Investment Theory - Technical Analysis

Technical Analysis Copyright 1996-2006 Investment Analytics

Copyright © 1996 – 2006 Investment Analytics

Slide: 1

Technical Analysis ¾

Technical Analysis: Study of past market action to forecast prices Looks for patterns in historical data


Slide: 2

Technical Analysis Tools Charting ¾ Gann ¾ Elliot Wave ¾ Cycle Theory ¾ Oscillators & Indicators ¾ Japanese Candlesticks ¾ Market Profile ¾ Computerized Trading Systems ¾


Slide: 3

Classical Charting Trend Lines ¾ Support/Resistance ¾ Continuation Patterns ¾ Reversal Patterns ¾ Gaps & Spikes ¾ Moving Averages ¾


Slide: 4

Trends ¾

Trend Direction

• Uptrend: higher highs, higher lows ¾

Downtrend: lower lows, lower highs

Trend timeframe: • 3 Trends: (e.g. weekly, daily, hourly)

¾

Main technical analysis tools: • Trend Lines • Moving Averages


Slide: 5

Trendlines ¾

Drawing Trendlines: • Connect highs to highs, lows to lows • Draw through congestion areas • Ignore ‘tails’ or ‘spikes’

¾

Trends are stronger . . . . • The longer the trendline • The more contacts between prices and the trendline • When volume expands in the direction of the trend


Slide: 6

Trendline Examples 74

72

70

68

Trend B is more significant than trend A . . . 1. More contact points 2. Longer trendline 3. Rising volume

A

`

B

66

64

g n i s Ri

e m u Vol

62 Copyright © 1996 – 2006 Investment Analytics

Slide: 7

Trading Rules for (UP)Trends ¾

Trade only in the direction of the trend • Ignore all signals to short a bull market

¾

Wait for a pullback to the trendline to get long • Wait! If no pullback - forget it!

¾

Use a trailing stop to get aboard the trend: • As pullback nears trendline, place an order to buy on a stop one tick above previous day’s high

¾

Set protective stop • Once you are long the market • Place a stop loss order just below the trendline • Move your stop up as trend progresses


Slide: 8

Trading Rule Illustrated 74

72

1. 2. 3. 4.

Pullback approaches trendline at point A Order to buy on a stop, 1 tick above high at A Get stopped in at next day’s open - point B Place an order to sell on a stop at level C

70

B 68

`

C

66

64

A

62 Copyright © 1996 – 2006 Investment Analytics

Slide: 9

Trendlines Breaks Trendlines provide support & resistance ¾ Steep trendlines (over 45 degrees) precede sharp breaks ¾ A pullback to the trendline after a break is often a good shorting opportunity ¾


Slide: 10

Copyright © 1996 – 2006 Investment Analytics 10/19/90

09/28/90

09/07/90

08/17/90

07/27/90

07/06/90

06/15/90

360.0

05/25/90

05/04/90

04/13/90

03/23/90

03/02/90

02/09/90

01/19/90

12/29/89

12/08/89

11/17/89

10/27/89

10/06/89

09/15/89

340.0

08/25/89

08/04/89

07/14/89

06/23/89

06/02/89

05/12/89

04/21/89

310.0

03/31/89

320.0

03/10/89

02/17/89

380.0

01/27/89

390.0

01/06/89

12/16/88

11/25/88

Trading Trendline Breaks

400.0

S&P 500 Futures

370.0

Selling Opportunity

350.0

Buying Opportunity

330.0

Buying Opportunity

300.0

Slide: 11

Channel Lines A line running parallel to the trendline ¾ Drawn through tops of rallies (bottoms of declines) ¾ Marks maximum power of bulls (bears) ¾ The wider the channel the stronger the trend ¾ Trading Rules: ¾

• Go long in lower quarter of channel • Take profits in upper quarter Copyright © 1996 – 2006 Investment Analytics

Slide: 12


09/28/90

09/07/90

08/17/90

07/27/90

07/06/90

06/15/90

360.0

05/25/90

05/04/90

04/13/90

03/23/90

03/02/90

02/09/90

01/19/90

12/29/89

12/08/89

11/17/89

10/27/89

10/06/89

09/15/89

340.0

08/25/89

08/04/89

07/14/89

06/23/89

06/02/89

05/12/89

04/21/89

310.0

03/31/89

320.0

03/10/89

02/17/89

380.0

01/27/89

390.0

01/06/89

12/16/88

11/25/88

Channel Lines

400.0

Take Profits

S&P 500 Futures

370.0

Selling Opportunity

350.0

Buying Opportunity

330.0

Buying Opportunity

300.0

Slide: 13

Moving Average ¾

Shows the average price during a given time window • E.g. a 5-day MA shows the average price over the last 5 days • 20-day MA shows the average price over the last 20 days

Averages the price series to smooth out effect of extreme highs or lows ¾ Reveals underlying trend

¾

• Longer MA’s show longer term trend • Shorter MA’s react more quickly to recent prices


Slide: 14


06/11/93

05/28/93

05/14/93

04/30/93

04/16/93

94.2

04/02/93

03/19/93

03/05/93

02/19/93

94.6

02/05/93

01/22/93

01/08/93

12/25/92

12/11/92

11/27/92

95.8

11/13/92

10/30/92

10/16/92

10/02/92

09/18/92

09/04/92

08/21/92

08/07/92

Moving Average Example Eurodollars

95.6

95.4

95.2

95

94.8

Formula: MN(t) = (X(t)+X(t-1)+...+X(t-N+1))/N

94.4

3 per. Mov. Avg.

94

Slide: 15

Moving Average Formula Formula: MA = P1 + P2 + . . . + PN N ¾ Example: Price • Time ¾

t1 t2 t3 t4


17 16 19 22

3-Day MA

N/A N/A (17+16+19)/3 = 17.3 (16+19+22)/3 = 19.0

Slide: 16

Using Moving Averages in Trading ¾

As Trend Indicators • Trend direction indicated by the slope of the MA • Short, medium, or long term trend • Similar trading rules as for trendlines – trade with the MA trend – buy on pullbacks to moving average


Slide: 17

Donchian’s MA Crossover System ¾

Method • Plot short and long term MA on same chart • Example: 9 day MA and 21 day MA

¾

Trading Signals • Buy when short MA crosses above long MA • Sell when short MA crosses below long MA

¾

When to use: • Works well in trending markets • Loses money in whipsaw markets

¾

Optimization • You can find the ‘optimal’ short and long MA


Slide: 18

Example: Moving Average Crossover 105

SELL

100

95

9 Day MA 90

21 Day MA

85

80

BUY

75

BUY 70

65


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06/11/93

05/28/93

05/14/93

04/30/93

04/16/93

94.2

04/02/93

03/19/93

03/05/93

02/19/93

02/05/93

01/22/93

01/08/93

12/25/92

94.4

12/11/92

11/27/92

95.8

11/13/92

10/30/92

10/16/92

95.6

10/02/92

09/18/92

09/04/92

08/21/92

08/07/92

Example: Moving Average Crossover Eurodollars Sell

Sell

95.4

95.2

95

94.8

94.6

Buy 3 per. Mov . Av g. 6 per Mov . Av g

94

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06/27/86

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08/08/86

BUY

06/06/86

05/16/86

04/25/86

04/04/86

SELL

03/14/86

02/21/86

01/31/86

BUY

01/10/86

12/20/85

11/29/85

11/08/85

10/18/85

SELL

09/27/85

09/06/85

08/16/85

BUY

07/26/85

07/05/85

540

06/14/85

05/24/85

05/03/85

480

04/12/85

03/22/85

03/01/85

02/08/85

01/18/85

560

12/28/84

12/07/84

11/16/84

10/26/84

10/05/84

Whipsaw Market

580

Gold Futures SELL

520

500

18 Per. Mov. Avg. 9 per. Mov. Avg.

460

440

Exponential Moving Averages Similar to simple moving average ¾ Gives more weight to recent observations ¾ Formula: EMAt = wPt + (1 - w) EMAt-1 ¾

• W is the ‘weight’ • Large w gives more weight to current price • Makes EMA more responsive • Typical w: 2/(N+1) where N is length of MA ¾

EMA is more responsive to recent trends than simple MA


Slide: 22

Exponential & Simple MA’s Compared 105

100

13 Day EMA 95

13 Day MA

90

85

80

75

70

65


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Lab: Self-Assessment Test Load Excel spreadsheet: technic.xls ¾ Restart test ¾ Work through trend & moving average sections ¾ MA data worksheet ¾

• Charts EMA & MA • Charts MA Crossover • Try different length MA’s for crossover system • Is there a better choice than 9 and 21 ? Copyright © 1996 – 2006 Investment Analytics

Slide: 24

Support & Resistance ¾

Support: • Price where buying power is sufficient to halt downtrend • Bears are hurting, start buying

¾

Resistance: • Price where selling power is sufficient to halt uptrend • Bulls are hurting, start selling

¾

Support & Resistance Lines • Draw horizontal lines through congestion areas • At upper and lower limits of trading range


Slide: 25


08/03/90

07/20/90

07/06/90

06/22/90

06/08/90

05/25/90

05/11/90

04/27/90

04/13/90

03/30/90

03/16/90

03/02/90

400.0

02/16/90

02/02/90

01/19/90

01/05/90

12/22/89

12/08/89

11/24/89

11/10/89

10/27/89

10/13/89

410.0

09/29/89

09/15/89

09/01/89

08/18/89

08/04/89

Support & Resistance Lines

420.0

S&P 500 Futures

Resistance

390.0

380.0

370.0

360.0

350.0

Support

340.0

Slide: 26

Support & Resistance Levels ¾

Levels are strongest: • The longer they continue • The more contacts between prices & the level • The wider the range • The greater the volume at the level

¾

If you are riding a trend: • Tighten protective stops as prices near levels


Slide: 27

Support & Resistance Contrarian Trading ¾

As Prices Approach Support: • Place stop order to buy above yesterday’s high • Place protective sell stop below support • If market bounces off support you will be stopped in long

¾

As Prices Approach Resistance: • Place stop order to sell below yesterday’s low • Place protective buy stop above resistance • If market bounces off resistance you will be stopped in short


Slide: 28

340.0

buy


08/03/90

07/20/90

07/06/90

06/22/90

06/08/90

05/25/90

05/11/90

04/27/90

04/13/90

03/30/90

03/16/90

400.0

03/02/90

sell

02/16/90

02/02/90

01/19/90

01/05/90

12/22/89

12/08/89

11/24/89

11/10/89

10/27/89

10/13/89

410.0

09/29/89

09/15/89

09/01/89

08/18/89

08/04/89

Support & Resistance Trading

420.0

S&P 500 Futures

Resistance

390.0

380.0

370.0

360.0

350.0

Support

Slide: 29

Trading Ranges ¾

NAKED (No view on volatility): • Go long at Support • Reverse & go short at Resistance

¾

GAMMA TRADE (volatility cheap/rising): • Buy Straddles or Strangles (strikes at S/R levels) • Rebalance Delta Neutral at Support/Resistance

¾

VEGA TRADE (volatility rich/falling): • Sell Straddles or Strangles, or • Sell Calls at Resistance, Sell Puts at Support • Roll up(down) or buy back options on breakout


Slide: 30

Gaps ¾

Occur when market is stampeded • Caused by news, panic • Breakdown of trend • Breakout of trading range • Losers dumping positions

¾

Breakaway Gap • Prices leap out of congestion area • Signifies start of new trend • Followed by several days of new highs (lows) • Usually market by high volume • Almost never gets closed by subsequent prices


Slide: 31

Gaps ¾

Continuation Gap • Occurs in middle of powerful trend • Accompanied by upsurge in volume • Measure distance from start of trend to gap • Gives target measured move

¾

Exhaustion Gap • Occurs towards the end of a trend • Market fails to follow through with new highs (lows) • Volume may be thin


Slide: 32

Gaps - Illustrated 87 87 86 86 85 85 84

Congestion Area

Breakaway Gap Sell short, with stop above rim Continuation Gap Add to shorts, with stop above rim

Distance to Continuation Gap

88

Target

Exhaustion Gap Target achieved - take profits


Island Reversal Slide: 33

Spikes & Tails ¾

Spikes & Tails

• Extreme price move up or down • Occurs in middle of congestion area • No follow-through • A failed ‘test’ of new trend direction • Market often reacts in opposite direction


Slide: 34

Continuation Patterns Bull

Bear Flag

Pennant

Volume Copyright © 1996 – 2006 Investment Analytics

Slide: 35

Triangles Bull

Bear

Descending

Ascending Symmetric

Volume Copyright © 1996 – 2006 Investment Analytics

Slide: 36


03/12/93

02/26/93

02/12/93

01/29/93

01/15/93

01/01/93

12/18/92

12/04/92

11/20/92

11/06/92

10/23/92

10/09/92

09/25/92

09/11/92

08/28/92

08/14/92

07/31/92

07/17/92

07/03/92

06/19/92

06/05/92

05/22/92

05/08/92

04/24/92

04/10/92

03/27/92

03/13/92

02/28/92

02/14/92

01/31/92

01/17/92

450.0

01/03/92

12/20/91

12/06/91

Example: Flag & Triangle

470.0

460.0

S&P 500

440.0

430.0

420.0

410.0

400.0

390.0

380.0

Slide: 37

Trading Continuations These are trend continuation signals ¾ Add to positions on breakout ¾ Buy (sell) stop 1 tick above pattern boundary, or ¾ Buy(sell) on close outside boundary ¾


Slide: 38

Reversal Patterns Indications of trend ending ¾ Most common patterns ¾

Double Tops Head & Shoulders

Price and Volume confirmation required ¾ Give indication of new price target ¾


Slide: 39


09/16/88

08/26/88

08/05/88

07/15/88

06/24/88

06/03/88

05/13/88

04/22/88

620

04/01/88

500

03/11/88

Volume lower on right peak, and declining

02/19/88

01/29/88

01/08/88

12/18/87

11/27/87

560

11/06/87

10/16/87

09/25/87

09/04/87

520

08/14/87

07/24/87

07/03/87

06/12/87

05/22/87

05/01/87

04/10/87

03/20/87

02/27/87

02/06/87

Double Top

640

Comex Gold Futures

600

580

Measured Move

540

Short on pullback to resistance on Big pickup in low volume volume on breakdown

480

Slide: 40

Reversal Patterns Head & Shoulders Head

Left Shoulder

Right Shoulder

N e c k li n e

D ecl in Volu ing me

Target Copyright © 1996 – 2006 Investment Analytics

Slide: 41

Trading Head & Shoulders Scale down position as pattern emerges ¾ Look for confirmation in declining volume ¾ Get short on right shoulder, with stop above head ¾ Add to short on break of neckline, with stop above neckline ¾ Add to short on pullback to neckline ¾ Place buy limit order at distance of measured move ¾


Slide: 42

Lab: Self Assessment Test Continue with test ¾ Worksheets: ¾

• Support & resistance • Gaps • Spikes • Continuations • Head & Shoulders


Slide: 43

Oscillators Measure extremes of market sentiment ¾ Oscillator: fluctuates between two extreme values ¾

• When market is overbought or oversold • Market likely to reverse

Oscillators work well in trading ranges ¾ Can also be used when market trends:

¾

• To time trades in direction of trend • Nb. must filter out trades against the trend • In trending markets oscillators can stay overbought/oversold for many periods Copyright © 1996 – 2006 Investment Analytics

Slide: 44

Classic Oscillators Momentum ¾ Stochastics ¾ Relative Strength Indicator (RSI) ¾ Williams %R ¾


Slide: 45

Momentum Measures trend acceleration ¾ When Trend is Up ¾

• If oscillator reaches new high, shows uptrend is continuing • When oscillator traces lower peak, shows uptrend may be weakening ¾

Formula: MN(t) = Pt - Pt-N • Pt is today’s price • Pt-N is price N days ago

¾

E.g 7 Day Momentum • Pt = 24; Price 7 days ago = 18 – 7 day Momentum = (24 - 18) = 6


Slide: 46

Momentum Chart 80

Double Top

75 70 65 60 55

Bearish Divergence: Sell short

50 45 10 405

BUY

0 -5 -10

Trendline break - take profits


Slide: 47

Momentum Trading Rules ¾

When Momentum crosses center line & ticks back up • Stock is oversold • Trend has slowed for a moment • Opportunity to get on board - Buy!

¾

Momentum is a leading indicator • Early warning of downturn in trend

¾

Apply charting techniques to the oscillator • Trendline break: take profits


Slide: 48

Divergence ¾

Bearish Divergence

Bullish Divergence

Prices

Prices

Oscillator

Oscillator ¾

Trading Rule: • Scale back / go short


Trading Rule: Scale back / go long Slide: 49

Stochastics Tracks relationship of closing price to recent HiLo range ¾ Formula: %K = Ct - Ln x 100 H n - Ln ¾ %D = 3 day sum of (Ct - Ln) x 100 3 day sum of (Hn - Ln) ¾

• Hn is the high of the last n days • Ln is the low of the last n days • Ct is today’s closing price • n = 5, or 9 is popular choice Copyright © 1996 – 2006 Investment Analytics

Slide: 50

Stochastics ¾

Stochastics fluctuates in range +/- 100 • Overbought range: 75-80 • Oversold range : 25-30

¾

Plot both %K and %D • Also plot overbought/oversold regions

¾

Sell signal: • %K, %D both in overbought region • %K crosses back down over %D

¾

Buy signal - the reverse


Slide: 51

Stochastics in Trading Range 115.0

110.0

Sell 105.0

100.0

Buy

95.0

100

Buy Overbought

75 90.0

50 25 0


Oversold

Bullish Divergence Slide: 52

Trading with Stochastics Ideal for range trading ¾ In Trends: ¾

• Tends to stay overbought/oversold for long periods • Ignore sell signals in uptrend • Wait for oversold signal on pullback to get on board • Ignore buy signals in downtrends • Wait for overbought signal on pullback to get on board

Charting: look for trendlines on the oscillator ¾ Divergence: trade same way as Momentum

¾


Slide: 53

Indicators These are trend following tools ¾ Usually based on moving averages ¾ Popular indicators ¾

• MACD (Moving Average ConvergenceDivergence) • Wilder’s ADX system


Slide: 54

MACD Histogram ¾

A variation on the MA crossover idea: • Uses two EMA’s (12 and 26 day) • The difference between them is the fast MACD line • Calculate a 9 day EMA of the fast MACD line (the Signal) • MACD histogram = (Fast MACD - Signal) Fast MACD Signal MACD Histogram


Slide: 55

How to use MACD Fast MACD reflects short term consensus ¾ The signal indicates consensus over a longer period ¾ When the fast MACD rises above the signal, bulls are in control: trade from the long side ¾ When the fast MACD falls below the signal, bears are winning: trade from the short side ¾


Slide: 56

The MACD Histogram ¾

Histogram Positive, rising • Meaning: trend strengthening • Trading rule: hold longs

¾

Histogram Positive, falling • Meaning: trend weakening / pullback ahead • Trading rule: (i) tighten protective stops (ii) place order to buy above yesterdays’ high

¾

Histogram Negative: reverse of above


Slide: 57

The MACD Histogram ¾

Histogram Crosses Zero Line • Meaning: trend change imminent • Trading rule: (i) liquidate position, if not stopped out (ii) reverse and go short (long)


Slide: 58

MACD Divergence

Bearish


Bullish

Slide: 59

Lab: Self Assessment Test Continue with tests ¾ Worksheets: ¾

• Momentum • Stochastics • MACD


Slide: 60

Summary: Technical Analysis ¾

Most useful techniques: • Trendlines, channel lines, moving averages • Support & resistance

¾

Charting: • Continuation & reversal patterns • Gaps, spikes

¾

Indicators • MACD & other trend indicators

¾

Oscillators • Momentum, Stochastics • Ideal for range trading, timing trend entry


Slide: 61

Problems with Technical Trading ¾

Trends • Identifying new trends • Deciding when trend is over • When to get in/out?

¾

Ranges • Sometimes support & resistance holds, sometimes not • False breakouts

¾

Charting • We tend to see the patterns we want to see • Even random prices show chart patterns & trends


Slide: 62

Trends in Random Prices 1240.0

1040.0

Ln(St+1 / St ) =εt ~ Niid ⇒ Ln(St+1) = M+P*Ln(St ) +εt

840.0

640.0

440.0

240.0

40.0


Slide: 63


07/06/95

07/03/95

06/28/95

06/23/95

06/20/95

06/15/95

06/12/95

06/07/95

06/02/95

05/30/95

05/25/95

106

05/22/95

108

05/17/95

05/12/95

05/09/95

05/04/95

05/01/95

04/26/95

04/21/95

04/18/95

04/13/95

04/10/95

04/05/95

03/31/95

03/28/95

03/23/95

03/20/95

03/15/95

03/10/95

03/07/95

116

03/02/95

02/27/95

02/22/95

Linear Behavior in Markets

118

Sept Bond Futures

114

112

110

y = 0.1571x + 100.09 R2 = 0.9142

104

102

100

Slide: 64

A Foolproof Way to Make Money Using Systems Devise a trading rule ¾ Test it - make sure it loses money ¾ Reverse the signals ¾ Optimize the parameters ¾ Ignore commission & slippage ¾ SELL THE SYSTEM! ¾


Slide: 65

Technical Analysis & EMH ¾

EMH: All information is incorporated in current prices Prices only change when new information arrives

¾

CONCLUSION: Technical Analysis is pointless BUT most traders use it - WHY?


Slide: 66

Rationale for Technical Analysis ‘Rational prices’ argument ¾ Psychological factors ¾ Market anomalies ¾


Slide: 67

‘Rational prices’ argument ¾

Technical analysts argue EMH is wrong on at least two counts: • it says prices are random • it says trends and chart patterns aren't real

¾

BUT: EMH does NOT say prices are random • EMH: price changes are random

¾

EMH does NOT say trends, chart patterns cannot occur • EMH: patterns occur by random chance & you have no way of knowing in advance which pattern is going to arise


Slide: 68

Psychological factors Technical analysis is easy ¾ ‘Working’vs. gambling ¾ Comfort factor ¾

• To back up a trading decision • To trade with the crowd


Slide: 69

Market Anomalies ¾

Small firm in January effect (Banz, 1981) • Abnormally high returns in first 2 weeks of January • Reasons: tax-loss selling, poor liquidity • ‘Neglected firm’ effect

¾

The Weekend effect (French, 1980) • A negative abnormal return on Mondays • Not large enough to overcome transaction costs • Nonetheless, don’t buy stocks on Fridays!

¾

Value Line (Black, 1971) • Portfolio 1 abnormal +ve returns, Portfolio 5 abnormal negative returns • Reranked stocks (esp. small) show abnormal returns


Slide: 70

Investment Theory - Technical Analysis

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