ELEC2815 Economics, Finance

and Marketing for Engineers

 Content
• Technical Analysis vs Foundamental Analysis
• Moving Average
• Moving Average Envelopes
• Relative Strength Index
What’d happened in the last 3 months?
What’d happened in the last 3 months?
What’d happened in the last 3 months?
 Two major approaches to analyze stock market

• Fundamental analysis
• analyze the characteristics of a company in order to
estimate its value
• looks at economic factors, e.g. ratio analysis, balance sheet,
profit/loss account, currency, interest rate…etc to
determine a company's value.
• a company's intrinsic value is measured
• if the price of a stock trades below its intrinsic value, it's a good
investment.
 Two major approaches to analyze stock market

• Technical analysis
– looks at the price and volume movement of a
security and uses this data to predict its future
price movements.
– Don’t consider the value of the stock or the
performance of the company
– Focus in the chart pattern
 Two major approaches to analyze stock market

• Most large brokerage, trading group, or

financial institutions will typically have both a
technical analysis and fundamental analysis
team.
Technical analysis vs Fundamental analysis

• Fundamental analysis
– takes a relatively long-term approach to analyzing the
market compared to technical analysis.

• Technical analysis
– can be used on a timeframe of weeks, days or even
minutes, fundamental analysis often looks at data over a
number of years.
Technical analysis vs Fundamental analysis
• It can take a long time for a company's value to be reflected in the market
• When a fundamental analyst estimates intrinsic value, a gain is not realized
until the stock's market price rises to its "correct" value - called “value
investing”
• Assumes that the short-term market is wrong, but that the price of a
particular stock will correct itself over the long run.
• E.g.

take time for the stock value

to be reflected in the market

Fundamental
analyst estimates
intrinsic value
Technical analysis vs Fundamental analysis

• Why fundamental analysis releases over long periods of time?

– Financial statements are filed quarterly and changes in earnings per
share don't emerge on a daily basis like price and volume
information.
– It is not easy to change management/performance of a company
overnight
– It takes time to create new products, marketing campaigns, supply
chains, etc.
– The fundamental data is generated much more slowly than the price
and volume data used by technical analysts.
Technical analysis vs Fundamental analysis

• Trading vs Investing

– Trading
• Traders buy assets they believe they can sell to
somebody else at a greater price.
• Short term
• Use technical analysis

– Investing
• Investors buy assets they believe can increase in
value
• Long term
• Use fundamental analysis
 Tools for Technical analysis
• Technical analysis employs models and
trading rules based on price and volume
transformations
• E.g.
– Moving average
– Relative strength index,
– Regressions,
– price correlations,
– recognition of chart patterns.
 Moving averages
• They smooth the price data to form a trend following
indicator.
• NOT to predict price direction, but rather define the current
direction with a lag because they are based on past prices.
• They help to smooth price action and filter out the noise.
• 2 popular types of moving averages:
– Simple Moving Average (SMA)
– Exponential Moving Average (EMA).
 Moving averages
• Applications
– used to identify the direction of the trend
– define potential support and resistance levels.
 Simple Moving Average Calculation

• Computing the average (closing) price of a security

over a specific number of periods.
• A 5-day SMA is the 5 day sum of closing prices
divided by 5.
• Old data is dropped as new data comes available.
•  move along the time scale.
Simple Moving Average Calculation
• Example:
– Daily Closing Prices: 11,12,13,14,15,16,17
– First day of 5-day SMA:
(11 + 12 + 13 + 14 + 15) / 5 = 13
– Second day of 5-day SMA:
(12 + 13 + 14 + 15 + 16) / 5 = 14
– Third day of 5-day SMA:
(13 + 14 + 15 + 16 + 17) / 5 = 15
 Simple Moving Average Calculation

• In this example
• Daily Closing Prices: 11,12,13,14,15,16,17

– 1st day: covers the last 5 days.

– 2nd day: drops the first data point (11) and adds the new data point (16)
– 3rd day: drops the first data point (12) and adding the new data point (17).
– prices gradually increase from 11 to 17 over a total of 7 days
– SMA rises from 13 to 15 over a 3 day calculation period.
– Each moving average value is just below the last price.
•  causes the moving average to lag.
 Exponential Moving Average Calculation

• They reduce the lag by applying more weight to

recent prices.
• The weighting applied to the most recent price
depends on the number of periods in the moving
average
• Usually weight of today closing price x 2

• Algorithm:
– 1. Calculate the simple moving average.
– 2. Calculate the weighting multiplier.
– 3. Calculate the exponential moving average.
 Exponential Moving Average Calculation

• Example: formula a 10-day EMA.

– 1) SMA: 10 period sum / 10
– 2) Multiplier: (2 / (Time periods + 1) )
= (2 / (10 + 1) ) = 0.1818 (18.18%)
2 = weighting factor
Without weighting: (1/Time periods)

– 3) EMA = (Close - EMA(previous day)) x

multiplier + EMA(previous day).
Exponential Moving Average Calculation

• Example:
– Daily Closing Prices: 11,12,13,14,15,16,17

– First day of 5-day EMA:

(11 + 12 + 13 + 14 + 15 + 15) / ( 5 + 1 ) = 13.33
– Second day of 5-day EMA:
(12 + 13 + 14 + 15 + 16 + 16) / ( 5 + 1 ) = 14.33
– Third day of 5-day EMA:
(13 + 14 + 15 + 16 + 17 + 17) / ( 5 + 1 ) = 15.33
 Exponential Moving Average Calculation

• Weighting to the most recent price:

– For 10-period EMA =18.18%
– For 20-period EMA = 2/(20+1) = 0.0952 = 9.52%

• Weighting for the shorter time period is more

than the weighting for the longer time period.
 Exponential Moving Average Calculation

• Example
– 10-day SMA and EMA:
– The 10-day SMA moves as new
prices become available and old
prices drop off.
– EMA calculation:
– 1) The EMA starts with the SMA
value (22.22)
– 2) EMA(today)=
(Close - EMA(previous day)) x
multiplier + EMA(previous day).

http://stockcharts.com/school/data/media/ch
art_school/technical_indicators_and_overla
ys/moving_averages/cs-movavg.xls
 The Lag Factor
• The longer the moving average, the more the lag.
• A 10-day EMA
– move with prices quite closely and turn shortly after prices
turn.
• A 100-day EMA
– contains lots of past data that slows it down.
– takes a larger and longer price movement for a
100-day moving average to change course.
 The Lag Factor.
• E.g. 10-day EMA closely following prices
• 100-day SMA grinding higher.
– Even with the Jan-Feb decline, the 100-day SMA held the
course and did not turn down.
• 50-day SMA fits somewhere between the 10 and 100
day SMA
 Comparison of SMA and EMA

• EMA:
– have less lag and are therefore more sensitive to recent
prices - and recent price changes.
– turn before simple moving averages.
• SMA
– represent a true average of prices for the entire
time period.
– may be better suited to identify support or
resistance levels.
 Comparison of SMA and EMA
• E.g.: Stock price of IBM
– SMA in red and EMA in green.
– Both peaked in late Jan
– but the decline in the EMA was sharper
– The EMA turned up in mid Feb, but the SMA continued lower
until the end of Mar.
– SMA turned up over a month after the EMA.
Moving Average for Trend Identification

• The same signals can be generated using moving averages.

• The direction of the moving average conveys important
information about prices.
• A rising (falling) moving average
– shows that prices are generally increasing (falling)
– reflects a long-term uptrend (downtrend)
 Moving Average - Trend reversal

• E.g. 150-day EMA of 3M Co.

• It shows how well moving averages
work when the trend is strong.
• 150-day EMA turned down in Nov
07 and again in Jan 08.
–  took a 15% decline to reverse the
direction of this moving average.
– These lagging indicators identify trend
reversals
• The price continued lower into Mar
09 and then surged 40-50%.
– EMA did not turn up until after this surge
 Another trend reversal (go up now!)
– The stock price continued higher the next
12 months!!!
 Moving Average - Double Crossovers

• Two moving averages can be used together to

generate crossover signals:
– E.g.
• one short moving average (e.g. 10 days) and
• one long moving average (e.g. 250 days) )
 Moving Average - Double Crossovers
• A bullish crossover (so-called the golden cross)
– Occurs when the shorter moving average crosses above the longer moving
average
• A bearish crossover (so-called the dead cross)
– Occurs when the shorter moving average crosses below the longer moving
average.

bullish

bearish
 Moving Average - Double Crossovers

• Moving average crossovers produce relatively late

signals.
• The information relies two lagging indicators
• The longer the moving average periods, the greater
the lag in the signals.
•  work great only when there is a good trend

• But when the market is stormy, it gives a lot of false

alarm!
 Moving Average - Double Crossovers

• E.g. using a moving average

crossover to catch the chance:
• [1] The 10-day EMA broke below
the 50-day EMA in late Oct
• [2] this did not last long as the 10-
day moved back above in mid
Nov. This cross lasted longer
• [3] But the next bearish crossover
in Jan occurred near late Nov
price levels, resulting in another
whipsaw.
• [4] This bearish cross did not last
long as the 10-day EMA moved
back above the 50-day a few days
later
 Support and Resistance
• Moving averages can also act as:
– support in an uptrend and
– resistance in a downtrend.
• A short-term uptrend might find support near the 20-day
simple moving average
• A long-term uptrend might find support near the 200-day
simple moving average
 Support and Resistance
• E.g. The 200-day SMA from mid
2004 until the end of 2008.
• The 200-day provided support
numerous times during the advance.
• Once the trend reversed with a
double top support break
–  the 200-day moving average acted as
resistance around 9500.

– Don’t expect exact support and

resistance levels from moving averages.
Markets are driven by emotion, which
makes them prone to overshoots.
 Technical Analysis:
Euro on down trend after range break

• http://www.youtube.com/watch?v=HT8YMGJWQ1w
 Technical Analysis:
Euro on down trend after range break
 Technical Analysis:
Euro on down trend after range break
 Technical Analysis:
Euro on down trend after range break
 Technical Analysis:
Euro on down trend after range break
 Moving Average Envelopes
• They are percentage-based envelopes set above and below a
moving average. (e.g. SMA or EMA)
• Each envelope is then set the same percentage above or below
the moving average.
•  creates parallel bands that follow price action.

• With a moving average as the base, Moving Average

Envelopes can be:
– used as a trend following indicator.
– Used to identify overbought and oversold levels when the trend is
relatively flat.
 Calculation of Envelopes
• Algorithm:
– 1. choose a SMA or EMA
– 2. select the number of time periods for the moving average.
– 3. Set the % for the envelopes
• e.g. A 20-day moving average with a 2.5% envelope would show
the following two lines:
Upper Envelope = 20-day SMA + (20-day SMA x .025)
Lower Envelope = 20-day SMA - (20-day SMA x .025)
 Moving Average Envelopes
• E.g. IBM with a 20-day SMA and 2.5% envelopes.
– The envelopes move parallel with the 20-day SMA.
– They remain a constant 2.5% above and below the moving average.
 Interpretation of Moving Average Envelopes

• When the price moves above or below the envelopes pay

attention!
• Trends often start with strong moves in one direction or another.
• A surge above the upper envelope shows extraordinary strength
• A plunge below the lower envelope shows extraordinary weakness
•  signal the end of one trend (trend reversal)
 Interpretation of Moving Average Envelopes

• Applications:
– used to identify overbought and oversold levels for
trading purposes.
• move above the upper envelope
–  overbought situation,
• move below the lower envelope
– oversold condition.
 Parameters of the envelopes
• Depend on the trading/investing objectives and the characteristics of
the security involved.

Trader Investor
Moving Average Shorter period longer period
(faster) (slower)
Envelopes Tighter wider

• Securities with high volatility will require wider bands to encompass

most price action.
• Securities with low volatility can use narrower bands.
 Parameters of the envelopes
• In choosing the right parameters, it often helps to overlay a
few different Moving Average Envelopes and compare.
• E.g. 3 Moving Average Envelopes based on the 20-day SMA.
– 2.5% envelopes (red) were touched several times (for short-term
trader)
– 5% envelopes (green) were only touched during the July surge. (for
medium term trader)
– The 10% envelopes (pink) were never touched  means this band is
too wide
 Parameters of the envelopes
• Stock indices and ETFs require tighter envelopes because they
are typically less volatile than individual stocks.
• E.g. The Alcoa chart has the same Moving Average Envelopes.
However, it breached the 10% envelopes numerous times
because it is more volatile.
 Moving Average Envelopes
Trend Identification
• Moving Average Envelopes can be used to identify strong
moves that signal the start of an extended trend.

• E.g.: DOW surged above the

upper envelope in mid Jul and
continued moving above this
envelope until early Aug 
shows extraordinary strength.
• After a move from 14 to 23,
the stock was clearly
overbought.
• However, this move
established a strong precedent
that marked the beginning of
an extended trend.
 Moving Average Envelopes
Trend Identification
• DOW was overbought soon after
establishing its uptrend
• Trader can wait for a playable pullback.
• Pullbacks often come in the form of
falling flags
• Falling flag in August and broke
resistance in Sep
• Another flag formed in late Oct with a
breakout in Nov
• After the Nov surge, the stock pulled
back with a 5 week flag into Dec.

• Tips
– When the bigger trend is up, oversold
readings can be used to identify
pullbacks to improve the risk-reward
profile for a trade.
 Moving Avg Envelopes - Overbought/Oversold

• Securities can become overbought (or

oversold )and remain overbought (or
oversold )in a strong uptrend (or downtrend).
• In a strong uptrend:
– prices often move above the upper envelope and
continue above this line.
– the upper envelope will rise as price continues
above the upper envelope.
– This may seem technically overbought, but it is a
sign of strength to remain overbought.

• The reverse is true for oversold.

 Moving Avg Envelopes - Overbought/Oversold

• E.g. Price of Nokia

– Red lines: 50-day Moving Average
– Pink lines: 50-day Moving Average Envelopes @ 10%
– It starts with an overbought level that stayed overbought as a strong
trend emerged in Apr-May.
 Moving Avg Envelopes - Overbought/Oversold

• E.g. Price of Nokia

– Price action turned choppy from Jun to Apr
•  scenario for overbought and oversold levels.
– Overbought levels in Sept and mid Mar foreshadowed a reversals.
– Similarly, oversold levels in August and late October foreshadowed
advances.
 Moving Average Envelopes
• How can we use moving average envelopes?
– Used as a trend following indicator, but can also be used to identify overbought
and oversold conditions.
– After a consolidation period, a strong envelope break can signal the start of an
extended trend.
– Overbought conditions and bounces can be used as selling opportunities within
a bigger downtrend.
• Moves above the upper envelope signal overbought readings
• Moves below the lower envelope signal oversold readings.

• Should incorporate other aspects of technical analysis to confirm

overbought and oversold reading.
– Resistance and bearish reversals patterns can be used to corroborate overbought
readings.
– Support and bullish reversal patterns can be used to affirm oversold conditions.
 Relative Strength Index
• RSI uses to calculate the current and historical strength (or
weakness) of a stock or market based on the closing prices
of a recent trading period.
• It is as a momentum oscillator (the rate of the rise or fall in
price)
• It measures the velocity and magnitude of directional price
movements.
• The RSI computes momentum as the ratio of higher closes
to lower closes:
– stocks which have had more or stronger positive changes have
a higher RSI than stocks which have had more or stronger
negative changes.
 Relative Strength Index
• The RSI is most typically used on a 14 day timeframe,
• Measured on a scale from 0 to 100,
• E.g.
– RSI High levels: marked at 70
– RSI Low levels: marked at 30
• More extreme high and low levels
– >80 or < 20
– occur less frequently
– but indicate stronger momentum.
 Calculation of RSI
• For each trading period an upward change U or downward change D is
calculated.
– If closenow > closeprevious , then Gain = closenow − closeprevious; Loss = 0
– If closenow < closeprevious , then Gain = 0; Loss = closeprevious − closenow
– If closenow = closeprevious then Gain=0; Loss =0
• Average Gain = avg Gain and Average Loss = Avg Loss (for 14 days)
RS = Relative Strength = Average Gain / Average Loss
RSI = 100 – 100
(1 + RS)
• If Avg loss = 0
– then RSI = 100.
 Examples
• http://stockcharts.com/
school/doku.php?
id=chart_school:techni
cal_indicators:relative
_strength_index_rsi
 Principles
• When price moves up very rapidly  overbought.
• When price falls very rapidly  oversold

• In either case, a reaction or reversal is expected

• RSI is a measure of the stock's recent trading strength.

• RSI slope: directly proportional to the velocity of a change in the
trend.
• RSI distance travelled: proportional to the magnitude of the move.
– RSI >70, it is considered to be in overbought territory
– RSI < 30 level are considered to be in oversold territory.
– 30 < RSI <70 level is considered neutral
– RSI= 50 means a sign of no trend.
 Divergence
• Analysts believe that divergence between RSI and price
action is a very strong indication that a market turning
point happens
– Bearish divergence occurs
• when price makes a new high but the RSI makes a lower high,
thus failing to confirm.
– Bullish divergence occurs
• when price makes a new low but RSI makes a higher low.
 Overbought and oversold conditions

• Areas of support and resistance could be more

easily seen on the RSI chart than
• The center line for RSI = 50
–  often seen as both the support and resistance
line for the indicator.
• If RSI <50  means that the stock's losses are
greater than the gains
• If RSI >50  means that the gains are greater
than the losses.
 RSI- Overbought-Oversold
• RSI overbought above 70 and oversold
below 30.
• E.g. The stock became oversold in late July
and found support around 44 (1)
• From oversold levels, RSI moved above 70
in mid Sep to become overbought.
• But the stock did not decline. Instead, the
stock stalled for a couple weeks and then
continued higher!
• 3 more overbought readings occurred before
the stock finally peaked in Dec (2).
• The first 3 overbought readings
foreshadowed consolidations.
• The fourth coincided with a significant peak.
• RSI then moved from overbought to
oversold in Jan
• The final bottom did not coincide with the
initial oversold reading as the stock
ultimately bottomed a few weeks later
around 46 (3).
Example: Esprit
• RSI <50 for most of the time
• Is it oversold? Should we
buy it now?
 RSI: Uptrends and downtrends
• Uptrends generally traded between RSI 40 and 80
– Overbought in general
• Downtrends usually traded between RSI 60 and 20
– Usually oversold in general
• When securities change from uptrend to downtrend and vice
versa, the RSI will undergo a "range shift."
 Other Technical Analysis tools
• Overlays
– Bollinger Bands - A chart overlay that shows the upper and lower limits of 'normal' price
movements based on the Standard Deviation of prices.
– Ichimoku Clouds - A comprehensive indicator that defines support and resistance,
identifies trend direction, gauges momentum and provides trading signals.
– Keltner Channels - A chart overlay that shows upper and lower limits for price movements
based on the Average True Range of prices.
– Parabolic SAR- A chart overlay that shows reversal points below prices in an uptrend and
above prices in a downtrend.
– Pivot Points- A chart overlay that shows reversal points below prices in an uptrend and
above prices in a downtrend.
– Price Channels - A chart overlay that shows a channel made from the highest high and
lowest low for a given period of time.
– Volume by Price - A chart overlay with a horizontal histogram showing the amount of
activity at various price levels.
– Volume-weighted Average Price (VWAP) - An intraday indicator based on total dollar value
of all trades for the current day divided by the total trading volume for the current day.
– ZigZag - A chart overlay that shows filtered price movements that are greater than a given
percentage.
 Other Technical Analysis tools
• Indicators
– Accumulation Distribution Line –
– Average Directional Index (ADX)
– Average True Range (ATR)
– Bollinger Bands %B -
– Bollinger BandWidth –
– Commodity Channel Index (CCI) –
– Correlation Coefficient –
– Chaikin Money Flow –
– Chaikin Oscillator –
– Detrended Price Oscillator (DPO)
– Force Index
– MACD - A
Ref: http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators
– MACD-Histogram –
– Money Flow Index (MFI) –
– On Balance Volume (OBV) –
– Percentage Price Oscillator (PPO)
-
– Percentage Volume Oscillator -
– Price Relative
– Rate of Change (ROC) –
– Relative Strength Index (RSI)
– Slope
– Standard Deviation (Volatility)
– Stochastic Oscillator
– StochRSI
– Ultimate Oscillator
 Tips for using technical analysis
• Don’t rely on a single analysis
– Technical analysis and fundamental analysis can
be used together to achieve great success
– E.g.
• Some fundamental analysts use technical analysis
techniques to figure out the best time to enter into an
undervalued security.
• E.g. when the security is severely oversold
–  the gains on the investment can be greatly improved.
Tips for using technical analysis
• Use both analysis to maximize the accuracy
– Some technical traders might look at fundamentals to add
strength to a technical signal.
– E.g.
• If a sell signal is given through technical patterns and
indicators
• Technical trader might look to reaffirm his or her
decision by looking at some key fundamental data.
 Tips for using technical analysis
Don’t Gamble Do farming!
 Reference:

• http://www.investopedia.com/univers
ity/technical/techanalysis2.asp
• http://stockcharts.com