Technical Analysis

Technical Analysis
• Technical analysts study the patterns of trading activity in order to forecast trends, with
the goal of pinpointing the correct time to buy and sell a stock in order to outperform
the market as a whole.
• Technical analysis is a trading discipline employed to evaluate investments and identify
trading opportunities in price trends and patterns seen on charts.
• Technical analysts believe past trading activity and price changes of a security can be
valuable indicators of the security's future price movements.
• In general, technical analysts look at the following broad types of indicators:
 Stock Market & Reflection of Known Information
 History
 Price trends
 Chart patterns
 Volume and Momentum indicators
 Oscillators - an indicator that measures the current price relative to the price range over a number of
periods
 Moving Averages
 Support and resistance levels
 Dow Theory
• Dow Theory was first introduced by Charles Dow, who was the
founder of Dow Jones and Company and the first editor of the Wall
Street Journal.
• This theory is based on the many editorials he had written between
the years of 1900-1902.
• Following his death, William Hamilton continued the work.
• The theory explains how the stock market can be used by investors
to understand the health of the business environment.
• It was the first theory to explain that the market moves in trends.
• And while a lot has changed in the stock markets over the years,
the basic tenets of Dow Theory still hold water.
 Key Principles (tenets) of Dow Theory
• The Market discounts all news
• The market has three trends
 Primary - indicates how the market moves in the long-term; could last for many
years
 Secondary - are considered to be corrections to a primary trend; could last for
some months
 Minor - Minor trends are fluctuations to market movement on a daily basis; last for
few weeks
• Trends have three phases
 Accumulation – done by traders
 Participation - done by investors
 Panic – excessive buying by Investors (speculation)
• Indices confirm each other
• Trends are confirmed by volume
• Trends continue until definitive signals indicate otherwise
 Technical Analysis Tools
On Balance Volume

 To measure the positive and negative flow of volume in a security over time.
 The indicator is a running total of up volume minus down volume.
 Up volume is how much volume there is on a day when the price rallied.
 Down volume is the volume on a day when the price falls.
 Each day volume is added or subtracted from the indicator based on whether the price went
higher or lower.
 When OBV is rising, it shows that buyers are willing to step in and push the price higher.
 When OBV is falling, the selling volume is outpacing buying volume, which indicates lower
prices.
 In this way, it acts like a trend confirmation tool. If price and OBV are rising, that helps indicate
a continuation of the trend.
 Technical Analysis Tools
Accumulation/Distribution Line
 One of the most commonly used indicators to determine the money flow in and out of a security
is the (A/D) Line.
 It is similar to the on-balance volume indicator (OBV), but instead of considering only
the closing price of the security for the period, it also takes into account the trading range for the
period and where the close is in relation to that range.
 If a stock finishes near its high, the indicator gives volume more weight than if it closes near the
midpoint of its range.
 The different calculations mean that OBV will work better in some cases and A/D will work
better in others.
 If the indicator line is trending up, it shows buying interest, since the stock is closing above the
halfway point of the range.
 This helps confirm an uptrend.
 On the other hand, if A/D is falling, that means the price is finishing in the lower portion of its
daily range, and thus volume is considered negative. This helps confirm a downtrend.
 Technical Analysis Tools
Average Directional Index

 The Average Directional Index is a trend indicator used to measure the strength and momentum
of a trend.
 When the ADX is above 40, the trend is considered to have a lot of directional strength, either
up or down, depending on the direction the price is moving.
 When the ADX indicator is below 20, the trend is considered to be weak or non-trending.
 Technical Analysis Tools
Aroon Indicator
 The Aroon Oscillator is a technical indicator used to measure whether a security is in a trend,
and more specifically if the price is hitting new highs or lows over the calculation period
(typically 25).
 The indicator can also be used to identify when a new trend is set to begin.
 The Aroon indicator comprises two lines: an Aroon Up line and an Aroon Down line.
 When the Aroon Up crosses above the Aroon Down, that is the first sign of a possible trend
change.
 If the Aroon Up hits 100 and stays relatively close to that level while the Aroon Down stays near
zero, that is positive confirmation of an uptrend.
 The reverse is also true. If Aroon Down crosses above Aroon Up and stays near 100, this
indicates that the downtrend is in force.
 Technical Analysis Tools
Moving Average Convergence Divergence (MACD)

 The Moving Average Convergence Divergence (MACD) indicator helps traders see the trend
direction, as well as the momentum of that trend. It also provides a number of trade signals.
 When the MACD is above zero, the price is in an upward phase. If the MACD is below zero, it
has entered a bearish period.
 The indicator is composed of two lines: the MACD line and a signal line, which moves slower.
 When MACD crosses below the signal line, it indicates that the price is falling.
 When the MACD line crosses above the signal line, the price is rising.
 If the indicator is above zero, watch for the MACD to cross above the signal line to buy.
 If the MACD is below zero, the MACD crossing below the signal line may provide the signal
for a possible short trade.
 Technical Analysis Tools
Relative Strength Index
 The Relative Strength Index (RSI) has at least three major uses.
 The indicator moves between zero and 100, plotting recent price gains versus recent price
losses.
 The RSI levels therefore help in gauging momentum and trend strength.
 The most basic use of an RSI is as an overbought and oversold indicator.
 When RSI moves above 70, the asset is considered overbought and could decline.
 When the RSI is below 30, the asset is oversold and could rally.
 However, making this assumption is dangerous; therefore, some traders wait for the indicator to
rise above 70 and then drop below before selling, or drop below 30 and then rise back above
before buying.
 Technical Analysis Tools
Stochastic Oscillator

 The stochastic oscillator is an indicator that measures the current price relative to the price range
over a number of periods.
 Plotted between zero and 100, the idea is that, when the trend is up, the price should be making
new highs. In a downtrend, the price tends to make new lows.
 The stochastic tracks whether this is happening.
 The stochastic moves up and down relatively quickly as it is rare for the price to make continual
highs, keeping the stochastic near 100, or continual lows, keeping the stochastic near zero.
 Therefore, the stochastic is often used as an overbought and oversold indicator. Values above 80
are considered overbought, while levels below 20 are considered oversold.
 Market Hypothesis
• The Efficient Market Hypothesis (EMH) maintains that all stocks are perfectly
priced according to their inherent investment properties, the knowledge of which
all market participants possess equally.

• The Efficient Market Hypothesis assumes all stocks trade at their fair value.
 weak tenet implies stock prices reflect all available information
 semi-strong implies stock prices are factored into all publicly available information,
 strong tenet implies all information is already factored into the stock prices.
 Principles (Tenets) of Market Hypothesis
• Weak
The weak form makes the assumption that current stock prices reflect all available
information. It goes further to say past performance is irrelevant to what the future holds for
the stock. Therefore, it assumes that technical analysis can't be used to achieve returns.

• Semi Strong
The semi-strong form of the theory contends stock prices are factored into all information
that is publicly available. Therefore, investors can't use fundamental analysis to beat the
market and make significant gains.

• Strong
All information, both public and private are already factored into the stock prices. So, it
assumes no one has an advantage to the information available, whether that's someone on
the inside or out. Therefore, it implies the market is perfect, and making excessive profits
from the market is next to impossible.
 Market Hypothesis
• The theory assumes it would be impossible to outperform the market and that all
investors interpret available information the same way.

• Although most decisions are still made by humans, the use of computers to
analyze information may be making the theory more relevant.
 Random Walk Theory
• The Random walk Theory maintains that individual stocks do not move in any
discernible pattern and therefore their short-term future movements cannot be
predicted in advance.
• Since the market indexes overall tend to rise over the long-term, adherents of
random walk theory would be likely to recommend investing in a passively-
managed diversified index fund.
• Random walk theory maintains that the movements of stocks are utterly
unpredictable, lacking any pattern that can be exploited by an investor.
• This is in direct opposition to technical analysis, which seeks to identify patterns
in price and volume in order to buy and sell stock at the right time.
• It also dismisses fundamental analysis, which is the study of company and
industry financials in order to identify undervalued stocks.
 Measurement of Market Efficiency
• Market efficiency refers to the degree to which market prices reflect all
available, relevant information.
• If markets are efficient, then all information is already incorporated into
prices, and so there is no way to "beat" the market because there are no
undervalued or overvalued securities available.
• Market efficiency refers to how well current prices reflect all available,
relevant information about the actual value of the underlying assets.
• A truly efficient market eliminates the possibility of beating the market,
because any information available to any trader is already incorporated into
the market price.
• As the quality and amount of information increases, the market becomes
more efficient reducing opportunities for arbitrage and above market returns.
 Empirical Tests
• The efficiency of the stock market can be measured through empirical
research
• Empirical testing is a research method that employs direct and indirect
observation and experience
• It is a test of a hypothesis by means of experiments or other systematic
observations.
 Types of Empirical Tests
 Weak Form
• The weak form of the market as stated is that no investor can use any information of the past to
earn a return of portfolio which is in excess of the portfolio’s risk.
• This means that the investor who develops the stingy based on past prices and chooses his
portfolio on that basis cannot continuously outperform another investor who ‘buys and holds’ his
investments over a long-term period.
• In other words, technical analysis or market index will not be indicative of superior portfolio
performance.

 Simulation Test
• A series of cumulative random numbers closely resembled in actual stock price
series and that changes in the random principles series as expected do not exhibit
pattern as it exhibits in the case of stock price changes.

 Serial Correlation Test

• Serial Correlation is said to measure the association of a series of numbers which
are separated by some constant time period like the association of the level of
Gross National Product in one year with the level of Gross National Product of the
previous year.
 Types of Empirical Tests
 Run Test
• Whether price changes were likely to be followed by further price changes of the same
sign.
 Filter Test
• To find out “if any abnormal return could be earned using past price data
 Relative Strength Method
• A relative strength method which is based on the ratio of a stock current price to its
average price. A rule which yielded abnormal portfolio return.
 Semi-Strong Form
• The security prices reflect all publicly available information within the purview of the
efficient market hypothesis.
• In this state, the market reflects even those forms of information which may be concerning
the announcement of a firm’s most recent earnings forecast and adjustments which will
have taken place in the prices of security.
 Market Reaction Test
• A stock generally indicates increased dividend pay-outs. Stock splits announcement
contains economic information. The research study showed that the stock splits
information brought in market reaction just before the split announcement
 Types of Empirical Tests
 Announcement Effects
• The absolute values of price changes and levels of trading are generally
significantly higher during the announcement week.
• In the week following the announcement week, it returned to pre-
announcement levels.
 Strong Form
• In the strong form of the market, it is stated that all information is
represented in the security prices in such a way that there is no opportunity
for any person to make an extraordinary gain on the basis of any information.
• This is the most extreme form of the efficient market hypothesis.
 Mutual Fund Performance.
• The hypothesis was “that the mutual funds could earn extraordinary return and
constantly achieve a higher than average performance because they are likely
to have excess inside information which is not otherwise publicly known.
 Bonds
• A bond is a fixed income instrument that represents a loan made by an investor to
a borrower
• Bonds are used by companies, municipalities, states, and sovereign governments
to finance projects and operations.
• Owners of bonds are debtholders, or creditors, of the issuer
• Bonds are units of corporate debt issued by companies and securitized as
tradeable assets.
• A bond is referred to as a fixed-income instrument since bonds traditionally paid a
fixed interest rate (coupon) to debtholders.
• Variable or floating interest rates are also now quite common.
• Bond prices are inversely correlated with interest rates: when rates go up, bond
prices fall and vice-versa.
• Bonds have maturity dates at which point the principal amount must be paid
back in full or risk default.
 Characteristics of Bonds
• Face value (par value) is the money amount the bond will be worth at maturity; it is
also the reference amount the bond issuer uses when calculating interest payments.
• For example, say an investor purchases a bond at a premium of $1,090, and another
investor buys the same bond later when it is trading at a discount for $980. When the
bond matures, both investors will receive the $1,000 face value of the bond.
• The coupon rate is the rate of interest the bond issuer will pay on the face value of
the bond, expressed as a percentage. For example, a 5% coupon rate means that
bondholders will receive 5% x $1,000 face value = $50 every year.
• Coupon dates are the dates on which the bond issuer will make interest payments.
Payments can be made in any interval, but the standard is semiannual payments.
• The maturity date is the date on which the bond will mature and the bond issuer
will pay the bondholder the face value of the bond.
• The issue price is the price at which the bond issuer originally sells the bonds. In
many cases, bonds are issued at par.