Technical Analysis and Profit

Advantages
Dr. Rahul Singh

Background
Main approaches to valuing stocks include
Risk-return analysis
Fundamental analysis
Technical analysis

Some technicians use only technical analysis

while others use both fundamental and technical
analysis
Technicians (chartists) focus on charts of market
prices and transactions statistics
Think that these statistics will reveal all

Technicians study patterns in security prices

Theoretical Foundation
Edwards & Magee (1997) state the basic assumptions of technical
analysis

A securitys market value is based on supply and demand

Supply and demand are based on both rational and irrational factors
Security prices tend to move in persistent trends
Changes in trends occur due to shifts in supply and demand
Shifts in supply and demand can be detected using charts of market
transactions
Some chart patterns tend to repeat themselves

Technicians believe past patterns will recur

Therefore can be predicted

Technical analysts estimate prices

Whereas fundamental analysts estimate value

Technicians tend to ignore issues such as a firms riskiness and

earnings growth
Instead focus on barometers of supply and demand

Dow Theory
Originated by Charles Dow
Founder of the Dow Jones Company and founder of Wall Street
Journal

Dow Theory presumes market moves in persistent bull

and bear trends
Often used for market as a whole, but used for individual
securities also

Types of movements defined by Dow theorists

Primary trends (bull or bear market)
Secondary trends (corrections)
Market collapses or upward surges lasting a few weeks or months

Tertiary moves (little daily fluctuations)

Meaningless random wiggles but should be studied to determine if
relate to a primary trend

Continued

Most Dow theorists do not think a new primary trend has been confirmed until pattern of
ascending or descending tops occur in both industrial and transportation averages.

Testing the DOW Theory

Results indicate forecasts based on 4
discernable patterns

Recent downward trends in index are sell signals

index falls from recent peaks are sell signals
Recent upward trends in index are buy signals
Recoveries from recent declines in index are buy
signals

When a buy or neutral signal was detected, a

hypothetical portfolio is fully invested in index
When a sell signal was detected, a hypothetical
portfolio is fully invested in cash

Support and Resistance Levels

Resistance level
Ceiling (peak) above which stock
price is not expected to go
Supply of security is expected to
increase

Support level
Floor (trough) below which stock price
is not expected to drop
Demand of security is expected to
increase

Suppose the following occurred

Moderate surge in trading volume at Point A
Larger surge in trading volume at Point B
3 times greater than surge at Point A

May surmise that some bullish new information

caused buying pressure at Point B which overcame
the previous resistance at Point A

 Support is the price level at which demand is thought to

be strong enough to prevent the price from declining
further. Support levels are usually below the current
price.
Resistance is the price level at which selling is thought to
be strong enough to prevent the price from rising further.

Congestion Area
Technicians are unable to offer reasons for price actions like this
Penetrating support line means sell
Penetrating resistance line means buy

Studies examining trading range breakouts find that, after deducting

commissions, return was slightly larger than riskfree interest rate

Price fluctuates in
first congestion
area for a while.

Price rises through 50 resistance

levelold resistance level
becomes new support level.

Relative Strength Index (RSI)

The RSI compares the magnitude of a stock's recent gains
to the magnitude of its recent losses and turns that
information into a number that ranges from 0 to 100
Stocks which score high on the relative strength
measure are considered good investments.
Wilder recommended using 70 and 30 and overbought and
oversold levels respectively. Generally, if the RSI rises
above 30 it is considered bullish for the underlying stock.
Conversely, if the RSI falls below 70, it is a bearish signal.
Some traders identify the long-term trend and then use
extreme readings for entry points. If the long-term trend is
bullish, then oversold readings could mark potential entry
points.

Formulae

It is important to remember that the Average Gain and Average Loss are not
true averages! Instead of dividing by the number of gaining (losing) periods,
total gains (losses) are always divided by the specified number of time periods 14 in this case.

Moving Average Analysis

Moving averages are used to provide a smooth
reference point for

Individual securities
Market indices
Commodity prices
Interest rates
Foreign exchange rates

Some use a 150-day (30 week) moving average

Changes each day
Most recent day is added and oldest day is dropped
Following calculation is performed
M150DAPt = (1/150)(Valuet + Valuet-1 + Valuet-149)

Continued
Moving averages computed over short time
frames follow daily prices more closely
More volatile than longer-term moving averages

Technicians analyze difference between daily

price and moving average
If daily prices penetrate moving average line it is a
signal to take action
If daily price moves down through a moving average, price
fails to rise for many months
Sell signal

If daily prices are above moving average but difference is

narrowing
Signals end of bull market may be near

Continued
Moving average analysts recommend buying stock if
Moving average line flattens and stock price moves up through moving
average line
Price of stock falls (temporarily) below moving average line that is rising
Stock price is above moving average line, falls, turns around and rises
again without penetrating moving average line

Moving average analysts recommend selling stock if

Moving average line flattens and stock price drops down through
moving average line
Stock price temporarily rises above a declining moving average line
Stock price falls through moving average line and turns around only to
fall again without penetrating above moving average line

Strategy is more successful if moving average is calculated over a

longer time frame

Serial Correlation
Serial correlation measures the correlation between
price changes in consecutive time periods
Measure of how much price change in any period
depends upon price change over prior time period.
0: imply that price changes in consecutive time periods are
uncorrelated with each other
>0: evidence of price momentum in markets (buying after
periods with positive returns and selling after periods with
negative returns )
<0: Evidence of price reversals (buying after periods with
negative returns and selling after periods with positive returns)

The correlations must be large enough for investors to

generate profits to cover transactions costs.

Continued
Serial correlations in most markets is small, it is unlikely that
there is enough correlation to generate excess returns.

The serial correlation in short period returns is also affected by

price measurement issues and the market micro-structure
characteristics.
Non-trading in some of the components of the index can create a
carry-over effect from the prior time period, this can result in positive
serial correlation in the index returns.
The bid-ask spread creates a bias in the opposite direction, if
transactions prices are used to compute returns, since prices have a
equal chance of ending up at the bid or the ask price. The bounce that
this induces in prices will result in negative serial correlations in
returns.

Bid-Ask Spread = Square root of (Serial Covariance in returns)

(where the serial covariance in returns measures the covariance between
return changes in consecutive time periods)

Filter Rule
In a filter rule, an investor buys an investment
if the price rises X% from a previous low and
holds the investment until the price drops
X% from a previous high.
The magnitude of the change (X%) that triggers
the trades can vary from filter rule to filter rule.
with smaller changes resulting in more
transactions per period and higher transactions
costs.

Illustration of Filter Rule

price changes are serially

correlated and that there is

price momentum

January Effect

Returns in January are significantly higher than

returns in any other month of the year.
The January effect is much more accentuated
for small firms than for larger firms.

Week End Effect

Monday effect is really a weekend effect since the bulk of the negative
returns is manifested in the Friday close to Monday open returns.
The returns from intraday returns on Monday are not the culprits in
creating the negative returns.
Monday effect is worse for small stocks than for larger stocks.
Monday effect is no worse following three-day weekends than twoday weekends.

New of the Today's

Artificial Intelligence: Software systems that
attempt to replicate aspects of human
intelligence.
Expert System: Computerized decision-making
technique that embodies knowledge gleaned
from experts.
Neural Network: Tries to mimic human brain
processes and learns from mistakes it makes.
Chaos Theory: Holds that seemingly random
event s actually have patterns that computers
can detect.