Technical

Analysis
ISE 563 Group 5 Darren Kim Hao Chi Syed Kazim (D) Xiaoming Lang Srinivas Mantha Wenzhou Wang Saishi Xiong

DEC.2, 2012

Technical Analysis

TABLE OF CONTENTS
1 INTRODUCTION ............................................................................................................................. 1 2 THE BASIC ASSUMPTIONS .............................................................................................................. 1 2.1 MARKET DISCOUNTS EVERYTHING ......................................................................................................... 1 2.2 PRICES MOVE IN TRENDS ...................................................................................................................... 1 2.3 HISTORY REPEATS ITSELF ...................................................................................................................... 1 3 TECHNICAL VS FUNDAMENTAL ANALYSIS ...................................................................................... 2 4 TOOLS FOR THE TECHNICIAN ......................................................................................................... 2 4.1 TYPES OF CHART ................................................................................................................................ 2 4.1.1 Bar chart ................................................................................................................................. 2 4.1.2 The Point and Figure Chart ..................................................................................................... 4 4.1.3 Candlesticks ............................................................................................................................ 4 4.2 TECHNICAL INDICATORS & PATTERNS .................................................................................................... 6 4.2.1 Why Use Indicators? ............................................................................................................... 6 4.2.2 Classification of Indicators ...................................................................................................... 6 4.2.3 Description of Two Trends Indicators ...................................................................................... 6 4.3 CHART PATTERNS ............................................................................................................................... 8 4.3.1 Head and Shoulders Pattern ................................................................................................... 8 4.3.2 Double tops and bottoms pattern ........................................................................................... 9 4.3.3 Triple Bottoms and Tops Pattern ............................................................................................ 9 4.3.4 Triangles Pattern .................................................................................................................. 10 5 A BRIEF COMPARISON OF TECHNICAL ANALYSIS IN STOCKS AND FUTURES .................................. 11 5.1 PRICING STRUCTURE ......................................................................................................................... 11 5.2 LIMITED LIFE SPAN ............................................................................................................................ 11 5.3 LOWER MARGIN REQUIREMENT .......................................................................................................... 11 5.4 TIME FRAME OF FUTURE CONTRACT IS MUCH SHORTER ........................................................................... 11 5.5 GREATER RELIANCE ON TIMING ........................................................................................................... 12 6 SOME CRITICISMS OF TECHNICAL ANALYSIS ................................................................................. 12 6.1 TECHNICAL ANALYSIS IS SUBJECTIVE ..................................................................................................... 12 6.2 DISCONNECTED WITH CURRENT RULES AND REGULATIONS ....................................................................... 12 6.3 DISREGARDS CURRENT FINANCIAL STATUS OF THE COMPANY .................................................................... 12 SUMMARY ......................................................................................................................................... 12 REFERENCES: ...................................................................................................................................... 13

Technical Analysis

Introduction

In Finance, Technical Analysis is a securities analysis method used for forecasting the direction of prices through the study of statistics generated by market activity, such as past prices and volume. Technical analysis does not result in a securitys intrinsic value and the absolute predictions about the future, but instead it can identify patterns that can suggest future activity and help investors anticipate what is likely to occur to securities prices over time. Technical analysts believe that the historical performance of stocks and markets are indicators of future performance.1 Unlike fundamental analysts who look at the qualitative data about a company, like earnings, dividends, research and development etc., technicians simply focus on the historical prices and other trading variables to analyze the market psychology as which they consider the key influential factor of investors trading. Any tradable instruments whose price is affected by the forces of supply and demand are applicable to technical analysis. Technicians employ many techniques to spot the trends in the market and individual stocks and to predict what will happen next. The primary one is the use of charts. The market indicators are also widely used to help assess the probability and continuation of the trend. 2 The Basic Assumptions

There are three basic premises on which the technical approach is based: 2.1 Market discounts everything

This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts assume that all relevant information is discounted into the market and already reflected in the prices. The information ranges from economic data to the emotions of investors, including companys fundamentals, broader economic factors as well as market psychology. It is the sum knowledge of all participants: traders, investors, portfolio managers, buy-side and sell-side analysts, fundamental analysts, technical analysts and many others.2 This assumption eliminates the need to consider each events and factors separately. The only thing left is to analyze the price movement. 2.2 Prices move in trends

Technical analysts believe that price movement follows trends, up, down, flat or some combinations. This implies that the future price movement tends to be in the same direction as the trend established earlier than to be against it. Thus, it is possible to identify a trend from the prices of stocks, invest or trade based on the trend and then makes money as the trend unfolds. It is almost unrealistic to make money through technical analysis if the prices of stocks are completely random. 2.3 History repeats itself

Another important assumption of the technical analysis is that history repeats itself, which reflected in the price movement of stocks. This is a logical conclusion since a chart pattern is the psychological picture of the emotions of different market player. For the simple reason that we as humans are emotional beings who have a tendency to overreact, the technicians think that investors always repeat the behaviors of the

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investors that precede them; 3 that it, market participants tend to provide a consistent reaction to similar market situation over time. And so the price movement is very likely to repeat itself. According to this premise, technical analysis could analyze price movements and predict the future trend, even with the charts that have been used for more than a century. 3 Technical VS Fundamental Analysis

Compared with technical analysis, fundamental analysis is a method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.4 The main difference of technical analysis and fundamental analysis is methods, data they utilize time horizon. Fundamental analysis prefer both quantitative and qualitative methods, whereas quantitative almost fully focus on quantitative methods. Whats more, the other differences in methods also link to this difference. The data fundamentalist use in their models is mostly from financial statements, which are only released quarterly or yearly. This property determines that fundamentalists investments focus on long-term returns. Fundamentalists are looking for the intrinsic value of the stock and their trading activities are trying to correct the wrong value. They believe the price will finally converge to intrinsic value and they can profit from the process. In contrast, technical analysts utilize short-term data as their input, and what they do is forecasting the next short-term period price movement. Also, technical analysts make decisions based on various indicators. Even though the two types of analyses have many opposite properties, they still co-exist. The main reason here is time frame. One of critical factors of fundamental analysis is the time enter the security. Therefore, some fundamentalists use technical analysis to find out the best time entering into the undervalued security. On the other side, some technical analyst put fundamental factors as add strength to a technical signal.5 4 Tools for the Technician 4.1 Types of Chart

The daily bar chart might be the most widely used in technique analysis. However, other types of chart are also commonly used, such as line chart, point and figure chart, and candlestick chart. 4.1.1 a. Bar chart

Daily Bar chart

In a daily bar chart, the vertical bar represents that days price range from the high price to the low. The high price of that day is the top of the bar. The low price is the other end. The right tic represents that days opening price, while the closing price is represented by the left tic of bar. The opening price can either higher or lower than, or even equal to the closing price. Accordingly, there is no fixed relative position relationship between the right tic and the left tic, which means the right tic can be above or under or side by side with the left tic. Figure 1 shows a standard daily bar chart. The length of the price bar is the price range of that day.

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Figure 1 A daily bar chart. Each vertical bar represents one days action. b. Weekly and monthly bar chart

The daily bar chart is usually used for short-term purpose. The average bar chart only covers short range (usually less than 1 year). If we need to do long-term technical analysis, longer-range chart, such as weekly bar chart and monthly bar chart might serve our purpose better. A weekly chart can cover as much as 5 years and a monthly chart even up to 20 years. For weekly bar chart, the price range is usually for a Monday-Friday week except that some holiday occurs during a week; in which case only available data will be used for plot its price bar. The top of the bar identifies the highest price of the week, while the lowest price is the lower end of the price bar. The opening price is the first trading price of the first trading day (usually Monday) of the week. The closing price the price right before the closing bell of the last trading day (usually Friday) of the week. As the weekly bar chart can show the price action for weeks, the monthly bar chart indicates the price activity for months. By compressing the price action from daily to weekly or monthly, we can better see through the trend of a longer period. The trend is extremely useful tools to identify the future price development and proper strategies. For example, if market prices of a agricultural product as shown on the monthly chart are downward continuously, a hedge strategy might be taken to reduce losses by buying future contracts; if its market price keeps going up, farmer long in futures may seek to close its position.

Figure 2 A monthly bar chart. Each bar represents one months price action. SOURCE: Markethead.com; Quoted data provided by Bar chart Market Data Solutions.
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4.1.2

The Point and Figure Chart

Point and figure chart consists of a series of X columns and O columns without taking the passage of time into consideration. X columns represent rising price action. O columns represent declining price action. Each column can only contain either Xs or Os, not both. X column and O column alternate while X column extends until the opposite price movement becomes larger than the reversal distance (or reversal amount), vice verse. Each X or O occupies what is called a Box. A box doesnt represent a single price, but rather a price range. The value of range is influenced by its location. If it is X box, the range rises; O box, the range falls. By compressing price actions, point and figure chart filters minor price movements and focus readers attention on major and important price movements. As a result, it provides a clear and practical visual view for technicians. Namely, it is much easier to identify support level, resistance level, bullish support level, and bearish resistance level. As a result, buy and sell signals can be spot effectively on the point and figure chart than on the bar chart.

Figure 3 A pint and figure chart. X-column shows rising prices. O-column shows falling prices. 4.1.3 Candlesticks

As with bar chart, candlestick chart can show high price, low price, opening price, closing price in a similar way for the time interval studied. In the candlestick chart, the candle itself is called real body. If the opening price is lower than the closing price, the candle is white and unfilled with its top representing the closing price and bottom representing the opening price. If the opening price is higher than the closing price, the candle is black and unfilled with its top representing the opening price and bottom representing the closing price. The high price is identified by the top of upper wick (also called shadow or tail), and the low price by bottom of the lower wick. Note that each candlestick needs not to have either the candle or the wick in some cases. For example, If the opening price equals the closing price, there will be a single wick with a crossed horizontal bar, which is called doji.

Technical Analysis

Figure 4 A candlestick chart. The color is determined by the relationship of the open and close. Compared with bar chart, candlestick chart is easier to read and interpret quickly. Furthermore, together with color coding candlestick chart provides reader far better visual insight to market psychology and traders emotion. Reading candlestick charts is an effective way to study the emotions of other traders and to interpret price. Candles provide a trader with a picture of human emotions that are used to make buy and sell decisions.6

Figure 5 White and Black Candlesticks Source: http://www.swing-trade-stocks.com/reading-candlestick-charts.html From the white candles, we can tell that buyers are in control of the market, while black candles indicate that seller was controlling the market. How can we make such conclusion? In the case of white candlestick, its superficial meaning is the closing price is higher than the opening and close to high price while the profound meaning is that buyers were more aggressive and willing to get in at any price. The sellers were only willing to sell at higher prices that cause the price to move up.7 The black candlestick means the opposite: sellers were willing to get out at any price while the buyers only buy at lower prices that cause the stock to move down.

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4.2

Technical Indicators & Patterns

A technical indicator is a series of data points that are derived by applying a formula to the price data of a security8. Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. 4.2.1 Why Use Indicators?

Indicators serve three broad functions: to alert, to confirm and to predict. An indicator can act as an alert to study price action a little more closely. If momentum is waning, it may be a signal to watch for a break of support. Or, if there is a large positive divergence building, it may serve as an alert to watch for a resistance breakout. Indicators can be used to confirm other technical analysis tools. If there is a breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout. Or, if a stock breaks support, a corresponding low in the On-Balance-Volume (OBV) could serve to confirm the weakness. Some investors and traders use indicators to predict the direction of future prices. 4.2.2 a. Classification of Indicators

Leading Indicators

Leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed look-back period, which is the number of periods used to calculate the indicator. For example, a 20-day Stochastic Oscillator would use the past 20 days of price action (about a month) in its calculation. All prior price action would be ignored. Some of the more popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R. b. Lagging Indicators:

Lagging indicators follow the price action and are commonly referred to as trend-following indicators. Rarely, if ever, will these indicators lead the price of a security. Trend-following indicators work best when markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. Some popular trend-following indicators include moving averages (exponential, simple, weighted, variable) and MACD. 4.2.3 a. Description of Two Trends Indicators

Moving Average Technical Index

The Moving Average Technical Indicator shows the mean instrument price value for a certain period of time. When one calculates the moving average, one averages out the instrument price for this time period. As the price changes, its moving average either increases, or decreases. There are four different types of moving averages: Simple, Exponential, Smoothed and Linear Weighted. Moving averages may be calculated for any sequential data set, including opening and closing prices,

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Technical Analysis

highest and lowest prices, trading volume or any other indicators. It is often the case when double moving averages are used. The only thing where moving averages of different types diverge considerably from each other, is when weight coefficients, which are assigned to the latest data, are different. In case we are talking of simple moving average, all prices of the time period in question are equal in value. Exponential and Linear Weighted Moving Averages attach more value to the latest prices. The most common way to interpreting the price moving average is to compare its dynamics to the price action. When the instrument price rises above its moving average, a buy signal appears, if the price falls below its moving average, what we have is a sell signal. This trading system, which is based on the moving average, is not designed to provide entrance into the market right in its lowest point, and its exit right on the peak. It allows to act according to the following trend: to buy soon after the prices reach the bottom, and to sell soon after the prices reached their peak. Moving averages may also be applied to indicators. That is where the interpretation of indicator moving averages is similar to the interpretation of price moving averages: if the indicator rises above its moving average, that means that the ascending indicator movement is likely to continue: if the indicator falls below its moving average, this means that it is likely to continue going downward. Figure 6 includes four types of moving averages: Simple Moving Average (SMA), Exponential Moving Average (EMA), Smoothed Moving Average (SMMA), Linear Weighted Moving Average (LWMA). Table 1 Formulas of Moving Average Index SMA =SUM(CLOSE, N)/N EMA =(CLOSE(i)*P)+(EMA(i-1)*(1-P)) N the number of calculation periods CLOSE(i) the price of the current period closure EMA(i-1) EMA of the previous period closure P the percentage of using the price value PREVSUM the smoothed sum of the previous bar SMMA (i) the SMA of the current bar CLOSE(i) the current closing price N is the smoothing period SUM(i, N) the total sum of weight coefficients

SMMA

LWMA

=(PREVSUM-SMMA(i-1) +CLOSE(i))/N PREVSUM = SMMA(i-1)*N SMMA(1)=SMA =SUM(Close(i)*i, N)/SUM(i, N)

Figure 6 Moving Average Technical Index

Technical Analysis

b.

Zig Zag

The Zigzag indicator is a series of trend lines connecting significant peaks and foundations at the price plot. Minimum price change parameter determines the percentage for the price to move in order to form a new "zig" or "zag" line. This indicator eliminates those changes on the plot we analyze that are less than the given value. Therefore, the Zigzag reflects significant changes only. In most cases, we use Zigzag to facilitate the perception of plots as it shows only the most important changes and turns. You can also reveal Elliot Waves and various figures on the plot with its aid.

Figure 7 Zig Zag Index It is important to understand that the last section of the indicator may vary depending on the changes of data you analyze. This is one of those indicators, where a change of securities price can provoke a change of the previous value. This ability to correct its values by the following price changes makes Zigzag a perfect tool for analyzing price changes that have already happened. Therefore, you should not try to create a trade system basing on the Zigzag. It is more suitable for analyzing historical data than for making prognoses. 4.3 Chart Patterns Head and Shoulders Pattern

4.3.1

The head and shoulders pattern is popular and reliable chart patterns in technical analysis. There are two versions of the head and shoulders chart patterns, top and bottom. They exactly contrast each other. There are four main parts to the head-and-shoulder chart pattern (see Figure 8): two shoulders, a head and a neckline. The head and shoulder top pattern is a prevailing pattern among short sellers, investors who profit from downtrends. The patterns are confirmed when the necklines is broken, after a formation of the second shoulder. In this pattern, neckline is a level of support or resistance for bottom version. After the descent from the right shoulder, the investor should short sell as soon as the price moves below the neckline. The target price should be obtained by entry price minus the pattern height. The inverse head and shoulder pattern (head and shoulder pattern bottom, see Figure 9) is the exact opposite of the head

Technical Analysis

and

shoulder

top,

as

it

signals

that

the

security

is

set

to

make

an

upward

move.

Figure 8 Head and Shoulder Top Pattern 4.3.2 Double tops and bottoms pattern

Figure 9 Head and Shoulder Bottom Pattern

Double tops and bottoms pattern is another well-known pattern that signals a trend reversal. It is considered to be one of the most reliable and is commonly used. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.

Figure 10 Double Bottom Pattern

Figure 11 Double Top Pattern

In the case of double bottom (see Figure 10), the price movement has tried to go lower twice, but has found support each time. The investor should purchase when the price exceeds the middle-peak price (after second bounce of support) because it assumes the security enters a new trend and heads upward. The two equal lows should not differ by more than 3% or 4 %. The target price would be obtained by entry price plus the patterns height. In the case of double top pattern (Figure 11), the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. The investor should short sell when the price drops below the middle-trough price and buy shares at a target price of entry price minus the patterns height. 4.3.3 Triple Bottoms and Tops Pattern

Technical Analysis

Figure 12 Triple Bottom and Top Patterns

Figure 13 Triple Top and Bottom Patterns

Another type of reversal chart pattern, triple bottoms and tops (see Figure 12), have similar disposition as double bottoms and tops. 4.3.4 Triangles Pattern

Triangles are considered to be another well-known chart pattern. It consist three different types: symmetrical, descending, ascending triangle. The symmetrical triangle (see Figure 14) is a continuation pattern that is formed by the convergence of a descending (resistance) line and ascending (support) line. These two lines should have a similar opposite converging at a point (apex). The price of the security will bounce between these two lines, towards apex, and typically breakout in the direction the prior trend. The investors can make a profit from either upwards or downwards breakouts. Investor should sell the stock at a target price of either entry price plus the patterns height for an upward breakout or entry price minus patters height for a downward breakout.

Figure 14 Symmetrical Triangle The ascending triangle (see Figure 15) is a bullish pattern, which gives an indication that the price of the security is headed higher upon completion. The pattern is formed by two trendlines: a flat trendline (a point of resistance) and an ascending line (support). Similar as symmetric triangle pattern, the price bounce between these two lines until it eventually breaks out to upside. The support line informs that sellers are beginning to leave the security. The buyers should enter the market when the price moves above the resistance level upon break point.

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Figure 15 Ascending Triangle

Figure 16 Descending Triangle

In a descending triangle, the lower trendline is flat and the upper trendline is descending. It is generally seen as a bearish pattern where chartists look for downward breakout. It is suggesting that the price will trend downward upon completion of pattern. 5 A brief comparison of Technical Analysis in stocks and futures

The basic principle of technical analysis in futures is the same as the stock market, but there are some significant differences due to the different properties of each financial product. Some major differences are listed below. 5.1 Pricing structure

The pricing structure in stock market is less complicated than in future market. In stock market, there is a general same procedure for the price determination of each stock. Moreover, the same and not that complicated specification for trading each stock exits. Otherwise, we can find many kinds of futures in the future market, like livestock, grain, gold, etc. Even if some kinds of futures are traded in the same category, their specifications may be different like maturity, delivery location. Also, we should take the cost of storing and convenience yield into consideration when analyzing the pricing structure in the future market. 5.2 Limited life span

Futures contract has expiration dates. All of them are traded before the expiration date. However, the life span of a stock is not specified. Only if the company is operating very well, the stock will be accessible in the market. As a result, sometimes a future trader has to confront the difficulty in matching life span of the future contract and the underlying. Some of them may use stack and roll strategy considering the cost of each contract as well. 5.3 Lower margin requirement

For many traders, one important aspect of the future contract is its lower margin requirement. All futures are traded on margin which is usually less than 10% of the value of the contract. Traders can enter into a contract with a large leverage. This leverage is a double-edge sword. They can lose large sums of money very in a short period by using future contracts. The correct timing of entry and exit points is more important in futures trading and much more difficult than market analysis. 5.4 Time frame of future contract is much shorter

In practice, stock market technicians will consider what the price of stock will be in several months. However, futures trader will have to judge the direction of movement in tomorrow or maybe later this

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afternoon. In the stock market, the popular moving average is watched are 50 and 200 days. In a futures contract, for example, the moving average maybe 4, 9 or 18 days. 5.5 Greater reliance on timing

In the stock market, time to entry may be not that serious than in the future market. If you have a correct prediction of the future price movement or the operation of the company, you can just buy the stock around several days and maybe the outcome is the same. But in the futures market, this kind of action is dangerous. The timing of the entry point is off by a day or even minutes. This will make you a loser if you are at the wrong side. 6 Some criticisms of Technical Analysis 6.1 Technical Analysis is Subjective

The most common criticism of Technical Analysis is that it is too subjective. The main difficulty of Technical Analysis is an uncertainty that allows interpretation of almost each specific market situation in several different ways. Two technicians may look at the same chart pattern and can come out with conflicting results. In-fact, the same analyst might even make a different call looking at the same data on a different day. Only a specific mathematical formula or algorithm can help in selecting a pattern more objectively. Nevertheless, human judgment plays a big part to accept the conclusion of a computerized program in analyzing the historical data. 6.2 Disconnected with current rules and regulations

Historical charts and trends do not take into consideration the current political, social and/or economic conditions which play a vital part in the future of any market. Federal regulations could change any time, or a new tax policy may have an affect (positive or negative) on the market trends. Analysts need to overcome this short-coming of Technical Analysis while making a call on any given company/market. Technical Analysts argue that the investors will find a way to get around these changes and find a way to speculate the market trends. Can we ever have a mathematical model which will include the complexity of socio-political variables and still be able to analyze the market trends? 6.3 Disregards current financial status of the company

Technical Analysis doesnt care about the company behind the stock. A Technical Analyst may be interested in the industry to which a given company belongs, but apart from that, the underlying company isnt really a concern. The company might be carrying more debt than it can handle, its revenues and cash flows might be weak, and it might not even be making a profit. Technical Analysis doesnt concern itself with such matters. As long as the chart patterns could be interpreted as positive (or negative) the decision will be made to hold (or fold) the stocks. Summary When we are making analysis in practice, basic valuation and technical analysis seem to be both useful and we can utilize them in different perspectives. Maybe the efficient market theory is quite right and there are certain theories guiding traders and analysts who function to use to analyze the market movements. Otherwise, sometimes it is very difficult to define a market and the category of a market may be changing during a financial crisis. As a result, it should be more useful and effective to analyze the market in a wider perspective.

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References: Demark, T. R. (1994). The New Science of Technical Analysis. Hoboken, NJ: John Wiley & Sons. Five chart patterns. (n.d.). From http://www.chartadvisor.com/freereport/report_index.aspx Forex Charts: Tic, Line, Bar, Point and Figure. (2011). From http://forexnewsnow.com/top-stories/forexcharts-tic-line-bar-point-and-figure Grimes, A. (2012). The Art & Science of Technical Analysis: Market Structure, Price Action & Trading Strategies. Hoboken, NJ: John Wiley & Sons. How to construct a Bar Chart. (n.d.). From http://futures.tradingcharts.com/learning/construct_bar_chart.html How to plot the daily bar chart. (2011, 1). From http://technicalsonline.blogspot.com/2011/01/how-toplot-daily-bar-chart.html Malonis, E. J. (2000). Technical Analysis. From Encyclopedia of Business: http://www.enotes.com/technical-analysis-reference/ Murphy, J. J. (1999). Technical Analysis of the Financial Market. Upper Saddle River, NJ: Prentice Hall. Palicka, V. J. (2011). Fusion Analysis. New York, NY: McGraw-Hill. Point & Figure Chart Basics. (n.d.). From Stockcharts: http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:pnf_charts:pnf_basics Technical Analysis. (n.d.). From http://stocktradingfundamentals.com/technical_analysis/the_charts Technical Analysis. (n.d.). From Wikipedia: http://en.wikipedia.org/wiki/Technical_analysis Technical Analysis. (n.d.). From Investopedia: http://www.investopedia.com/university/technical/#axzz2CcCFWZlv

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