Chapter 16
TECHNICAL ANALYSIS
Chapter 16 Questions
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?
What are the major advantages of technical
analysis compared to fundamental analysis?
Chapter 16 Questions
What are the major challenges to technical
analysis and its rules?
What is the logic for the major contraryopinion rules used by technicians?
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?
Chapter 16 Questions
What are the types of price movements
postulated in the Dow Theory, and how are
they used by a technician?
Why is the volume of trading important and
how do technicians it in their analysis?
What are support and resistance levels, when
do they occur, and how are they used by
technicians?
Chapter 16 Questions
What is the purpose of moving average lines
and how do technicians use them to detect
major changes in trends?
What is the rationale behind the relativestrength line for an industry or a stock?
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 markets?
Technical Analysis vs.
Fundamental Analysis
Technical analysis involves the development
of trading rules based on past price and
volume data for individual stocks and the
overall stock market.
Fundamental analysis involves economic,
industry, and company analysis that lead to
valuation estimates for companies, which can
then be compared to market prices to aid in
investment decisions.
Technical Analysis
To “non-believers,”
technical analysis
can sound like a lot
of focus-pocus!
Underlying Assumptions
of Technical Analysis
Trading via technical analysis involve a
number of assumptions about markets
The market value of any good or service is
determined solely by the interaction of
supply and demand
 Supply and demand are governed by
numerous factors, both rational and
irrational

Underlying Assumptions
of Technical Analysis
Technical analysis assumptions:


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
Prevailing trends change in reaction to shifts in
supply and demand relationships and these shifts
can be detected in the action of the market
Advantages of Technical
Analysis
Unlike fundamental analysis, technical
analysis is not heavily dependent on
financial accounting statements

Problems with accounting statements:
Lack information needed by security analysts
 GAAP allows firms to select reporting
procedures, resulting in difficulty comparing
statements between firms
 Many psychological and other 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 to “correct” prices as quickly
Challenges to Technical
Analysis
Challenges to basic assumptions

Empirical tests of Efficient Market Hypothesis
(EMH) show that prices do not move in trends
Challenges to technical trading rules




Rules that worked in the past may not be repeated
Patterns may become self-fulfilling prophecies
A successful rule will gain followers and become
less successful
Rules all require subjective judgement
Technical Trading Rules
and Indicators
Stock cycles typically go through a peak
and trough
For instance, consider the following
stock price graph over time, and then
consider how a technical analyst would
interpret the chart
Typical Stock Market
Cycle
Stock
Price
Typical Stock Market
Cycle
Stock
Price
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


Buy when the mutual fund cash position is high,
sell when low
Assumes that mutual fund managers are poor
judges of market turning points
Credit balances in brokerage accounts

Buy when credit balances increase, sell when
credit balances fall
Investment advisory opinions

Buy when advisory firms become more bearish
Contrary-Opinion Rules
OTC versus NYSE volume

If OTC volume increases relative to NYSE volume,
sell since speculation increases at peaks
Chicago Board Options Exchange (CBOE)
put/call ratio

Buy when option purchasers are bearish (when
the put/call ratio increases)
Futures traders bullish on stock index futures

Sell when speculators are bullish
Follow the Smart Money
While contrary-opinion rules assume that
most investors are not smart, these indicators
seek to follow the path of sophisticated, and
assumed smart, investors
The Barron’s Confidence Index


Measures the yield spread between high-grade
bonds and a large cross section of bonds
Declining (increasing) yield spreads increase
(decrease) this index, and are a bullish (bearish)
indicator
Follow the Smart Money
T-Bill - Eurodollar yield spread

Decreases in this spread indicates greater
confidence, and is a bullish indicator
Debit balances in brokerage accounts
Such balances represent buying on
margin, which is assumed to be done by
largely sophisticated investors
 Increases are a bullish signal

Other Market Indicators
These indicators are meant to gauge overall
market sentiment
Breadth of market

Advance-decline (number of advancing minus the
number of declining issues)
Short interest


Cumulative number of shares sold short in
uncovered positions
Actually a bullish indicator, as it indicates potential
demand
Other Market Indicators
Stocks above their 200-day moving average

Technicians use moving averages to compute
general trends, and evaluate current stock prices
relative to those trends
Block uptick-downtick ratio

Gauges institutional investor sentiment by looking
at the proportion of block trades that resulted in an
uptick (buy) or a downtick (sell)
Stock Price and Volume
Techniques
The Dow theory
1.
2.
3.

Major trends are like tides in the ocean
Intermediate trends resemble waves
Short-run movements are like ripples
Key is to identify the nature of a current price
movement
Importance of volume


Ratio of upside-downside volume
Price movements are not very important unless
they are “confirmed” by volume
Stock Price and Volume
Techniques
Support and resistance levels



Support level: the level that a price is unlikely to
decline below; when price reaches the support
level, demand surges for the stock
Resistance level: the level that a price is unlikely
to rise above; when price reaches the resistance
level, we observe selling or “profit taking”
Movements below (bearish) and above (bullish)
this range provide indicators
Stock Price and Volume
Techniques
Moving average lines


Moving average prices are calculated and
track for several different time periods
When the shorter-term moving average
line is consistently above the longer-term
line, it is considered a bullish signal
Stock Price and Volume
Techniques
Relative-strength (RS) ratios


For individual stocks and industry groups
Measure relative price changes across different
stocks or industries
Other Indicators



Bar charting
Multiple indicator charts
Point-and-figure charts
Idea is to get an overall feel from numerous
technical indicators
Technical Analysis of
Foreign Markets
Some foreign market data is more limited
than U.S. market data

Greater reliance on stock and volume data
Merrill Lynch publishes various indicators for
several countries
Technical analysis of foreign exchange rates

Traders look for trends in exchange rates that
could give rise to profit opportunities
Technical Analysis of
Bond Markets
Many of the same indicators and trading
rules can be applied to bond markets
Generally not possible to get bond
market volume data