Introduction
Technical analysis is the attempt to forecast stock prices
on the basis of market-derived data.
Technicians (also known as quantitative analysts or
chartists) usually look at price, volume and psychological indicators over
time.
They are looking for trends and patterns in the data that
indicate future price movements.
Dow Theory
This theory was first stated by Charles Dow in a series of
columns in the WSJ between 1900 and 1902.
A change in the trend of the DJIA must be confirmed by a
trend change in the DJTA in order to generate a valid signal.
Primary Trend
Called “the tide” by Dow, this is the trend that defines the
long-term direction (up to several years).
Others have called this a “secular” bull or bear market.
Secondary Trend
Called “the waves” by Dow, this is shorter-term departures
from the primary trend (weeks to months)
Day to day fluctuations
Not significant in Dow Theory
Not significant in Dow Theory
Does Dow Theory Work?
n According
to Martin Pring, if you had invested $44 in 1897 and followed all buy and sell
signals, by 1981 you would have accumulated about $18,000.
If you had simply invested $44 and held that portfolio, by
1981 you would have accumulated about $960
Elliot Wave Principle
n R.N.
Elliot formulated this idea in a series of articles in Financial World in 1939.
n Elliot
believed that the market has a rhythmic regularity that can be used to predict
future prices.
n The
Elliot Wave Principle is based on a repeating 8-wave cycle, and each cycle is
made up of similar shorter-term cycles (“Big fleas have little fleas upon their
backs to bite 'em - little fleas have smaller fleas and so on ad infinitem”).
n Elliot
Wave adherents also make extensive use of the Fibonacci series.
Charting the Market
n Chartists
use bar charts, candlestick, or point and figure charts to look for patterns
which may indicate future price movements.
n They
also analyze volume and other psychological indicators (breadth, % of bulls vs
% of bears, put/call ratio, etc.).
n Strict
chartists don’t care about fundamentals at all.
Basic Technical Tools
n Trend
Lines
n Moving
Averages
n Price
Patterns
n Indicators
n Cycles
Trend Lines
n three
basic kinds of trends:
¡ An
Up trend where prices are generally increasing.
n A
Down trend where prices There are
¡ are
generally decreasing.
¡ A
Trading Range.
Support & Resistance
n Support
and resistance lines indicate likely ends of trends.
n Resistance
results from the inability to surpass prior highs.
n Support
results from the inability to break below to prior lows.
n What
was support becomes resistance, and vice-versa.
Simple Moving Averages
n A
moving average is simply the average price (usually the closing price) over the
last N periods.
n They
are used to smooth out fluctuations of less than N periods.
n This
chart shows MSFT with a 10-day moving average.
Note how the moving average shows much less volatility than the daily
stock price.
Price Patterns
n Technicians
look for many patterns in the historical time series of prices.
n These
patterns are reputed to provide information regarding the size and timing of
subsequent price moves.
n But
don’t forget that the EMH says these patterns are illusions, and have no real
meaning. In fact, they can be seen in a
randomly generated price series.
Head and Shoulders
n This
formation is characterized by two small peaks on either side of a larger peak.
This is a reversal pattern, meaning that it signifies a
change in the trend
Double Tops and Bottoms
n These
formations are similar to the H&S formations, but there is no head.
These are reversal patterns with the same measuring
implications as the H&S
Triangles
n Triangles
are continuation formations.
n Three
flavors:
¡ Ascending
¡ Descending
¡ Symmetrical
n Typically,
triangles should break out about half to three-quarters of the way through the
formation.
Rounded Tops & Bottoms
Rounding formations are characterized by a slow reversal of
trend
Broadening Formations
n These
formations are like reverse triangles.
n These
formations usually signal a reversal of the trend.
Technical Indicators
n There
are, literally, hundreds of technical indicators used to generate buy and sell
signals.
n We
will look at just a few that I use:
¡ Moving
Average Convergence/Divergence (MACD)
¡ Relative
Strength Index (RSI)
¡ On
Balance Volume
¡ Bollinger
Bands
MACD
n MACD
was developed by Gerald Appel as a way to keep track of a moving average
crossover system.
n Appel
defined MACD as the difference between a 12-day and 26-day moving average. A 9-day moving average of this difference is
used to generate signals.
n When
this signal line goes from negative to positive, a buy signal is generated.
n When
the signal line goes from positive to negative, a sell signal is generated.
n MACD
is best used in choppy (trendless) markets, and is subject to whipsaws (in and
out rapidly with little or no profit).
Relative Strength Index (RSI)
n RSI
was developed by Welles Wilder as an oscillator to gauge overbought/oversold
levels.
n RSI
is a rescaled measure of the ratio of average price changes on up days to
average price changes on down days.
n The
most important thing to understand about RSI is that a level above 70 indicates
a stock is overbought, and a level below 30 indicates that it is oversold (it
can range from 0 to 100).
Also, realize that stocks can remain overbought or oversold
for long periods of time, so RSI alone isn’t always a great timing tool
On Balance Volume
n On
Balance Volume was developed by Joseph Granville, one of the most famous
technicians of the 1960’s and 1970’s.
n OBV
is calculated by adding volume on up days, and subtracting volume on down
days. A running total is kept.
n Granville
believed that “volume leads price.”
n To
use OBV, you generally look for OBV to show a change in trend (a divergence
from the price trend).
If the stock is in an uptrend, but OBV turns down, that is a
signal that the price trend may soon reverse
Bollinger Bands
n Bollinger
bands were created by John Bollinger (former FNN technical analyst, and regular
guest on CNBC).
n Bollinger
Bands are based on a moving average of the closing price.
n They
are two standard deviations above and below the moving average.
n A
buy signal is given when the stock price closes below the lower band, and a
sell signal is given when the stock price closes above the upper band.
n When
the bands contract, that is a signal that a big move is coming, but it is
impossible to say if it will be up or down.
In my experience, the buy signals are far more reliable than
the sell signals
Too Many Others To List
n A
whole semester could easily be spent on just a handful of these.
n To
close, just note that there is nothing so crazy that somebody doesn’t use it to
trade.
n For
example, many people use astrology, geometry (Gann angles), neural networks,
chaos theory, etc.
n There’s
no doubt that each of these (and others) would have made you lots of money at
one time or another. The real question
is can they do it consistently?
n As
the carneys used to say, “You pays your money, and you takes your chances.”
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