Technical Analysis Answers to end of chapter questions According to the Dow theory, market trends can be classified as primary,

secondary and minor trends. Primary trends are long term trends, secondary trends are short term upward and downward movements that help maintain the long term trend, and minor trends are day to day fluctuations. The upward primary trend normally has a series of successive upward secondary movements, where each successive rally should be higher the previous rally and even the successive declines between rallies should end above the previous declines. Similarly, in a downward primary trend each successive rally should be lower than the previous rally and each decline should be lower than previous lows. Also, rallies in bull markets are longer and reactions are shorter while reactions in bear markets are longer and rallies are shorter. 1. To have an idea of the market as a whole it may not be sufficient to study a small inde consisting of !" or #" shares.. $or this reason it is desirable to see whether ma%ority of the share prices are rising &advancing' or falling &declining'. The advances and declines are compared to measure the dispersion &breadth' of the market. The inde cannot continue to rise if ma%ority of stocks continue to decline and vice versa. (ncreasing divergence between the inde movement and the cumulative difference between advances and declines could signal a market trend reversal. According to the Dow theory, in a rising market, volumes also increase with price rises and fall when price decreases. (n a falling market, volumes should increase with price declines and decrease when prices rise. )n balance volume &)*+' measures cumulative positive and negative volume flow. (t adds the volume when the closing price is higher than the previous day and subtracts the volume when the closing price is lower. The cumulative total of the volume additions and subtractions forms the )*+ line which is compared with the price chart. A rising )*+ line indicates that increased volumes accompanied increased prices which is a bullish sign and would confirm an up trend in price. ,owever, if prices are increasing while the volume line is dropping, a negative divergence is present indicating that the price trend may not continue. *ar -harts use vertical bars to represent various prices for each day.week.month. The bar shows the highest and lowest highest price and can have a single hori/ontal line cutting the bar to represent closing price, or two hori/ontal lines, one to the left to show opening and one to the right to show closing price. -andlestick charts show the same details as bar charts, but have a different visual impact. The opening and closing prices are used to create a bo &body' within the bar &shadow' which depicts the high and low price. (f closing is higher than opening & up day' the bo is left empty, if closing is lower than opening & down day' it is depicted by a black bo . -andle stick charts also have a variety of patterns that are interpreted in a uni0ue manner.

1ine charts use a line to %oin data points such as daily.weekly.monthly closing prices, moving averages of price, momentum etc. Point 2 figure charts have no time scale, only registering changes when significant price increase or decrease occurs. A column of 3s is used to show rising prices, while a column of )s shows falling prices. Additional 3s or )s are added only when the price changes by more than a predefined amount known as the bo si/e. 4ew columns are added only when price changes direction by more than a predefined reversal amount The chart can be made more or less sensitive to price changes to discern between long and short term trends by varying bo and reversal si/es. The advantage of these charts is that they ignore minor movements and help identify trends, support and resistance.

5hen the secondary price movements seem to move in a channel, constrained by an upper or lower limit, known as the resistance and support levels. 6esistance is the level where many sellers step in and do not allow price to rise further. Support is the level where many buyers prevent price from falling further. 5hen prices move hori/ontally between support and resistance lines the area is known as a congestion or consolidation. 7oving averages follow price changes with a lag 8. There are various types of momentum indicators including 7A-D, 6S(, stochastics and 6)-. !. 7arket wide analysis9 increasing divergence between the inde movement and the cumulative difference between advances and declines could signal a market trend reversal. (ncreasing divergence between the inde movement and the moving average of number of highs minus lows could signal a reversal. Single stock analysis9 if prices are increasing while the )*+ line is dropping, a negative divergence is present indicating that the price trend may not continue. $undamental analysis attempts to measure the fair value of an e0uity share or other instruments by studying the economic, industry and company information. Technical analysis is the study of past price and volume data to forecast future price movements.

:. Technical analysis assumes that the market discounts every thing, i.e. all relevant information including fundamental factors have already been built into the price at any given point of time, and focuses only on the market forces of demand and supply. (t also assumes that prices move in trends and that history repeats itself. Technical analysts believe that traders act with a herd mentality as prices rise and fall. Although their individual actions may be based on facts or rumours, or on emotions such as greed or panic, their collective reaction to market situations is consistent. This results in price trends and patterns that are repeated over time, which can be used to forecast future prices. #. The ;7, is concerned with the precision with which the market prices securities. (n efficient markets, prices of securities should reflect all information that is relevant and available. (t assumes that there are a large number of informed and rational participants and stock prices ad%ust rapidly to reflect the effect of new information. According to the efficient market hypothesis, it is impossible to beat the market and technical analysis cannot be effective. Technical analysts on the other hand claim that

human behaviour is not rational and claim that they can forecast the future prices based on this behaviour.

Chapter 12 Market Efficiency Answers to end of chapter questions There should be a large number of informed and rational participants, as this makes the markets li0uid. (nformation should be available 0uickly and freely to all. The weak form of the ;7, states that current prices already fully reflect all the information available in the historical se0uence of prices, rates of return, and trading volume data. (t implies that technical analysis is not useful. The semi<strong form of the ;7, states that current security prices reflect all public information, including the information already considered in the weak form. This implies that in addition to price and volume data, information about the economy, annual reports, dividend and bonus share announcements and other information published in newspapers and %ournals is 0uickly absorbed and reflected in prices, and therefore not useful for forecasting future price changes. (t implies that fundamental analysis is not useful. The strong form of the ;7, states that stock prices fully reflect all information from public and private sources. All information includes the information considered in the semi strong form, i.e. historical price and volume information, publicly available information and insider information. This also re0uires that information is available free of cost to all investors at the same time. (t implies that large institutional investors, mutual funds and even insiders should not be able to take advantage of this information to get consistently superior returns. Describe any one for each of the following forms9 $or the weak form9 simulation studies, serial correlation or autocorrelation, runs test, filter tests, momentum and reversal effect. $or the semi strong form9 time series analysis of returns based on dividend yield, default spreads, term structure yield spreads, 0uarterly earnings reports and calendar effects etc. -ross sectional returns are used to test if various securities have e0ual risk ad%usted returns based on si/e, P.; ratios etc. ;vent studies to check abnormal return due to stock splits, initial public offers, une pected world events and economic news, mergers and ac0uisitions etc $or the strong form9 analysis of the activities of company insiders, recommendations of security analysts, and earnings of mutual funds. (f markets are weak form efficient this is directly against technical analysis, but fundamental analysis can be used to identify under . over valued stocks. (f efficient in the semi<strong form, fundamental analysis will be of no use. (f markets are efficient in the strong form there is no need for portfolio managers and advisors, we can simply buy and hold a diversified like an inde fund. Simulation studies9 patterns implied that stock prices are random. ,owever, stock prices do not follow a normal distribution, they have been found to be more peaked, with fatter tails and skewed to the right. Tests of serial correlation or autocorrelation9 cannot be e ploited to make profits due to low correlations and high transaction costs involved in daily transactions. 7ost filter rules did not give higher profits than a buy and hold strategy, after taking into account the

transaction costs. 7omentum and reversal effect have been found in many studies -ompany insiders did have higher returns, but analyst recommendations were right only half the time. 6isk ad%usted returns of ma%ority of mutual funds, did not outperform the market. Discuss any two of the following9 ,igher returns in =anuary, negative returns on 7onday, low P.; gives higher return smaller si/e gives higher return, higher book value to market value ratio higher returns. >. (f markets are weak form efficient this is directly against technical analysis, but fundamental analysis can be used to identify under . over valued stocks. (f efficient in the semi<strong form, fundamental analysis will be of no use. (f markets are efficient in the strong form there is no need for portfolio managers and advisors, we can simply buy and hold a diversified like an inde fund.