SAPM - Technical analysis
- 2. Objective: (Module 4) Understand Technical Analysis Chart Patterns Moving Averages RSI / ROC /MACD Learn of the Efficient Market Hypothesis and the Random walk theory References: SAPM texts by Punithavathy Pandian Prassana Chandra 2 Jaissy@gmail.com
- 3. Fundamental Vs. Technical Analysis Fundamental Analysis looks at analysis the stock’s ‘intrinsic value’ ( using valuation techniques & EIC methodologies). If intrinsic value < market price – BUY, If intrinsic > market price – SELL Technical Analysis – Analysis only of the stock’s market price trends BUY if the stock price shows an ‘upward’ trend SELL if the stock prices shows a downward trend Technical Analysis 3 Jaissy@gmail.com
- 4. Technical Analysis: Intro Based on the assumption that there are trends in the market prices – upward trend shows market is on the rise & vice versa Assumes that the markets prices movements incorporates all information about the stock and reflects sentiments of investors ( hope & fear) – reflects supply and demand of shares Technical Analysis 4 Jaissy@gmail.com
- 5. DOW Theory: Assumptions Father of technical Analysis: Charles Dow Analyzed stock movement charts, computed moving averages to develop the ‘DOW theory’ ( now implemented using computers) 1. Assumption 1: No single investor can influence market trends ( only a stock trend if traded in large quantities) 2. Assumption 2: Market factors in everything – natural calamities, global recession etc 3. Assumption 3: Theory can only be used to understand market, not beat it Technical Analysis 5 Jaissy@gmail.com
- 6. Dow theory Trend = direction of movement Share prices moves up & down in a zigzag; trend lines connect either 2 tops / bottom There are 3 types of trends 1. Primary ( upward / downward – 1 / 2 years)… ( like TIDES of the sea) 2. Intermediary ( corrective movements – 1 – 3 months)…(like WAVES of the sea) 3. Short term ( day to day oscillations)…RIPPLES Technical Analysis 6 Jaissy@gmail.com
- 7. Trend Lines Rising trend line : BULL market Falling Trend line : BEAR market Prices rises, then falls then rises even more.. B2 > B1 Indicates revival, growth in profitsB1 B2 Prices falls, then rises, then falls even more & rises again.. B2 < B1 Indicates decline B1 B2 speculation Distress selling Decline in profit Good profit Loss of faith Hope! Technical Analysis 7 Jaissy@gmail.com
- 8. Trends Technical Analysis Primary Trend Intermediate / Secondary Trend = correction of primary trend by 1/3 to 2/3 of original gain Bull Bear Minor Trends (intra day) 8 Jaissy@gmail.com
- 9. Support & Resistance Levels Prices will go up / down till there is a demand / supply correction at that price Support level – lowest price the stock will drop to before rising again Resistance level – highest price the stock will rise before falling again Resistance level Support level Technical Analysis 9 Jaissy@gmail.com
- 10. Chart Patterns - 1 Capture stock price movements over time Stock price is plotted over days Distinct patterns based on the trend: 1. V formation ( and inverted V) Technical Analysis 10 Jaissy@gmail.com
- 11. Chart Patterns - 2 2. Double top / double bottom formation 3. Head & Shoulder formation / inverted head & shoulder Neckline Bear market Bull market Technical Analysis 11 Jaissy@gmail.com
- 12. Chart Patterns - 3 4. Rounding bottom 5. Cup and handle Technical Analysis 12 Jaissy@gmail.com
- 13. Chart Patterns - 3 6. Triangles ( Symmetrical, Ascending, Descending triangles) Support level Resistance level Bull Bear Neutral Technical Analysis 13 Jaissy@gmail.com
- 14. INDICATORS & OSCILLATORS Indicator is a set of data points obtained by applying a formula to the price data ( Open, close price, volume) of a stock / index. Technical indicators – used to find the overall direction of the market. Oscillator – shows the stock price movement between two points Oscillators show stock momentum & indication on a possible trend reversal Technical Analysis 14 Jaissy@gmail.com
- 15. Indicators: Volume of trade indicates trend – bull or bear Indicator 1: Volume; Volumes expand in a bull market & narrow in bear market Indicator 2: Breadth of market : Diff between advance & declines Advances (# of shares that have risen in price) Declines (# of shares that have declined in price) in volume Indicator 3: Short sales ( in bear market) – selling shares that you don’t have hoping for future price decrease. # of short sales of a months compared with avg daily volume for previous month ( >1..oversold – bull trend) Technical Analysis 15 Jaissy@gmail.com
- 16. Indicator 4: Moving Averages Moving averages = ( average of a body of data ( price) over time) Short term ( 10-30 days)/ medium term (50 – 125 days) / long term ( 200 days) trends of moving average studied to identify trends Stock price moving avg. compared with index moving avg. to identify trends Technical Analysis 16 Jaissy@gmail.com
- 17. Moving Averages Stock Price Moving average Sell Buy Cutting of the moving averages Signals a trend reversal Technical Analysis 17 Jaissy@gmail.com
- 18. Types of moving averages Simple moving average – equal weightage to each days price Exponential moving average – higher weightage to more recent prices. Moving averages are studied for ‘buy’ and ‘sell’ signals. Rising moving average- rising trends and declining moving average -declining trend Technical Analysis 18 Jaissy@gmail.com
- 19. MACD ( Moving Average convergence & divergence Oscillator 1: MACD= difference between 2 exponential moving averages MACD – difference between Short Term ( SEMA - 12 days) & Long Term (LEMA - 26 days) exponential moving averages MACD = SEMA - LEMA Convergence = when the difference-> 0 Divergence = when the difference-> high MACD: + = rising trend MACD: - = declining trend Technical Analysis 19 Jaissy@gmail.com
- 20. RSI- Relative Strength Index : Oscillator 2: RSI shows inherent strength or weakness of a particular stock RSI = 100 – 100 1 + avg. daily gain avg. daily loss RSI avg. Gain / loss can be calculated for 9, 14 days or more.. Higher the better. RSI >70 likely downturn – sell, RSI<30 likely upturn- buy Technical Analysis 20 Jaissy@gmail.com
- 21. ROC ( Rate of change) Oscillator 3: ROC measures rate of change between current price & price a number of days in past (could be 12 days/ 12 weeks / 12 months) Used to indicate trend reversal ROC = % change of current price vs. earlier price ROC = Todays price * 100 - 100 Price ‘n’ days ago Current price – 210 and price 12 weeks ago – 230, ROC = 210/230 * 100 – 100= -8.69( negative sign means decline) ROC plotted against time: highest peak – overbought region ( sell here) , lowest point – oversold region( buy here) Overbought / oversold points indicate trend reversals Technical Analysis 21 Jaissy@gmail.com
- 22. Efficient Market Theory Introduced by Fama – Efficient market theory states that stock price movements are random and without any pattern ( unlike technical analysis which identifies chart patterns) This theory assumes that any information regarding the stock will be factored into the stock prices. Higher the market efficiency, quicker will be the incorporation of future expectations / any information into the stock price. Arbitrageurs look to make a quick profit in the time before the market prices adjust to new information; their actions cause the market to adjust. Intense competition will ensure a fair price for securities in the market Efficient Markets 22 Jaissy@gmail.com
- 23. Efficient Markets This is a market in which market price of a security is an unbiased estimate of its intrinsic value This means any deviation of market price from intrinsic value is unbiased & random. What leads to efficient markets? Investor rationality (investors respond rationally to new information) Independent deviation from rationally ( even if some investors don’t behave rationally – this is random & not correlated – will be net off finally) Arbitrage: Rational investors will try to exploit any inefficiencies in the market – thereby correcting the inefficiency. Efficient Markets 23 Jaissy@gmail.com
- 24. Random Walk Theory Introduced by Maurice Kendall, a statistician who studied stock & commodity prices looking for regular cycles. He found that the security price movements are random and that the stock price movements follow a series of ‘random’ walks. At each point of time, the stock price is independent of what it was before. The theory deals with successive changes in price (looks at absolute price delta for that security not relative to other securities price delta) Efficient Markets 24 Jaissy@gmail.com
- 25. Random Walk & Efficient Markets Academicians state that the randomness of stock prices is the result of the efficient market. i.e.: All information is freely & quickly available to all market participants Keen competition ensures that in time the market prices will reflect ‘intrinsic values’ Prices change only in response to new information New information cannot be predicted so prices cannot be forecast & hence prices behave like a ‘random walk’ Efficient Markets 25 Jaissy@gmail.com
- 26. Sem Three forms of efficient market hypothesis Efficient Market Hypothesis Weak form efficiency Semi strong form efficiency Strong form efficiency Security prices factor in all security market info Security prices factor in all public market info as well as non market info Security prices factor in all available info – pubic & private 26 Jaissy@gmail.com
- 27. Stock price factors in the following info: Weak Market Hypothesis All security market info: prices, trading volumes, rate of return, insider transactions, block trades, odd lot transactions Semi Strong Market Hypothesis All public info– market & non market: macro- economic data, industry reports, corporate announcements, P:E ratio, div yield Strong Market Hypothesis All available info – public & private. Assumes that no investor has monopolistic access to info that would lead to higher risk adjusted returns. This means no one can getter returns than the market using info! Efficient Market Hypothesis 27 Jaissy@gmail.com
- 28. Contradiction to concept of ‘efficient markets’ 1. Over reactions of the market – Stock prices decline dramatically after bad results - and take time to come to ‘normal’ – during which time investor can buy at low rates & sell at high rates making abnormal profit – against efficient market theory Efficient Market Hypothesis 28 Jaissy@gmail.com
- 29. Contradiction to concept of ‘efficient markets’ 2. Stock price will go back to ‘average’ return after low or high returns – thereby giving an investor a chance to ‘predict’ price : against random walk theory 3. Delayed adjustment to new information: stock prices tend to continue to rise / decline for some time after corporate announcements are positive / negative. Efficient Market Hypothesis 29 Jaissy@gmail.com
- 30. Contradiction to concept of ‘efficient markets’ 4. Small firm: A theory that says small firms give better returns than large firms – confirmed by a study done on the NYSE 5. Weekend effect: Stock prices tend to rise all week reaching a peak on Friday. So it makes sense to buy on Monday and sell on Friday – the ‘weekend’ effect contradicts the efficient market hypothesis Efficient Market Hypothesis 30 Jaissy@gmail.com