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

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

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

Trends
¾ Trend Direction
• Uptrend: Downtrend:
higher highs, higher lows lower lows, lower highs
¾ Trend timeframe:
• 3 Trends: (e.g. weekly, daily, hourly)
¾ Main technical analysis tools:
• Trend Lines
• Moving Averages
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

Trendline Examples
74
Trend B is more significant than trend A . . .
72 1. More contact points
2. Longer trendline
70 3. Rising volume
68
A `
B
66
m e
u
64
n g Vol
s i
Ri
62

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
Trading Rule Illustrated
74
1. Pullback approaches trendline at point A
2. Order to buy on a stop, 1 tick above high at A
72 3. Get stopped in at next day’s open - point B
4. Place an order to sell on a stop at level C
70
B
68
`
C
66
64
A
62
Trendlines Breaks
¾ 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

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Futures
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S&P 500
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Buying
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Opportunity
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Copyright © 1996 – 2006 Investment Analytics

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Buying
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Opportunity
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Trading Trendline Breaks
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Selling
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Opportunity
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Slide: 11
Channel Lines
¾ 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:
• Go long in lower quarter of channel
• Take profits in upper quarter

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Futures
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S&P 500
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Buying
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Take Profits
Opportunity
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Buying
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Opportunity
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Channel Lines
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Selling
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Opportunity
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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
¾ Averages the price series to smooth out effect of
extreme highs or lows
¾ Reveals underlying trend
• Longer MA’s show longer term trend
• Shorter MA’s react more quickly to recent prices

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Eurodollars
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Formula:
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3 per. Mov. Avg.
Moving Average Example
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MN(t) = (X(t)+X(t-1)+...+X(t-N+1))/N
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Slide: 15
Moving Average Formula
¾ Formula: MA = P1 + P2 + . . . + PN
N
¾ Example:
• Time Price 3-Day MA
t1 17 N/A
t2 16 N/A
t3 19 (17+16+19)/3 = 17.3
t4 22 (16+19+22)/3 = 19.0

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

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
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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Buy
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Eurodollars
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6 per Mov . Av g
3 per. Mov . Av g.
Sell
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Example: Moving Average Crossover
Slide: 20
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Gold Futures
BUY

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SELL
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09/06/85 BUY
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SELL
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Whipsaw Market
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BUY
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SELL
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9 per. Mov. Avg.
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18 Per. Mov. Avg.
Slide: 21
Exponential Moving Averages
¾ Similar to simple moving average
¾ Gives more weight to recent observations
¾ Formula: EMAt = wPt + (1 - w) EMAt-1
• 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

Exponential & Simple MA’s
105
Compared
100
13 Day EMA
95
13 Day MA
90
85
80
75
70
65

Lab: Self-Assessment Test
¾ Load Excel spreadsheet: technic.xls
¾ Restart test
¾ Work through trend & moving average
sections
¾ MA data worksheet
• Charts EMA & MA
• Charts MA Crossover
• Try different length MA’s for crossover system
• Is there a better choice than 9 and 21 ?

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

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Resistance
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Support & Resistance Lines
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Support
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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

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

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buy
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S&P 500 Futures
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Resistance
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Support & Resistance Trading
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Support
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Slide: 29
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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

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
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

Gaps - Illustrated
88
Congestion Breakaway Gap
87
Area Sell short, with stop above rim
Continuation Gap
87
Continuation
Add to shorts, with stop

Distance to
above rim
Gap
86
86
85
Target
85
Exhaustion Gap Island
84 Target achieved - take profits Reversal
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

Continuation Patterns
Bull Bear
Flag
Pennant
Volume
Triangles
Bull Bear
Ascending Descending
Symmetric
Volume
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Example: Flag & Triangle
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Slide: 37
Trading Continuations
¾ 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

Reversal Patterns
¾ Indications of trend ending
¾ Most common patterns
Double Tops
Head & Shoulders
¾ Price and Volume confirmation required
¾ Give indication of new price target

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Move
peak, and declining

Volume lower on right
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Measured
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Double Top
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volume on
breakdown
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Futures
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Big pickup in low volume
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Comex Gold
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to resistance on
Short on pullback
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Slide: 40
Reversal Patterns -
Head & Shoulders
Head
Right
Left Shoulder
Shoulder N e c k li n e
D ecl
in
Volu ing
me
Target

Trading Head & Shoulders
¾ 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
Lab: Self Assessment Test
¾ Continue with test
¾ Worksheets:
• Support & resistance
• Gaps
• Spikes
• Continuations
• Head & Shoulders

Oscillators
¾ Measure extremes of market sentiment
¾ Oscillator: fluctuates between two extreme values
• When market is overbought or oversold
• Market likely to reverse
¾ Oscillators work well in trading ranges
¾ Can also be used when market trends:
• 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

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

Momentum
¾ Measures trend acceleration
¾ When Trend is Up
• 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

Momentum Chart
80
Double Top
75
70
65
60
55
Bearish Divergence:
50
Sell short
45
10
405
BUY
0
-5 Trendline break
-10 - take profits
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

Divergence
¾ Bearish Divergence Bullish Divergence
Prices Prices
Oscillator
Oscillator
¾ Trading Rule: Trading Rule:

• Scale back / go short Scale back / go long

Stochastics
¾ Tracks relationship of closing price to recent Hi-
Lo 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)
• 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
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

Stochastics in Trading Range
115.0
110.0
Sell
105.0
100.0
Buy Buy
95.0
100 Overbought
75
90.0
50
25
0 Bullish
Oversold Divergence
Trading with Stochastics
¾ Ideal for range trading
¾ In Trends:
• 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
¾ Charting: look for trendlines on the oscillator
¾ Divergence: trade same way as Momentum

Indicators
¾ These are trend following tools
¾ Usually based on moving averages
¾ Popular indicators
• MACD (Moving Average Convergence-
Divergence)
• Wilder’s ADX system

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
How to use MACD
¾ 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

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

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)

MACD Divergence
Bearish Bullish

Lab: Self Assessment Test
¾ Continue with tests
¾ Worksheets:
• Momentum
• Stochastics
• MACD

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
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

Trends in Random Prices
1240.0
1040.0 Ln(St+1 / St ) =εt ~ Niid ⇒

Ln(St+1) = M+P*Ln(St ) +εt
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40.0

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Sept Bond Futures
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R2 = 0.9142
Linear Behavior in Markets
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y = 0.1571x + 100.09
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Slide: 64
A Foolproof Way to Make Money
Using Systems
¾ 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!

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?

Rationale for Technical Analysis
¾ ‘Rational prices’ argument

¾ Psychological factors
¾ Market anomalies

‘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

Psychological factors
¾ Technical analysis is easy
¾ ‘Working’vs. gambling
¾ Comfort factor
• To back up a trading decision
• To trade with the crowd

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

Investment Theory - Technical Analysis

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Add to shorts, with stop

¾ Spikes & Tails

• Extreme price move up or down

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¾ These are trend continuation signals

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peak, and declining

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¾ Trading Rule: Trading Rule:

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¾ Histogram Negative: reverse of above

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1040.0 Ln(St+1 / St ) =εt ~ Niid ⇒

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¾ ‘Rational prices’ argument

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