The Role of Technical Analysis within Portfolio Management Bachelor Thesis Finance

Name: Rick van Kessel Anr: s228781 Supervisor: Jrmie LeFebvre Study Program: Business studies 1

Table of Content
Preface Introduction What is technical analysis? Charting Mechanical rules 3 4 6 6 7 11 11 12 13 13 14 19 21 24 25 28

The theory for price movements Efficient Market Hypothesis Market efficiency in the modern world

The mutual exclusivity of EMH and technical analysis Why EMH rules out technical analysis Technical analysis right to exist: empirical evidence

Conclusions and implications Bibliography Appendix A Appendix B Appendix C

Preface

This thesis is written for the course Bachelor Thesis Finance for the Business Studies program at Tilburg University. From a broad list of topics, I chose to write my thesis about portfolio management. Within the field of portfolio management, I decided to focus on technical analysis. I chose technical analysis because the idea of making profit with seeking patterns in stock price charts appeals to me personally. I would like to thank my supervisor Jrmie LeFebvre for his advice and guidance during this period.

Rick van Kessel

June, 2007

Introduction
The intrinsic value of a stock is determined by the present value of all future dollar benefits. But how do you determine if a stock is undervalued? That is, if the intrinsic value is higher than the current stock price. In the search for an answer to this question, two distinct schools originated: the fundamental school and the technical school.

The Fundamental school depends on accounting figures. These figures get analyzed and then it is determined if the stock is priced correctly. If the stock is undervalued, a buy signal is generated and if the stock is overvalued, a sell signal is generated (Edwards & Magee, 1992). Practitioners of technical analysis are also called charters and this is because these analysts predict future prices by looking at charts of past stock prices (Lo et al., 2000). They try to seek for patterns in price movements and from infer information from these changes in the price (Schwager, 1966). Since computers have taken over the world, technical analysis has advanced to a higher level and new technical indicators are discovered. Technical indicators and trading rules are normally used for short-term investment strategies (Leung & Chong, 2003).

Technical analysis role as a tool for managing portfolios has been controversial in the literature (Wong et al., 2003). Profits are made with technical analysis and these profits cannot be explained from a theoretical point of view because theory says technical analysis cannot be profitable (Brunnermeier, 2001). If technical analysis is profitable, this means that information can be inferred from past prices that help technical traders make good trading decisions. In this thesis it is questioned if information can be extracted from past prices, thus, too what extend can information inferred from past stock prices tell something about the future stock price? In order to come to a reasoned conclusion, the generally accepted theory for price movements is compared to the results achieved in practice. My contribution to the whole discussion is a hopefully clearer description of the role technical analysis could fulfill within portfolio management.

Section one is about what technical analysis exactly entails and shows how technical traders come to their trading decisions. Section two deals with the efficient market hypothesis. This is the generally accepted theory for price movements and is the greatest challenger of the

technical analysis existence (Fama, 1970). In section three, theory and practice are linked and the position of technical analysis is discussed. The last section contains the conclusions and implications.

What is technical analysis?

The use of technical analysis to predict future prices has been around for decades and hundreds of indicators have been developed. It dates back to the 1600s, where Japanese rice traders who were trading on the Dojima Rice Exchange used technical analysis. Technical analysis developed and became Chartism in the 20th century, where mechanical trading rules generated buy/sell signals (Wong et al., 2003). The reason why it attracts people is that its visual nature is easy to understand and appealing for humans. The two types of analysis this technique consists of are charting and mechanical rules. In this section, I will deal with the most common chart types and mechanical rules within technical analysis. For mechanical rules, there are two main categories of technical trading systems: trend following and countertrend systems. Trend following trading systems wait for a certain price movement and than acts on it in the same direction, thinking that this trend will continue. Counter-trend systems wait for a certain price movement and than acts on it in the opposite direction, thinking that the time has come for a trend reversal (Schwager 1996). I will explain a trend following trading system and a counter-trend trading system in this section.

Charting

Symmetrical triangles

The stock price falls and rises with a great magnitude in the beginning but then converges to a certain point (see appendix A for the graph). While the oscillations become smaller, there comes a point, where it breaks out of its pattern. The stock price will then rise or fall drastically. This pattern originates from the doubts that investors have about the value of a stock. (Schwager, 1996 & Murphy, 2006 )

Ascending/Descending triangles

Although the stock price is exhibiting an upward trend, the stock price cannot break through the resistance level (see appendix A for the graph). However, at a certain point later in time, the stock price finally breaks out and then rises sharply. Conversely, for descending triangles it is the other way around. (Schwager, 1996).

Head and Shoulders

You can recognize the head and shoulders pattern (see appendix A for the graph) by the three peaks and the neckline (the blue line in the graph) and it sort of resigns to the humans head and shoulders. The biggest peak lies in the middle and it is surrounded by two smaller ones. The first minimum indicates that the buying demand decreases. Investors who believe that the stock is undervalued start buying and thereby pushing the price until traders think the price is too high and so they sell the stock. Again, there is an upward trend because traders think the stock is undervalued but this trend does not hold very long because investor perceive the price as too high. After this short trend, the stock price will fall tremendously to the appropriate price. (Edwards and Magee, 1992 & Murphy)

Bottom/Top patterns

Bottom/Top patterns indicate that a specific trend is about to shift. The double bottom pattern (see appendix A for the graph) has the shape of a W and has two equal minimums. The double top pattern has the shape of an M and has two equal peaks. It can happen that the stock price reverses in the way you expected but then reverses again. In that case, there is a good probability that you are dealing with a triple bottom patterns and triple top patterns. The rule for bottom patterns implies that you should buy when the price exceeds the peaks and for top patterns to sell when the price is below the minimums (Schwager 1996).

Mechanical rules

Moving averages

The moving average is a trend following indicator and the purpose of moving averages is to help technical traders to discover trends in an asset by smoothing day-to-day price fluctuations. The simplest form of moving averages is called the simple moving average and is a very reliable and useful indicator. The simple moving average is the arithmetic mean of a sample of stock prices. In order to calculate the moving average for the next day you have to drop the first day and add a new day to your sample. This is also called the moving window.

Algebraically, the calculation of the simple moving average can be stated in the following way,

SMAi =

Where,

SMai = Simple Moving average on a specific day Pi = Stock price on a specific day N = Number of dates included in the moving average i = A specific date

The number of days for which you calculate the moving average has a lot of influence on the sensitivity of your moving average. For short time periods, the moving average will be much more sensitive to the price change on the last day than for longer time periods, as you can see in Yahoos price chart in appendix A, figure 1. The danger with moving averages for short time periods is the greater number of false moves. Instead of using moving averages for short time periods in order to make sure sensitivity to more recent prices, one could also use the exponential moving average in order to secure this sensitivity. This technique gives more weight to recent data and less weight to older data. The calculation of the exponential moving average can be stated in the following way,

EMA = (P * ) + (Previous EMA * (1-))

Where:

EMA = exponential moving average P = current stock price = smoothing factor N = number of time periods

In order to calculate the exponential moving average on a specific date you need the previous exponential moving average. In the beginning, the simple moving average is calculated as the 8

first average because there is no previous exponential moving average at that time. The main difference between the simple moving average and the exponential moving average is that the latter responds more quickly to changes in the stock price. This is incorporated into the formula where the current stock price has more influence on the moving average than for a simple moving average.

Now we have smoothened out the day-to-day price fluctuations, what can be done with these smoothened charts? There have been established several trading rules for moving averages and their extensions.

For moving averages, the basic rule holds that there is an upward trend when the stock price exceeds the moving average and a buy signal is generated. On the other hand, there is a downward trend when the stock price falls below the moving average and a sell signal is generated. Because stock prices can flip back and forth, some investors only buy when the stock price exceeds the moving average with a certain amount and sell the asset when it is below the moving average with a certain amount. The choice of the number of days you take into account in your moving window influences the signals that are generated. This is also reflected in Yahoos price chart (Appendix A, Figure 1). For short time moving windows, there are a lot more signals generated than for longer time moving windows.

Moving averages are also used as price support and resistance. The price support is a price level the stock price finds hard to fall below and the price resistance is a price level the stock price finds hard to exceed (Schwager, 1996). Once the stock price has risen with a serious amount above the moving average, technical traders consider the moving average as the price support for the stock price. It cannot fall below this boundary and the moving average is the price support. On the other hand, once the stock price has fallen with a serious amount below the moving average, technical traders consider the moving average as the price resistance for the stock price. The stock price cannot rise above the moving average. Technical traders do not blindly follow this strategy and check also other technical indicators. (Schwager, 1996)

However, if the stock price does fall below the price support line, this does not mean that the moving average has become useless. The moving average then functions as a stop-loss order, which makes sure that losses do not become any greater (Schwager, 1996). In this way, the

moving average is a risk management tool that generates a sell signal when the stock price crosses the moving average.

The relative strength index

The relative strength index is an example of a counter-trend indicator. The relative strength is a ratio of the average up-closes and down-closes within a time interval. (Wong et al., 2003) An up-close is the difference between the preceding and the current closing price and an upclose price is only noted when the closing price of today is higher than yesterday. For downcloses, the opposite holds. Then, for the relative strength index at time t for period p the following formula holds,

RSIt,p = 100 -

Where:

RSIt,p = relative strength index at time t for period p p = time period over which relative strength index is calculated t = a specific moment in time

If the relative strength index is 100, there are pure upward price movements (overbought market) and if it is 0, there are pure downward price movements (oversold market) (Wong, 2003).

There are several technical trading rules for this index. For example, the touch method says you should buy if the index touches the lower bound (usually 30) because it is oversold and you should sell if it touches the upper bound (usually 70) because it is overbought. Another rule for the relative strength index is called the 50 crossover method, which says you should buy if the index crosses 50 and sell if it falls below 50. (Wong et al., 2003)

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The theory for price movements

Efficient Market Hypothesis

There are several theories developed in order to explain movements in stock prices. For example, the Orthodox theory suggests that corporate earnings changes cause price movements (Leung and Chong 2003). However, the efficient market hypothesis is a more popular and prevailing theory in finance (Leung and Chong, 2003). The efficient market hypothesis stems from the PhD dissertation of Eugene Fama (1970) who suggested that in an efficient market, prices fully reflect all available information.

Fama (1970) divided the efficient market hypothesis into three forms. The weak form implies that for securities, all past market prices and data are fully reflected in the price and technical analysis useless. In the weak form, the under- or overvaluation of a stock can be determined by fundamental analysis. The semi-strong form implies that all information that is publicly available is reflected in security prices and fundamental analysis is useless. The strong form implies insider information is useless because all information is fully reflected in security prices (Fama, 1970).

The efficient market hypothesis incorporates the random walk theory that states that short term price changes cannot be predicted (Malkiel, 1973). Successive price changes are independent and identically distributed. Price changes are independent and identically distributed if all price changes are mutually independent and each price change has the same probability distribution as the others.1 The only factor that can cause price changes is news which has a random nature itself. (Fama, 1970)

The randomness of price changes in a market can be calculated with a couple of statistical tests. The Dickey-Fuller unit root test is an example of a test that determines if price changes in a market follow a random walk. A large sample of daily stock prices is required. Explaining this test would be out of the scope of this thesis. (Dickey & Fuller, 1979)

www.answers.com/topic/independent-and-identically-distributed-random-variables 11

Market efficiency in the modern world

In the early nineties, Fama (1991) found with the use of event studies that his claim still held because there was a quick reaction from markets to new information. Although private information can provide investors with premiums, this information did not get to investors very often. More recently, Malkiel (2005) substantiated with his work that all available information is still reflected in markets. Through technological advancements, the efficiency of markets has increased over time (Yanxiang Gu, 2004 & Dixon, 2005)

In the following sections, the focus lies on the weak form of the efficient market hypothesis because it deals primarily with technical analysis.

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The mutual exclusivity of EMH and technical analysis

Mutual exclusivity implies that whenever there are two propositions in a certain situation, they cannot be both correct and one of them is definitely wrong. This is the case with technical analysis and the efficient market hypothesis. Technical analysis has achieved positive returns while the efficient market hypothesis rules out that information can be inferred from past prices. This section links theory to practice and shows why the efficient market hypothesis rules out technical analysis and shows why technical analysis still exists. The moving average envelopes, Bollinger Bands and the trading break range are three new technical indicators that will be dealt with in this part. The first two indicators are derived from the simple moving

Why EMH rules out technical analysis

The efficient market hypothesis holds that prices fully reflect all available information, and there is no room for technical analysis at all. For example, if a group of investors heard that company X has developed a new technique that will double the earnings and stock price of that company tomorrow, the stock price will double today because the investors will end up buying all the shares until the price reaches the appropriate amount. This gives chartists no time at all to step in and profit (Malkiel, 1973).

The efficient market hypothesis is based on the random walk theory which compares patterns in stock price charts with flipping a coin. By flipping a coin, you could get a sequence of successes (either head or tail) that looks just like a pattern you can find in charts of stock prices. So called trends are just matters of luck and says nothing about the dependability or duration of upward trends (Malkiel, 1973). These theorists do believe that the history repeats itself, but there are so many sequences possible that profiting from it is somewhat impossible. To a pure mathematician, the next move is unpredictable on the basis of past price behaviour and there is no such thing as a momentum in the market. A momentum in the market gives an indication that a price change in positive/negative direction will continue in the near future. Stocks that have been rising will continue to do so, and stocks that begin falling will fall even deeper (Malkiel 1973). However, the market has no memory (suggested by a momentum in the market) because the correlation between past price movements and present and future 13

price movement is close to zero (Malkiel 1973). This would mean that the price change of today is independent from the price movement of yesterday which is in line with the random walk. Random walk theorists think technical analysis still exists because human beings find randomness hard to accept and always seek for patter A series of successes can occur but according to the random walk there should also come a moment in time where this pattern is broken. This is substantiated by the works of Lebaron (1999), Sullivan et al. (1999), and Mills (1997) who did further research on technical trading rules that were profitable during the seventies and eighties. They applied these rules for ten more years and concluded that technical trading rules that once were profitable were not profitable anymore ten years later.

Technical analysis right to exist: empirical evidence

Technical analysis does not have a supporting theory because it only looks at price actions in the market, and does not look at why these price actions occur (Fong and Yong, 2005). However, it is widely used according to Taylor and Allen (1990) and they indicated that 90% of the London foreign exchange dealers used some form of technical analysis in their work.

If technical trading rules are profitable in a certain market, it is claimed that the market is inefficient and stock prices do not follow a random walk (Brock et al., 1992, Liu, 2003, Wong et al. 2005). In practice, there are no markets that are perfectly efficient. There are markets where anomalies were found and dependencies existed between stock prices (Malkiel, 1973). In 1988, Lo and MacKinlay showed in their research that for a broad portfolio, stock returns for weekly and monthly holding periods have a positive correlation. This means that for a positive return in one period, it is more likely to be followed by another positive return than by a negative one. Conversely, Fama and French (1986) and Poterba and Summers (1988) proved that stock returns over longer horizons, say a year or more, tend to be negatively correlated. There was also found evidence suggesting that time influences changes in stock prices. Haugen and Lakonishok (1988) found that high returns could be made in January and French (1980) found that stock prices sell for a higher price at the end of the week compared to other days of the week.

Researchers not only found dependencies among stock prices but also that profit could be made from these dependencies. In the last part of this section, I will review some of the most 14

influential works in favor of technical analysis and some of the more recent works supporting the technique.

Fundamental work

Brock et al. (1992) tested the profitability of the two most popular technical indicators, namely the moving average and the trading range break (Brock et al., 1992). A trading range is a corridor through which the price moves. If it does this for a while, the boundaries become resistance and support levels. If the price breaks out and rises above the resistance level, a buy signal is generated. If the price breaks out and falls below the support level, a sell signal is generated. The longer the duration of the trading range and the narrower the range, the stronger the signal of a breakout will be (Schwager, 1996). These indicators were applied to the closing prices of the Dow Jones index from 1897 to 1986. This is a long time period and which is good for the reliability of the test because it mitigates data snooping biases. Additionally, the full sample was divided into four subsamples. This was done to take into account historical events (wars, economic depressions, etc.). Standard statistical tests and the bootstrap methodology (in order to deal with the non-normality problem) were used to test the indicators. The returns of the buy/sell signals were compared to returns from simulated comparison series. These series were generated by a fitted model from the null hypothesis class being tested (Brock et al., 1992). The null models that were tested are the random walk with a drift, AR (1), GARCH-M, and EGARCH. The results of the tests supported the claim that technical rules have predictive power. The buy/sell signals generate consistently higher than normal returns. The four null models were not likely to achieve the same returns. However, transaction costs were not taken into account in the tests. The results of this research have been very influential for recent work done on Technical analysis (Fong and Yong, 2003).

Taylor et al. (1990) wanted to know how well a panel of chartists could forecast price movements and if among this panel, significant differences in performance could be found. For one and four weeks ahead, forecasts of the $/, DM/$, and the /$, were made by a panel of chart analysts. Only chartists who were regarded as specialists were selected. The chartists were called every week over the period June 1988 March 1989 to forecast the exchange rates. First, Taylor compared the average forecasts of all the members in the panel with the actual price movements. Subsequently, because not all chartists use the same techniques, it 15

was tested if among the members of the panel; systematic differences in the accuracy of forecasting could be discovered. In order to do this, a non-parametric test procedure allowing matched samples was used. The forecast errors were ordered into ranks, for each data point, exchange rate, time horizon. For n forecasters, the forecaster who made the biggest forecast error was assigned rank n and the forecaster who made the best prediction was assigned rank 1. The null-hypothesis stated that the distribution of ranks across the forecasters is purely random. The panel was found to have more predictive accuracy when forecasting one week ahead than when forecasting four weeks ahead. This was also in line with the qualitative survey that Taylor also held among two hundred foreign exchange dealers who preferred using charts more for forecasting on short-term horizons than for long-term horizons. Furthermore, the forecasting errors of the panel decreased when the exchange rate was trending. The test to see if there were significant differences among the forecasters concluded that at a ninety percent confidence level, the null-hypothesis that stated that there were no differences among chartists was rejected. There was one chartists, called chartist M, who very accurate across all currencies and time horizons. He consistently outperformed the median and the random walk. (Allen & Taylor, 1990)

This was a significant finding because research of Meese and Rogoff (1983) had shown that no structural model was able to outperform a random walk out of a sample, as measured by the root mean square error. (Allen & Taylor, 1990)

Meese and Rogoff (1983) tested the out-of-sample forecasting accuracy of the flexible priceand sticky price monetary models and the sticky price which takes the current account into consideration. 2 The monthly Dollar/Mark, Dollar/Pound, and the Dollar/Yen exchange rates from March 1973 to June 1981 are compared to one, three, six and twelve month horizon forecasts made by the models. The accuracy was measured by the root mean square error and the three models could not perform better than a simple random walk model. (Meese & Rogoff, 1983)

Explaining these models would be out of the scope of this thesis. For further explanation of the models: MacDonald, R., Taylor, M.P. (1992). Exchange Rate Economics: A Survey. International Monetary Fund Staff Papers, vol.39 (1992) nr.1 (March) p.1-57

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Recent work

The technical indicators and their profitability studied by Leung and Chong (2003) were the moving average envelopes and the Bollinger Bands3. They were tested for the daily closing stock market indices of the G74 and the four Asian tigers5. These two interval indicators are derived from the simple moving average and are more appropriate when the market does not have a clear trend or when prices fluctuate a lot around a trend (Leung and Chong 2003). The width of the moving average envelopes is determined by an arbitrarily chosen constant. For Bollinger Bands, the width is determined by the arbitrarily chosen number of volatilities. These indicators have the ability to capture the short term price fluctuations. For both indicators, the region that is above the upper bound is considered overbought and investors should sell because the stock is expected to fall. For the region below the lower bound, the stock is considered oversold and investors should buy. Acting on these buy/sell signals, annualized returns were computed and the performances were compared for 10-day, 20-day, 50-day, 250-day moving average envelopes of 3% and 5% and Bollinger Bands of 2 standard deviations (Leung and Chong 2003). Considerable rate of returns were achieved for the Dow Jones, DAX, CAC and Hang Seng for both trading rules. The moving average envelopes performed better than the Bollinger Bands when the moving average was calculated for a 10, 20, and 50-day moving window. For a 250-day moving window, the Bollinger Bands performed better. In short, the moving average envelopes were more appropriate for the short term and the Bollinger bands for the long term. Since technical indicators are normally designed to predict on a short time horizon, it was reasonable to state that the moving average envelopes perform better than the Bollinger Bands. (Leung and Chong, 2003)

Wong (2003) measured the profitability of the relative resistance index and the moving average family was using test statistics against the daily closing prices of the Singapore Straits Times Industrial Index (STII) from 1 January 1974 to 31 December 1994. The sample was split into three subsamples of each of 7 years. For six periods, the relative resistance index was calculated and the crossover rule was applied. For the simple moving average, a 5-day moving window was used and for the dual and triple, respectively, a 3-5 and a 4-9-19 day moving window. The tests concluded that the simple moving average produced the greatest

3 4

For further explanation on moving averages envelopes and Bollinger Bands, see appendix B USA, Canada, Italy, United Kingdom, Germany, Japan, France. 5 South Korea, Singapore, Hong Kong, Taiwan.

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returns. The second best performer was the dual moving average followed by the relative strength index using the 50-crossover method. In general, they found that for the timing of stock market entry or exits, technical trading is helpful. (Wong, 2003)

Because there was not much research done on technical analysis in the Asian markets, Wong, Du and Chong (2005) decided to test if it was profitable in Asia. They tested whether the moving average and its extensions were profitable in Asia and if they could outperform a simple buy-and-hold strategy (buy a stock and keep it for a longer period of time). They focused on the daily closing prices of the Shanghai A-shares index from January 2, 1992 to December 31, 2004, the Hang Seng Index and the Taiwan Stock Exchange Index from January 1, 1988 to December 31, 2004. These time periods capture both periods of economic prosperity and a depression (1997 Asian Financial Crisis). The average returns generated by the moving average rules were compared to the average return of a buy-and-hold strategy using test statistics. In all the markets, the buy-and-hold strategy was outperformed, even when transaction costs were included. Hence, they concluded that these technical trading rules can play a significant role for the determination of entering or leaving the stock market. (Wong, Du and Chong, 2005)

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Conclusions and Implications

The results achieved with technical analysis in the past and in more recent studies are varying. Technical analysis has shown that it can significantly outperform the random walk in some cases for short-term investment purposes and in other cases it generated as much or even less than a simple buy-and-hold strategy (Malkiel, 1973). Because of these varying results, a definite answer to the question if information can be inferred from past prices is still not possible.

The efficient market hypothesis is the prevailing theory for price movements in finance since the seventies and still holds (Malkiel, 2005). Efficient markets make it impossible for technical analysis to be a profitable tool. Conversely, if technical indicators are profitable, the market is probably not perfectly efficient (Brock et al., 1992 & Wong et al., 2003). From logical reasoning it follows that the profitability of technical analysis probably is dependent on the degree of efficiency of the market. In efficient markets, no information can be inferred from past prices in order to predict future prices. For markets that are not perfectly efficient, returns that have been achieved indicate that information could be inferred from past prices. Unfortunately, because markets are getting more and more efficient, the chances for profitable use of technical analysis seem to shrink (Yanxiang Gu, 2004).

Because the risk of achieving bad returns is considerable and technical analysis has not shown it can constantly outperform the random walk, it is reasonable to say that technical analysis could at most fulfill a supporting role (assuming that the investors do not like too much risk). This is in line with the practice where many investors combine technical and fundamental analysis in order to value stock prices (Malkiel 1973 & Wong et al., 2003). These investors value technical analysis but do not dare to rely solely on it.

In order to decrease the risk of bad returns, one could first test the randomness of the price movements in the market (the Dickey-Fuller test for example) before using technical analysis for portfolio management. Non-randomness of price movements could indicate a probable inefficient market and increases the probability of profitable use of technical analysis.

Unfortunately, there are limitations to the data used in this thesis. The works supporting technical analysis on which I have derived my conclusions do not all take into account 19

transaction costs. Transaction costs can have an influence on the results of these works. Furthermore, although I dealt with fundamental papers supporting technical analysis, the limited number of academic papers supporting technical analysis on which I made my generalizations is also a limitation of this thesis.

It would be hard for future researchers to provide investors with a definite answer to the question if information can be inferred from past prices. An explanation for this could be the fact that technical analysis has no supporting theory. If this question cannot be clearly answered it would be more interesting to focus on the supporting role technical analysis can fulfill. For example, one could try to determine if technical analysis in its role supporting fundamental analysis could generate significant returns (outperforming the random walk) and if the buy and sell signals of under- and overvaluation are the same for the two techniques.

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Appendix A

Fig 1

Extracted from: http://finance.yahoo.com/q/ta?s=YHOO&t=1y&l=on&z=m&q=l&p=m200,m50,m5&a=&c=

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Appendix B
Symmetrical triangles

40 35 30
stock price

25 20 15 10 5 0 1 2 3 4 5
days

10

Ascending triangles

50 45 40 35
stock price

30 25 20 15 10 5 0 1 2 3 4 5 6 7
days

10

11

12

13

25

Descending triangles

Head and Shoulders

10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

26

Double bottom pattern

12 10
stock price

8 6 4 2 0 1 2 3
days

27

Appendix C
Moving averages envelopes

Where:

MAE= moving average envelope N = Number of dates included in the moving average t = a specific moment in time k = an arbitrarily chosen constant that determines the width of the interval. A normal value would lie within the interval 0% and 10%

Bollinger Bands

Where:

BB = Bollinger Bands SMA= Simple moving average k is the number of standard deviations. N = Number of dates included in the moving average t = a specific moment in time P(i) = Stock price at a certain date k = an arbitrarily chosen number of volatilities that determines the width of the interval. a normal value would lie within the interval 1 and 5.

The Bollinger Bands have an advantage over the moving averages envelopes. Price volatility is taken into account by the Bollinger Bands. Bollinger Bands depend on fluctuations around the mean and not on the level of the moving average as is the case with the moving averages envelopes. It can happen that the moving average remains the same while the volatility increases. In that case, Bollinger Bands capture these price fluctuations by expanding the width. Moving average envelopes do not capture these price fluctuations. 28

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