Chapter 15

Investment
by

Dr. Kumail Rizvi, CFA, FRM

Chapter 15
Technical Analysis
Questions to be answered:
How does technical analysis differ from
fundamental analysis?
What are the underlying assumptions of technical
analysis?
What major assumption causes a difference
between technical analysis and the efficient
market hypothesis?

Chapter 15
Technical Analysis
What are the major advantages of technical
analysis compared to fundamental analysis?
What are the major challenges to the assumptions
of technical analysis and its rules?
What is the logic for the major contrary opinion
rules used by technicians?

Chapter 15
Technical Analysis
What are some of the significant rules used by
technicians who want to follow the smart
money and what is the logic of those rules?
What are the breadth of market measures and
what are they intended to indicate?
What are the types of price movements postulated
in the Dow Theory and how are they used by a
technician?

Chapter 15
Technical Analysis
Why is volume of trading important and how do
technicians use it?
What are support and resistance levels and how
are they used?
How do technicians use moving-average lines to
detect changes in trends?

Chapter 15
Technical Analysis
What is the rationale behind the relative strength
line for an industry or a stock and how is it
interpreted?
How are bar charts different from point-andfigure charts?
What are some uses of technical analysis in
foreign security markets?
How is technical analysis used when analyzing
bond?

Underlying Assumptions
of Technical Analysis
1. The market value of any good or service is
determined solely by the interaction of
supply and demand
2. Supply and demand are governed by
numerous factors, both rational and
irrational

Underlying Assumptions
of Technical Analysis
3. Disregarding minor fluctuations, the prices
for individual securities and the overall
value of the market tend to move in trends,
which persist for appreciable lengths of
time
4. Prevailing trends change in reaction to
shifts in supply and demand relationships.
These shifts, no matter why they occur, can
be detected sooner or later in the action of
the market itself.

Advantages of Technical Analysis

Not heavily dependent on financial
accounting statements
Problems with accounting statements:
1. Lack information needed by security analysts
2. GAAP allows firms to select reporting
procedures, resulting in difficulty comparing
statements from two firms
3. Non-quantifiable factors do not show up in
financial statements

Advantages of Technical Analysis

Fundamental analyst must process new
information and quickly determine a new
intrinsic value, but technical analyst merely
has to recognize a movement to a new
equilibrium
Technicians trade when a move to a new
equilibrium is underway but a fundamental
analyst finds undervalued securities that
may not adjust their prices as quickly

Challenges to Technical Analysis

Assumptions of Technical Analysis
Empirical tests of Efficient Market Hypothesis
(EMH) show that prices do not move in trends

Technical Trading rules

The past may not be repeated
Patterns may become self-fulfilling prophecies
A successful rule will gain followers and become
less successful
Rules require a great deal of subjective judgement

Technical Trading Rules

and Indicators
Stock cycles typically go through a peak
and trough
Analyze the following chart of a typical
stock price cycle and we will show a rising
trend channel, a flat trend channel, a
declining trend channel, and indications of
when a technical analyst would want to
trade

Typical Stock Market Cycle

Stock
Price

Peak
Flat Trend Channel

Sell Point
Rising Trend
Channel Declining
Buy Point
Trend
Channel

Trough

Typical Stock Market Cycle

Stock
Price

Peak
Flat Trend Channel

Sell Point
Rising Trend
Channel Declining
Trend
Channel

Trough

Typical Stock Market Cycle

Stock
Price

Flat Trend Channel

Declining
Trend
Channel

Trough

Typical Stock Market Cycle

Stock
Price

Flat Trend Channel

Declining
Trend
Channel

Trough

Typical Stock Market Cycle

Stock
Price

Flat Trend Channel

Trough

Typical Stock Market Cycle

Stock
Price

Flat Trend Channel

Trough

Typical Stock Market Cycle

Stock
Price

Flat Trend Channel

Trough

Typical Stock Market Cycle

Stock
Price

Trough

Typical Stock Market Cycle

Stock
Price

Typical Stock Market Cycle

Stock
Price

KSE
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
99

00

01

02

03

04

05

06

07

08

09

Typical Stock Market Cycle

Stock
Price

Exhibit 15.2

Declining
Trend
Channel

Peak
Flat Trend Channel

Sell Point
Rising Trend
Channel Declining
Buy Point
Trend
Trough

Channel

Buy Point
Trough

Typical Stock Market Cycle

Stock
Price

Exhibit 15.2

Declining
Trend
Channel

Peak
Flat Trend Channel

Sell Point
Rising Trend
Channel Declining
Buy Point
Trend
Trough

Channel

Buy Point
Trough

Contrary-Opinion Rules
Many analysts rely on rules developed from
the premise that the majority of investors
are wrong as the market approaches peaks
and troughs
Technicians try to determine whether
investors are strongly bullish or bearish and
then trade in the opposite direction
These positions have various indicators

Contrary-Opinion Rules

Mutual fund cash positions (at 4%, S; 11% B)

Credit balances in brokerage accounts (LS; HB)
Investment advisory opinions (Bear/Bull)
OTC versus NYSE volume (87 B, 112 S)
Chicago Board Options Exchange (CBOE) PutCall ratio (0.4 S, 0.6 B)
Futures traders bullish on stock-index futures

Follow the Smart Money

Indicators showing behavior of sophisticated
investors
The Barrons Confidence Index (HGY/AvgY)
T-Bill - Eurodollar yield spread
Short sales by specialists
Debit balances in brokerage accounts (margin
debt) (High..B; Low..S)

Other Market Indicators

Momentum Indicators
Breadth of market
Advance-decline
Diffusion index

Short interest
Stocks above their 200-day moving average
Block uptick-downtick ratio

Stock Price and Volume Techniques

The Dow theory oldest technical trading
rule
1. Major trends are like tides in the ocean
2. Intermediate trends resemble waves
3. Short-run movements are like ripples

Importance of volume
Ratio of upside-downside volume

Support and resistance levels

Moving average lines

Stock Price and Volume Techniques

Relative-strength (RS) ratios
For individual stocks and industry groups

Bar charting
Multiple indicator charts
Point-and-figure charts
Overall feel from a consensus of
numerous technical indicators

Technical Analysis
of Foreign Markets
Foreign stock market series
Technical analysis of foreign
exchange rates
Technical analysis of bond markets

The Internet
Investments Online
http://www.mta.org
http://www.bigcharts.marketwatch.com
http://www.stockcharts.com

End of Chapter 15
Technical Analysis

Future topics
Chapter 16
Equity Portfolio Management
Strategies