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Reading 56: Technical Analysis (Technical Analysis Charts and Graphs (Line…
Reading 56: Technical Analysis
Principles
Price are determined by investor's supply and demand for asset
Supply and demand are driven by both rational and irrational behaviors
Technical analysts use prices and trading volume to analyze changes in supply and demand
Prices move in trends, and exhibit patterns that can be identified and will repeat over time in predictable ways
Technical Analysis Charts and Graphs
Line chart: a continuous line connecting closing prices for each period.
Bar chart: Show the open, high, low and close price for each period.
Volume chart: Show the volume traded, usually accompany line chart
Point-and-figure chart: indicate significant changes in price direction. X is price going up, O is price going down
Candle-stick chart: like bar chart; unfilled if close > open; filled if open > close price
Trend; support & resistance lines, and change in polarity
Trend
Up-trend
: shows that prices are reaching higher highs and higher lows.
How to draw: Connect the increasing lows with a straight line
Down-trend: shows that prices are reaching lower highs and lower lows.
How to draw: Connect the decreasing highs with a straight line
Support and Resistance lines
Support lines: Price where buying pressure limits a downtrend
Resistance lines: Price where selling pressure limits an uptrend
Change in polarity principle: the previously breached resistance (or support) level will become the new support (or resistance) level
Common chart patterns
Reversal Patterns
@ end of uptrend
Head-and-shoulder
Price target = Neckline - (Head - Neckline)
Double/ tripple tops
@ end of downtrend
Inverse Head-and-shoulder
Price target = Neckline + (Neckline - Head).
Double/ Tripple bottoms
Continual Patterns
Triangles
Rectangles
Flags
Pennants
Size of the pattern: measuring how big the pattern is, to tell about the possible fall or rise in stock price
Trade volume is important to interpret data
Common technical analysis indicators
Price-based indicators
Identify changes in price trends
Moving averages
Mean of last n prices
Bollinger bands
Drawn above and below moving average by a specific number of standard deviation
Short-term (contrarian)
Sell at top band - security overbought
Buy at bottom band - security oversold
Longer term
Buy on significant breakout above the top band
Sell on significant breakout below lower band
are price-based indicators
Momentum oscillators
(Ex: Relative Strength Index)
Price-based indicators that oscillate either between 2 values or around 1 value
Oscillators make extremes of market sentiment more clear
Extreme highs indicate overbought, extreme lows indicate oversold
Convergence: when oscillator moves with price trend → price trend will continue
Divergence: when oscillator move opposite to price trend → price trend will reverse
stochastic oscillators
Arms Index (Short-Term Trading Index (TRIN))
compares the number of advancing and declining stocks (AD Ratio) to advancing and declining volume (AD volume
\( TRIN=\frac{Advancing.Stock/Declining.Stoc}{Advancing.Volume/Declining.Volume}\)
Advancing Stock: No. Stocks with higher price at the end of trading day.
Declining Stock: No.Stocks with lower price
Advancing Volume: Total trade volume of advancing stock
Declining Volume: Total trade volume of declining stock
Reading
TRIN > 1: bearish signal
TRIN = 1: neutral market
TRIN < 1: Bullish signal
Sentiment Indicators
interpret from a contrarian perspective
Opinion polls
Put/ Call ratio
Put > Call or Ratio >1 → Negative sentiment
Put < Call or Ratio < 1 → Positive sentiment
Contrarian indicator
volatility index
High when investors fear market decline
margin debt
short-interest ratio
Flow of fund indicators
Margin debt
Arms index
Cash position
New equity issuance
Secondary offering
Log-scale
A logarithmic scale (or log scale) is a way of displaying numerical data over a very wide range of values in a compact way
Cycle
Market price move in cycles
Decennial pattern theory: years ending with a 5 will have the best performance of any of the 10 years in a decade and that those ending with a zero will have the worst
54-year Kondratieff wave: stated that the period of a wave ranges around 54 years
4-year US-presidential election cycle:politicians desiring to be reelected inject money into the economy in the third year to improve their chances of winning the following year.
Elliott Wave Theory & Fibonacci Number
Elliott Wave Theory:
prices exhibit a pattern of 5 waves in direction of a trend and 3 waves counter to the trend
equity market moves in cycles following Fibonacci ratios
Fibonacci Number sequence: used by technical analysts to estimate price targets and identify potential support and resistance levels
Inter-market Analysis
Inter-market Analysis: examines the relationships among various asset market (ex: stock, bonds, commodities, currencies, etc.) by relative strength analysis to identify attractive asset classes and attractive sectors within these classes.
Equities, bonds, currencies, commodities
Industry groups: Energy, utilities, consumer staples, healthcare, financials, info tech, materials, industrials, telecom, consumer discretionary
Major exchanges: London, New York, Tokyo, etc.
Relative Strength Analysis:
is a type of momentum investing
consists of selecting investments that are outperforming their market or benchmark.
assume that the trend of outperformance will continue.
If the trend reverses, their investment will likely perform poorly.
Vs. Fundamental Analysis
Fundamental analyst looks for changes in intrinsic values (what price should be) based primarily on anticipated financial results and estimates of future cash flows
Technical analysts try to predict price changes through analysis of past trade prices and volume
Pros and Cons
Pros
Can be used for assets with no cash flows to be discounted for valuation
Don't have to learn accounting
Based on trade data, whereas fundamental analysis is based on accounting values
Cons
Not work in illiquid market
Not work in markets subject to manipulation (e.g., central bank currency intervention)
Bankrupt companies may have stock price going to 0 but still have positive technical patterns due to short covering
Will not work if markets are weak form efficient