CFA Level I - Technical Analysis

CFA Level I – Technical Analysis : CFA Level I – Technical Analysis

Technical Analysis : Technical Analysis Study of collective market sentiment Assumptions Market price is determined by supply and demand Market prices reflect both rational and irrational investor behavior Efficient markets hypothesis does not hold Trends and patterns tend to repeat and can be used for forecasting

Fundamental v/s technical analysis : Fundamental v/s technical analysis Fundamental analysis tries to determine the intrinsic value of an asset Technical analysis uses only the firm’s share price and trading volume data to project target price Technical analysis is not concerned with identifying buyers’ and sellers’ reasons for trading, but only with the trades that have occurred

Advantages : Advantages Price and volume are observable, much of the data used in fundamental analysis is based on assumptions Can be applied to assets that do not produce cash flows Useful when financial statement fraud occurs, price and volume may reflect true value even before fraud is widely known

Disadvantages : Disadvantages Usefulness limited if price and volume do not truly reflect supply and demand Example – illiquid markets and markets subject to outside manipulation (currency markets by central banks) For bankrupt companies, short covering can create positive technical patterns even when it is known that stock price will go to zero

Price Charts : Price Charts

Price charts : Price charts

Price charts : Price charts

Slide 9 :

Volume charts : Volume charts

Trend, support, resistance & change in polarity : Trend, support, resistance & change in polarity Uptrend – constructed by connecting increasing lows (breakdown may suggest reversal, represents resistance) Downtrend – constructed by connecting decreasing highs (breakout may suggest reversal, represents support) Support – buying expected to emerge Resistance – selling expected to emerge Breakouts, breakdowns, round number prices, historic highs and lows

Change in polarity : Change in polarity Breached resistance becomes support Breached support becomes resistance

Reversal patterns : Reversal patterns Trend approaches a range but fails to continue beyond that range Size of the head and shoulders = top – neckline (size is used to predict the extent of the down move) Other reversal patterns Double top/triple top Double bottom/triple bottom Inverse head and shoulders

Continuation patterns : Continuation patterns Triangles – Pennants Rectangles - Flags

Moving average lines : Moving average lines Used to smooth fluctuations in a price chart Mean of last n closing prices Uptrend – incremental price is higher than moving average, vice-versa in a downturn Moving average lines are often viewed as support or resistance levels Short term average crosses above long term average indicates buy Short term average crosses below long term average indicates sell

Moving average and bollinger bands : Moving average and bollinger bands

Oscillators : Oscillators Oscillate around a given value Convergence of the oscillator with market prices indicates the trend will continue Divergence of the oscillator with market prices indicates that trend will change

Slide 18 : Rate of change or Momentum Oscillator 100 x (last closing price – closing price n periods earlier) Oscillates around 0 Buy when oscillator changes from negative to positive Sell when oscillator changes from positive to negative

Slide 19 : Relative Strength Index Ratio of total price increases to total price decreases Scaled to oscillate between 0 and 100 Overbought when > 70 (indicates sell) Oversold when < 30 (indicates buy)

Slide 20 : Moving average convergence/divergence (MACD) Uses exponential smoothed moving averages which put greater weight on more recent averages MACD line – Difference b/w to exponentially smoothed moving average lines Oscillate around 0 but are not bounded Signal line – Exponentially smoothed moving average of the MACD line MACD line crossing above signal line is viewed as a buy indication and vice versa

Slide 21 : Stochastic Oscillator – Calculated from the latest closing price and highest and lowest price in a recent period, like 14 days %K line = (latest price – low)/(high – low) %D line = 3 period average of the %K line %K line crosses above the %D line, indicates buy and vice versa

Non – price based indicators : Non – price based indicators Put call ratio Volume of puts/volume of calls Increasing ratio indicates bearish outlook Extremely high ratios indicate strong bearish sentiment and possible overselling, vice versa Volatility Index (VIX) Measures volatility of options the S&P 500 High VIX suggests investors fear declines Analysts often interpret VIX in a contrarian way

Slide 23 : Margin debt Increasing margin debt tends to coincide with increasing market prices Decreasing margin debt tends to coincide with decreasing prices Short interest ratio High short interest ratio means investors expect the stock price to decrease, it also implies future buying demand when short sellers must return their borrowed shares

Flow of funds : Flow of funds Arms index or short term trading index Value close to 1 suggests funds are flowing evenly to advancing and declining stocks > 1 , more volume in declining stocks, vice – versa Spikes upwards have historically coincided with large daily losses and vice versa

Slide 25 : Margin debt Increase suggests investors want to buy more stocks and vice versa Mutual fund cash position Mutual fund cash to total assets Typically viewed as a contrarian indicator Accumulation of cash represents future buying power and vice versa New equity issuance and secondary offering Issuance of new shares coincide with market peaks

Elliott wave theory : Elliott wave theory Market prices can be described by an interconnected set of cycles Cycle periods range from a few minutes to centuries Uptrend – Upward moves consist of 5 waves, downward moves consist of 3 waves Downtrend – Downward moves consist of 5 waves, upward moves consist of 3 waves

Elliot wave patterns : Elliot wave patterns

Slide 28 : Size of the waves are thought to correspond to Fibonacci ratios 0, 1, 1, 2, 3, 5, 8, 13, 21, 34 and so on Down leg can be 2/3 or ½ of up leg Price target can be 21/13 of previous high etc. Ratios of consecutive Fibonacci numbers converge to 0.618 and 1.618 as numbers get larger

Slide 29 : Intermarket analysis Interrelationships among the market values of major asset classes, such as stocks, bonds, commodities, and currencies Relative strength ratios are a useful tool for determining which asset classes are outperforming others