that the market would
    peak in 1987 (correct), but he thought it would peak at
    3686 (± 100 points).
   The DJIA actually peaked on 25 August 1987 at
    2722.42, more than 960 points lower.
Too Many Others To List

   As noted, there are literally hundreds of indicators and thousands of
    trading systems.
   A whole semester could easily be spent on just a handful of these.
   To close, just note that there is nothing so crazy that somebody
    doesn’t use it to trade.
   For example, many people use astrology, geometry (Gann
    angles), neural networks, chaos theory, etc.
   There’s no doubt that each of these (and others) would have made
    you lots of money at one time or another. The real question is can
    they do it consistently?
   As the carneys used to say, “You pays your money, and you takes
    your chances.”

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Technical analysis ppt

  • 2. Introduction  Technical analysis is the attempt to forecast stock prices on the basis of market-derived data.  Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time.  They are looking for trends and patterns in the data that indicate future price movements.
  • 3. The Potential Rewards  This chart, from Norman Fosbeck, shows how market timing can benefit your returns. The only problem is that you have to be very good at it. Alternative Market Strategies (1964 to 1984) Strategy Avg. Annual Gain $10,000 Grows To Buy and Hold 11.46% $ 87,500 Avoid Bear Markets 21.48% $ 489,700 Long and Short Major Swings 27.99% $ 1,391,200 Long and Short Every 5% Swing 93.18% $ 5,240,000,000
  • 4. The Potential Rewards  This chart, from Barron’s, shows the benefit of being smart enough to miss the worst 5 days of the year between Feb 1966 and Oct 2001. Source: “The Truth About Timing,” by Jacqueline Doherty, Barron’s (November 5, 2001)
  • 5. Agenda  Charting Stocks  Bar Charts and Japanese Candlestick Charts  Point and Figure Charts  Major Chart Patterns  Price-based Indicators  Volume-based Indicators  Dow Theory  Elliot Wave
  • 6. Charting the Market  Chartists use bar charts, candlestick, or point and figure charts to look for patterns which may indicate future price movements.  They also analyze volume and other psychological indicators (breadth, % of bulls vs % of bears, put/call ratio, etc.).  Strict chartists don’t care about fundamentals at all.
  • 7. Drawing Bar (OHLC) Charts  Each bar is composed of 4 elements:  Open  High High High  Low Close Open  Close  Note that the candlestick body is empty (white) on up days, and filled (some color) Open Close on down days Low Low  Note: You should print the Standard Japanese Standard Japanese Bar Chart Candlestick Bar Chart Candlestick example charts (next two slides) to see them more clearly
  • 8. Types of Charts: Bar Charts  This is a bar (open, high, low, close or OHLC) chart of AMAT from early July to mid October 2001.
  • 9. Types of Charts: Japanese Candlesticks  This is a Japanese Candlestick (open, high, low, close) chart of AMAT from early July to mid October 2001
  • 10. Drawing Point & Figure Charts  Point & Figure charts are independent of time.  An X represents an up move.  An O represents a down move.  The Box Size is the number of points needed to make an X or O. X  The Reversal is the price X change needed to recognize a X XO X XO change in direction. XO O  Typically, P&F charts use a 1- XO O X point box and a 3-point reversal.
  • 11. Chart Types: Point & Figure Charts  This is a Point & Figure chart of AMAT from early July to mid October 2001.
  • 12. Basic Technical Tools  Trend Lines  Moving Averages  Price Patterns  Indicators  Cycles
  • 13. Trend Lines  There are three basic kinds of trends:  An Up trend where prices are generally increasing.  A Down trend where prices are generally decreasing.  A Trading Range.
  • 14. Support & Resistance  Support and resistance lines indicate likely ends of trends.  Resistance results from the Breakout inability to surpass prior highs.  Support results from the inability to break below to prior lows.  What was support becomes resistance, and vice-versa. Support Resistance
  • 15. Simple Moving Averages  A moving average is simply the average price (usually the closing price) over the last N MSFT Daily Prices with 10-day MA 9/23/93 to 9/21/94 60 periods. 55  They are used to smooth out fluctuations of less than N 50 periods. Price 45  This chart shows MSFT with 40 a 10-day moving average. 35 Note how the moving average 30 1 21 41 61 81 101 121 141 161 181 201 221 241 shows much less volatility Date than the daily stock price.
  • 16. Price Patterns  Technicians look for many patterns in the historical time series of prices.  These patterns are reputed to provide information regarding the size and timing of subsequent price moves.  But don’t forget that the EMH says these patterns are illusions, and have no real meaning. In fact, they can be seen in a randomly generated price series.
  • 17. Head and Shoulders H&S Top  This formation is Head characterized by two small peaks on either Left Shoulder Right Shoulder side of a larger peak.  This is a reversal Neckline pattern, meaning that it H&S Bottom signifies a change in the Neckline trend. Left Shoulder Right Shoulder Head
  • 18. Head & Shoulders Example Sell Signal Minimum Target Price Based on measurement rule
  • 19. Double Tops and Bottoms Double Top  These formations are similar to the H&S formations, but there is no head.  These are reversal Target patterns with the same Target measuring implications as the H&S. Double Bottom
  • 21. Triangles  Triangles are continuation formations.  Three flavors: Ascending  Ascending  Descending Symmetrical  Symmetrical  Typically, triangles Symmetrical should break out about half to three-quarters of Descending the way through the formation.
  • 22. Rounded Tops & Bottoms  Rounding formations are Rounding characterized by a slow Bottom reversal of trend. Rounding Top
  • 24. Broadening Formations  These formations are like reverse triangles. Broadening Bottoms  These formations usually signal a reversal of the trend. Broadening Tops
  • 25. DJIA Oct 2000 to Oct 2001 Example What could you have known, and when could you have known it?
  • 26. DJIA Oct 2000 to Oct 2001 Example Nov to Mar Trading range Descending triangles Gap, should get Double bottom filled
  • 27. Technical Indicators  There are, literally, hundreds of technical indicators used to generate buy and sell signals.  We will look at just a few that I use:  Moving Average Convergence/Divergence (MACD)  Relative Strength Index (RSI)  On Balance Volume  Bollinger Bands  For information on other indicators see my Investments Class Links page under the heading “Technical Analysis Links.” (http://clem.mscd.edu/~mayest/FIN3600/FIN3600_Links.htm)
  • 28. MACD  MACD was developed by Gerald Appel as a way to keep track of a moving average crossover system.  Appel defined MACD as the difference between a 12- day and 26-day moving average. A 9-day moving average of this difference is used to generate signals.  When this signal line goes from negative to positive, a buy signal is generated.  When the signal line goes from positive to negative, a sell signal is generated.  MACD is best used in choppy (trendless) markets, and is subject to whipsaws (in and out rapidly with little or no profit).
  • 30. Relative Strength Index (RSI)  RSI was developed by Welles Wilder as an oscillator to gauge overbought/oversold levels.  RSI is a rescaled measure of the ratio of average price changes on up days to average price changes on down days.  The most important thing to understand about RSI is that a level above 70 indicates a stock is overbought, and a level below 30 indicates that it is oversold (it can range from 0 to 100).  Also, realize that stocks can remain overbought or oversold for long periods of time, so RSI alone isn’t always a great timing tool.
  • 31. RSI  a technical analysis tool that is banded between two extreme values and built with the results from a trend indicator for discovering short term overbought and over sold conditions. As the value of the oscillator approach the upper extreme value the asset is seem to be over brought and as it is approaches to be lower extreme as it seems to be over sold.
  • 32. RSI Example Chart Overbought Oversold
  • 33. On Balance Volume  On Balance Volume was developed by Joseph Granville, one of the most famous technicians of the 1960’s and 1970’s.  OBV is calculated by adding volume on up days, and subtracting volume on down days. A running total is kept.  Granville believed that “volume leads price.”  To use OBV, you generally look for OBV to show a change in trend (a divergence from the price trend).  If the stock is in an uptrend, but OBV turns down, that is a signal that the price trend may soon reverse.
  • 34. OBV Example Chart Divergence, OBV failed OBV confirms trend change but doesn’t lead
  • 35. Bollinger Bands  Bollinger bands were created by John Bollinger (former FNN technical analyst, and regular guest on CNBC).  Bollinger Bands are based on a moving average of the closing price.  They are two standard deviations above and below the moving average.  A buy signal is given when the stock price closes below the lower band, and a sell signal is given when the stock price closes above the upper band.  When the bands contract, that is a signal that a big move is coming, but it is impossible to say if it will be up or down.  In my experience, the buy signals are far more reliable than the sell signals.
  • 36. Bollinger Bands Example Chart Sell signal Buy signals Sometimes, the buy signals just keep coming and you can go broke!
  • 37. Dow Theory  This theory was first stated by Charles Dow in a series of columns in the WSJ between 1900 and 1902.  Dow (and later Hamilton and Rhea) believed that market trends forecast trends in the economy.  A change in the trend of the DJIA must be confirmed by a trend change in the DJTA in order to generate a valid signal.
  • 38. Dow Theory Trends (1)  Primary Trend  Called “the tide” by Dow, this is the trend that defines the long-term direction (up to several years). Others have called this a “secular” bull or bear market.  Secondary Trend  Called “the waves” by Dow, this is shorter-term departures from the primary trend (weeks to months)  Day to day fluctuations  Not significant in Dow Theory
  • 40. Does Dow Theory Work?  According to Martin Pring, if you had invested $44 in 1897 and followed all buy and sell signals, by 1981 you would have accumulated about $18,000.  If you had simply invested $44 and held that portfolio, by 1981 you would have accumulated about $960.
  • 41. Elliot Wave Principle (1)  R.N. Elliot formulated this idea in a series of articles in Financial World in 1939.  Elliot believed that the market has a rhythmic regularity that can be used to predict future prices.  The Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is made up of similar shorter-term cycles (“Big fleas have little fleas upon their backs to bite 'em - little fleas have smaller fleas and so on ad infinitem”).  Elliot Wave adherents also make extensive use of the Fibonacci series.
  • 42. The Elliot Wave Principle (2) 5 B A C 3 4 1 2
  • 43. Fibonacci Numbers  Fibonacci numbers are a series where each succeeding number is the sum of the two preceding numbers.  The first two Fibonacci numbers are defined to be 1, and then the series continues as follows: 1, 1, 2, 3, 5, 8, 13, 21…  As the numbers get larger, the ratio of adjacent numbers approaches the Golden Mean: 1.618:1.  This ratio is found extensively in nature, and has been used in architecture since the ancient Greeks (who believed that a rectangle whose sides had the ratio of 1.618:1 was the most aesthetically pleasing).  Technical analysts use this ratio and its inverse, 0.618, extensively to provide projections of price moves.
  • 44. Does Elliot Wave Work?  Who knows? One of the biggest problems with Elliot Wave is that no two practitioners seem to agree on the wave count, and therefore on the prediction of what’s to come.  Robert Prechter (the most famous EW practitioner) made several astoundingly correct predictions in the 1980’s, but hasn’t been so prescient since (he no longer gets much press attention).  For example, in 1985 he predicted that the market would peak in 1987 (correct), but he thought it would peak at 3686 (± 100 points).  The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.
  • 45. Too Many Others To List  As noted, there are literally hundreds of indicators and thousands of trading systems.  A whole semester could easily be spent on just a handful of these.  To close, just note that there is nothing so crazy that somebody doesn’t use it to trade.  For example, many people use astrology, geometry (Gann angles), neural networks, chaos theory, etc.  There’s no doubt that each of these (and others) would have made you lots of money at one time or another. The real question is can they do it consistently?  As the carneys used to say, “You pays your money, and you takes your chances.”