Cleary / Jones
Investments: Analysis and
Management
CHAPTER
CHAPTER EIGHTEEN
EIGHTEEN
Technical
Technical Analysis
Analysis
Learning
Learning Objectives
Objectives
To define technical analysis and explain
why it is used
To describe the major techniques used in
technical analysis
To discuss the limitations of technical
analysis
What
What is
is Technical
Technical Analysis?
Analysis?
Use of published market data for analysis
of both aggregate stock prices and
individual stocks
May produce insight into the psychological
dimensions of the market
Used by investors and investment advisory
firms
Oldest approach to stock selection
Technical
Technical Approach
Approach
Prices move in trends determined by changing
attitudes of investors
Identify change in trend at an early stage and
maintain investment posture until evidence
indicates otherwise
Market itself is the best source of data about
trends
– Data includes prices, volume, and technical
indicators
Technical
Technical Approach
Approach
Technicians disagree with fundamental
analysis because they believe it is extremely
difficult to estimate intrinsic value and to
obtain and analyze information consistently
– Technicians believe market data indicates forces
of demand and supply
– Record of investor mood that can be detected
and is likely to continue
Tools
Tools For
For Technical
Technical Analysis
Analysis
Use of graphs, charts, and technical trading
rules and indicators
Price and volume are primary tools of the
pure technical analyst
– Technicians use charts to identify trends and
patterns in stock prices that provide trading
signals
– Volume data used to gauge market condition and
to assess its trend
The
The Dow
Dow Theory
Theory
Based on three types of price movements
– Primary move: a broad market movement that lasts
several years
– Secondary moves: occurring within primary move,
lasting several weeks or months
– Day-to-day moves: occurring randomly around
primary and secondary moves
Bull (bear) market refers to upward (downward)
primary move
The
The Dow
Dow Theory
Theory
Bull market occurs when successive rallies
penetrate previous highs
– Declines remain above previous lows
Bear market occurs when successive rallies
fail to penetrate previous highs
– Declines penetrate previous lows
Secondary moves called technical corrections
– Day-to-day “ripples” are of minor importance
Charting
Charting Price
Price Patterns
Patterns
Price changes can be recognized and
categorized
Support price level: significant increase in
demand is expected
Resistance price level: significant increase in
supply is expected
Trendline: identifies a trend or direction
Momentum: speed of price changes
Charting
Charting Price
Price Patterns
Patterns
Bar Chart
– Vertical bar’s top (bottom) represents the high
(low) price of the day
Point-and-Figure Chart
– Compresses price changes into small space
Areas of “congestion” identified
– X (O) used to indicate significant upward
(downward) movement
Moving
Moving Averages
Averages
Used for analyzing both the overall market
and individual stocks
Used specifically to detect both the direction
and rate of change
– New value for moving average calculated by
dropping earliest observation and adding latest
observation to the average
– Comparison to current market prices produces
buy or sell signal
Relative
Relative Strength
Strength
Ratio of a stock’s price to a market or
industry index
– Ratios plotted to form graph of relative price
across time
– Rising (falling) ratio indicates relative strength
(weakness)
– What if overall market is weak?
– What if a stock is declining less quickly than the
market?
Breadth
Breadth Indicators
Indicators
Advance-Decline Line
– Measures the net difference between number
of stocks advancing and declining
– Plot of running total across time is compared
to a stock average to analyze any divergence
Divergence implies trend changing
Number hitting new highs (lows)
High trading volume regarded as bullish
Sentiment
Sentiment Indicators
Indicators
Short interest is number of stocks that have
been sold short
Short interest ratio =
Total shares sold short/Average daily trading volume
– Indicates number of days needed to “work off” the
short interest
Many technicians take a high short interest ratio
as a bullish sign
– Short interest figures may be distorted
Mutual
Mutual Fund
Fund Liquidity
Liquidity
Based on contrary opinion
Mutual funds, viewed like odd-lotters,
assumed to act incorrectly before a
market turning point
– Low liquidity implies funds fully invested
(bullish) and market is near or at peak
– High liquidity implies funds are bearish
Considered a good time to buy
Put/Call
Put/Call Ratio
Ratio
Speculators buy calls (puts) when stock
prices expected to rise (fall)
Rise (fall) in ratio of put option purchases
to call option purchases indicates
pessimism (optimism)
– Buy (sell) signal to a contrarian
– Extreme readings (below .7 or above .9)
convey trading information
Testing
Testing Technical
Technical Analysis
Analysis
Strategies
Strategies
What constitutes a fair test of a technical
trading rule?
– Risk considerations
– Include transaction and other costs
– Consistency in performance
– Out-of-sample validation
Filter rule tests
– Trades made when price change greater than
predetermined filter
Conclusions
Conclusions About
About Technical
Technical
Analysis
Analysis
Thorough tests of technical analysis have
failed to confirm their value, given all
trading costs and the alternatives, such as
a buy-and-hold strategy
Several interpretations of each technical
tool and chart pattern are not only
possible, but usual
– Art or science?
Conclusions
Conclusions About
About Technical
Technical
Analysis
Analysis
Strong evidence exists suggesting that
stock price changes are weak-form
efficient
Impossible to test all techniques of
technical analysis
Regardless of evidence, technical analysis
remains popular with many investors
