Technical analysis of investment portflio.ppt
- 2. Technical Analysis Questions to be answered: How does technical analysis differ from fundamental analysis? What are the underlying assumptions of technical analysis? What major assumption causes a difference between technical analysis and the efficient market hypothesis? 2
- 3. Technical Analysis What are the major advantages of technical analysis compared to fundamental analysis? What are the major challenges to the assumptions of technical analysis and its rules? What is the logic for the major contrary opinion rules used by technicians? 3
- 4. Technical Analysis What are some of the significant rules used by technicians who want to “follow the smart money” and what is the logic of those rules? What are the breadth of market measures and what are they intended to indicate? What are the types of price movements postulated in the Dow Theory and how are they used by a technician? 4
- 5. Technical Analysis Why is volume of trading important and how do technicians use it? What are support and resistance levels and how are they used? How do technicians use moving-average lines to detect changes in trends? 5
- 6. Technical Analysis: •Technical analysts base trading decisions on examinations of prior price and volume data to determine past market trends from which they predict future behavior for the market as a whole and for individual securities. 6
- 7. Underlying Assumptions of Technical Analysis 1. The market value of any good or service is determined solely by the interaction of supply and demand 2. Supply and demand are governed by numerous factors, both rational and irrational 3. Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time 4. Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself. 7
- 8. Assumptions: •The first two assumptions are almost universally accepted by technicians and non-technicians. •Significant difference of opinion regarding the speed of adjustment of stock prices to changes in supply and demand. •Technical analysts expect stock prices to move in trends that persist for long periods . •New information does not come to the market at one point in time but rather enters the market over a period of time •Technicians do not expect the price adjustment to be as abrupt as fundamental analysts and efficient market supporters do rather, they expect a gradual price adjustment to reflect the gradual dissemination of information. 8
- 9. Advantages of Technical Analysis Not heavily dependent on financial accounting statements Problems with accounting statements: 1. Lack of lot of information needed by security analysts, such as information related to sales, earnings, and capital utilized by product line and customers. 2.GAAP allow firms to choose among several procedures for reporting expenses, assets, or liabilities. These alternative procedures can produce very much different values for expenses, income, return on assets, and return on equity, resulting in difficulty comparing statements from two firms. 3. Many psychological factors and other non-quantifiable variables do not appear in financial statements. 9
- 10. Advantages of Technical Analysis Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst simply has to recognize a movement to a new equilibrium Fundamental analyst determines that a given security is under- or overvalued a long time before other investors. For example, assume that based on your analysis in February, you expect a firm to report substantially higher earnings in June. Although you could buy the stock in February, you would be better off waiting until about May to buy the stock so that your funds would not be tied up for an extra three months. Technicians do not invest until the move to the new equilibrium is underway, they challenge that they are more likely than a fundamental analyst to experience ideal timing. 10
- 11. Challenges to Technical Analysis Assumptions of Technical Analysis Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends. Technical Trading rules The past may not be repeated Patterns may become self-fulfilling forecasts. For Example, assume that many analysts expect a stock selling at $40 a share to go to $50 or more if it should rise above its current pattern and break through its channel at $45. As soon as it reaches $45, enough technicians will buy to cause the price to rise to $50, exactly as predicted. 11
- 12. Challenges to Technical Analysis •A successful rule will gain followers and become less successful. For example, suppose it becomes known that technicians who employ short-selling data have been enjoying high rates of return. Based on this knowledge, other technicians will likely start using these data and thus accelerate the stock price pattern following changes in short selling. As a result, this profitable trading rule may no longer be profitable after the first few investors react. 12
- 13. Challenges to Technical Analysis •Rules require a great deal of subjective judgment Two technical analysts looking at the same price pattern may arrive at widely different interpretations of what has happened and, therefore, will come to different investment decisions. •The standard values that signal investment decisions can change over time. Technical analysts adjust the specified values that trigger investment decisions to conform to the new environment. In other cases, trading rules have been discarded because they no longer work. 13
- 14. Technical Trading Rules and Indicators Stock cycles typically go through a peak and trough Analyze the following chart of a typical stock price cycle and we will show a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would want to trade 14
- 15. Typical Stock Market Cycle Stock Price 15
- 16. Typical Stock Market Cycle Stock Price Declining Trend Channel Trough Buy Point Rising Trend Channel Flat Trend Channel Sell Point Peak Declining Trend Channel Trough Buy Point 16
- 17. Contrary-Opinion Rules Many analysts rely on rules developed from the idea that the majority of investors are wrong as the market approaches peaks and troughs Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction These positions have various indicators 17
- 18. Contrary-Opinion Rules Mutual fund cash positions Contrary-opinion technicians believe that mutual funds usually are wrong at peaks and troughs. They expect mutual funds to have a high percentage of cash near a market trough—the time when they should be fully invested to take advantage of the future market rise. At the market peak, these technicians expect mutual funds to be almost fully invested with a low percentage of cash when they should be selling stocks and realizing gains. Contrary-opinion technicians watch for the mutual fund cash position to approach one of the extremes and act contrary to the mutual funds. Specifically, they would tend to buy when the cash ratio is high and to sell when the cash ratio is low. 18
- 19. •Credit balances in brokerage accounts Technical analysts view these credit balances as potential purchasing power, a decline in these balances is considered bearish because it indicates lower purchasing power as the market approaches a peak. Alternatively, a buildup of credit balances indicates an increase in buying power and is a bullish signal. Investment advisory opinions •OTC versus NYSE volume Many technicians believe that if a large proportion of investment advisory services are bearish, this signals the approach of a market trough and the onset of a bull market 19
- 20. •Chicago Board Options Exchange (CBOE) Put-Call ratio Contrary-opinion technicians use put options, which give the holder the right to sell stock at a specified price for a given time period, as signals of a bearish attitude. A higher put-call ratio indicates a pervasive bearish attitude for investors, which technicians consider a bullish indicator. •Futures traders bullish on stock-index futures This contrary opinion measure is the percentage of speculators in stock-index futures who are bullish regarding stocks based on a survey of individual futures traders. These technicians would consider it a bearish sign when more than 70 percent of the speculators are bullish, and a bullish sign when this ratio declines to 30 percent or lower. 20
- 21. Follow the Smart Money Indicators showing behavior of sophisticated investors The Barron’s Confidence Index The Confidence Index (CI) is the ratio of Barron’s average yield on the “Best grade Bonds” list to the average yield on the Dow Jones “Intermediate Grade Bonds” list. This index measures the change in yield spread over time between high-grade and intermediate grade bonds. this ratio should approach 100 as the spread between the two sets of bonds gets smaller. Technicians believe the ratio is a bullish indicator ,because during periods of high confidence, investors are willing to invest in lower-quality bonds for the added yield, which causes a decrease in the yield spread between the intermediate grade bonds and best grade bonds. Therefore, the Confidence Index will increase. 21
- 22. •When investors are pessimistic, the yield spread will increase, and there is a decline in the Confidence Index •This interpretation assumes that changes in the yield spread are caused almost exclusively by changes in investor demand for different quality bonds. In fact, the yield differences have frequently changed because of changes in the supply of bonds 22
- 23. •T-Bill - Eurodollar yield spread The spread between T-bill yields and Eurodollar rates measured as the ratio of T-bill/Eurodollar yields. It is argued that, at times of international crisis, this spread widens as the smart money flows to safe-haven U.S. T-bills, which causes a decline in this ratio. It is argued that the stock market typically experiences a trough shortly thereafter. 23
- 24. •Debit balances in brokerage accounts (margin debt) Debit balances in brokerage accounts represent borrowing (margin debt) by knowledgeable investors from their brokers. Hence, these balances indicate the attitude of sophisticated investors who engage in margin transactions. Therefore, an increase in debit balances implies buying by these sophisticated investors and is considered a bullish sign, while a decline in debit balances would indicate selling and would be a bearish indicator. •Short sales by specialists 24
- 25. Other Market Indicators Momentum Indicators Breadth of market The breadth of market series measures the number of issues that have increased each day and the number of issues that have declined. It helps explain what caused a change of direction in a composite market index such as the S&P 500 Index. A stock-market index can experience an overall increase while the majority of the individual issues are not increasing, which means that most stocks are not participating in the rising market. Such a divergence can be detected by examining the advance- decline figures for all stocks on the exchange, along with the overall market index. 25
- 26. •The advance-decline index is typically a cumulative index of net advances or net declines. •Technicians often compute moving averages of an index to determine its general trend. The market is considered to be overbought and subject to a negative correction when more than 80 percent of the stocks are trading above their 200-day moving average. In contrast, if less than 20 percent of the stocks are selling above their 200-day moving average, the market is considered to be oversold, which means investors should expect a positive correction. 26
- 27. Stock Price and Volume Techniques The Dow theory – oldest technical trading rule 1. Major trends are like tides in the ocean 2. Intermediate trends resemble waves 3. Short-run movements are like ripples Followers of the Dow Theory attempt to detect the direction of the major price trend (tide), recognizing that intermediate movements (waves) may occasionally move in the opposite direction. They recognize that a major market advance does not go straight up, but rather includes small price declines as some investors decide to take profits. Importance of volume Ratio of upside-downside volume Support and resistance levels Moving average lines 27
- 28. Stock Price and Volume Techniques Relative-strength (RS) ratios For individual stocks and industry groups Bar charting Candlestick Charts Multiple indicator charts Point-and-figure charts 28
- 29. Technical Analysis of Foreign Markets Foreign stock market series Technical analysis of foreign exchange rates Technical analysis of bond markets 29