Investment Theory - Technical Analysis

Copyright © 1996 – 2006 Investment Analytics Slide: 1

Technical Analysis

Copyright 1996-2006 Investment Analytics


Technical Analysis

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


Technical Analysis Tools

ChartingGann Elliot WaveCycle TheoryOscillators & IndicatorsJapanese CandlesticksMarket ProfileComputerized Trading Systems


Classical Charting

Trend LinesSupport/ResistanceContinuation PatternsReversal PatternsGaps & SpikesMoving Averages


Trends

Trend Direction

• Uptrend: Downtrend: higher highs, higher lows lower lows, lower highs

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

Main technical analysis tools:• Trend Lines• Moving Averages


Trendlines

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

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

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Rising Volume

BA

Trend B is more significant than trend A . . .1. More contact points2. Longer trendline3. Rising volume


Trading Rules for (UP)TrendsTrade only in the direction of the trend

• Ignore all signals to short a bull market

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

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

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

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1. Pullback approaches trendline at point A2. Order to buy on a stop, 1 tick above high at A3. Get stopped in at next day’s open - point B4. Place an order to sell on a stop at level C

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Trendlines Breaks

Trendlines provide support & resistanceSteep trendlines (over 45 degrees) precede sharp breaksA pullback to the trendline after a break is often a good shorting opportunity


Trading Trendline Breaks

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S&P 500 Futures

Buying Opportunity

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Selling Opportunity


Channel Lines

A line running parallel to the trendlineDrawn through tops of rallies(bottoms of declines)Marks maximum power of bulls (bears)The wider the channel the stronger the trendTrading Rules:

• Go long in lower quarter of channel• Take profits in upper quarter


Channel Lines

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S&P 500 Futures

Buying Opportunity

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Selling Opportunity

Take Profits


Moving AverageShows 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 lowsReveals underlying trend

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


Moving Average Example

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Eurodollars

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


Moving Average Formula

Formula: MA = P1 + P2 + . . . + PNN

Example:• Time Price 3-Day MA

t1 17 N/At2 16 N/At3 19 (17+16+19)/3 = 17.3t4 22 (16+19+22)/3 = 19.0


Using Moving Averages in TradingAs 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 SystemMethod

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

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

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

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


Example: Moving Average Crossover

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9 Day MA

21 Day MA

BUY

SELL

BUY


Example: Moving Average Crossover

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3 per. Mov. Avg.6 per Mov. Avg

Eurodollars

SellSell

Buy


Whipsaw Market

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Gold Futures

BUY

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Exponential Moving Averages

Similar to simple moving averageGives more weight to recent observationsFormula: 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

EMA is more responsive to recent trends than simple MA


Exponential & Simple MA’s Compared

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13 Day EMA

13 Day MA


Lab: Self-Assessment Test

Load Excel spreadsheet: technic.xlsRestart testWork through trend & moving average sectionsMA 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

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

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

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


Support & Resistance Lines

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S&P 500 Futures

Resistance

Support


Support & Resistance Levels

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

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


Support & ResistanceContrarian Trading

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

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


Support & Resistance Trading

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S&P 500 Futures

Resistance

Support

sell

buy


Trading RangesNAKED (No view on volatility):

• Go long at Support• Reverse & go short at Resistance

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

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


GapsOccur when market is stampeded

• Caused by news, panic• Breakdown of trend• Breakout of trading range• Losers dumping positions

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

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

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


Gaps - Illustrated

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88 Congestion Area

Breakaway Gap Sell short, with stop above rim

Continuation Gap Add to shorts, with stop above rim

Exhaustion GapTarget achieved - take profits

Island Reversal

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ap

Target


Spikes & Tails

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 PatternsBull

Flag

Bear

Pennant

Volume


TrianglesBull

Descending

Bear

Symmetric

Volume

Ascending


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Example: Flag & Triangle

S&P 500


Trading Continuations

These are trend continuation signalsAdd to positions on breakoutBuy (sell) stop 1 tick above pattern boundary, orBuy(sell) on close outside boundary


Reversal Patterns

Indications of trend endingMost common patterns

Double TopsHead & Shoulders

Price and Volume confirmation requiredGive indication of new price target


Double Top

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Comex Gold Futures

Volume lower on right peak, and declining

Big pickup in volume on breakdown

Short on pullback to resistance on low volume

Measured Move


Reversal Patterns -Head & Shoulders

Neckline

Head

LeftShoulder

RightShoulder

Target

Declining Volume


Trading Head & Shoulders

Scale down position as pattern emergesLook for confirmation in declining volumeGet short on right shoulder, with stop above headAdd to short on break of neckline, with stop above necklineAdd to short on pullback to necklinePlace buy limit order at distance of measured move


Lab: Self Assessment Test

Continue with testWorksheets:

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


OscillatorsMeasure extremes of market sentimentOscillator: fluctuates between two extreme values

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

Oscillators work well in trading rangesCan 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

MomentumStochasticsRelative Strength Indicator (RSI)Williams %R


MomentumMeasures trend accelerationWhen Trend is Up

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

weakening

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

E.g 7 Day Momentum• Pt = 24; Price 7 days ago = 18

– 7 day Momentum = (24 - 18) = 6


Momentum Chart

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BUY

Trendline break - take profits

Double Top

Bearish Divergence:Sell short


Momentum Trading Rules

When Momentum crosses center line & ticks back up

• Stock is oversold• Trend has slowed for a moment• Opportunity to get on board - Buy!

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

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


Divergence

Bearish Divergence Bullish Divergence

Trading Rule: Trading Rule:• Scale back / go short Scale back / go long

Prices

Oscillator

Prices

Oscillator


StochasticsTracks relationship of closing price to recent Hi-Lo rangeFormula: %K = Ct - Ln x 100

Hn - Ln

%D = 3 day sum of (Ct - Ln) x 1003 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

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

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

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

Buy signal - the reverse


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Stochastics in Trading Range

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Bullish Divergence

Buy


Trading with StochasticsIdeal for range tradingIn 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

Charting: look for trendlines on the oscillatorDivergence: trade same way as Momentum


Indicators

These are trend following toolsUsually based on moving averagesPopular indicators

• MACD (Moving Average Convergence-Divergence)

• Wilder’s ADX system


MACD Histogram

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

Fast MACD reflects short term consensusThe signal indicates consensus over a longer periodWhen the fast MACD rises above the signal, bulls are in control: trade from the long sideWhen the fast MACD falls below the signal, bears are winning: trade from the short side


The MACD Histogram

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

Histogram Positive, falling• Meaning: trend weakening / pullback ahead• Trading rule: (i) tighten protective stops

(ii) place order to buy above yesterdays’ high

Histogram Negative: reverse of above


The MACD Histogram

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

Continue with testsWorksheets:

• Momentum• Stochastics• MACD


Summary: Technical AnalysisMost useful techniques:

• Trendlines, channel lines, moving averages• Support & resistance

Charting:• Continuation & reversal patterns• Gaps, spikes

Indicators• MACD & other trend indicators

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


Problems with Technical TradingTrends

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

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

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


Trends in Random Prices

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LnS S NiidLnS M P LnS

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Linear Behavior in Markets

y = 0.1571x + 100.09R2 = 0.9142

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Sept Bond Futures


A Foolproof Way to Make Money Using Systems

Devise a trading ruleTest it - make sure it loses moneyReverse the signals Optimize the parametersIgnore commission & slippageSELL THE SYSTEM!


Technical Analysis & EMH

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

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


Rationale for Technical Analysis

‘Rational prices’ argumentPsychological factorsMarket anomalies


‘Rational prices’ argumentTechnical analysts argue EMH is wrong on at least two counts:

• it says prices are random• it says trends and chart patterns aren't real

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

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

Technical analysis is easy‘Working’vs. gamblingComfort factor

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


Market AnomaliesSmall firm in January effect (Banz, 1981)

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

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!

Value Line (Black, 1971)• Portfolio 1 abnormal +ve returns, Portfolio 5 abnormal

negative returns• Reranked stocks (esp. small) show abnormal returns

Documents

Investment Theory - Technical Analysis