Sunday, September 16, 2012

Quantitative Methods - Technical Analysis

Start: 10:45 pm

Technical Analysis

Assumptions of technical analysis
  • Values and thus prices are determined by supply/demand
  • These are driven by both rational and irrational behavior
  • Security prices move in trends that persist for long periods
  • While causes of changes in supply/demand are difficult to determine, actual shifts in supply and demand can be observed in market price behavior
The major challenge to technical analysis is the efficient market hypothesis
  • EMH followers believe all information is impounded in prices
  • EMH followers believe technical rules too subjective, and decision variables change over time
Fundamental analysis - price based on underlying fundamentals, i.e. return and risk - so analyze earnings etc.

Technicians think mkt reaction is slow, where fundamentalists believe prices are quick to adjust

Fundamentalists look for changes in basis of value, technicians look at market signals/indicators, EMH says this is all hopeless

Advantages of technical
  • Quick and easy
  • Does not involve accounting data/analytical adjustments for accounting method differences
  • Incorporates psychological as well as economic reasons for price changes
  • It tells when to buy, rather than why
Disadvantages/challenges
  • EMH
  • Too subjective and rules may change over time
  • If tech worked, price movements would become self fulfilling prophecies
  • If it worked, everyone would do it and it would not be profitable
There are four categories of technical trading rules

1) Contrarian view - the majority is generally wrong, so do the opposite
  • Mutual fund ratio: Mutual fund cash / mutual fund total assets
    • MF's are wrong so when they are in cash, go in stock
    • If MF ratio > 11%, MFs are bearish so go bull
    • If MF ratio < 4%, MFs are bullish, so go bear
  • Investor credit balances in brokerage accounts
    • These are uninvested cash - more cash means mass is bearish
  • Opinions of investment advisory services
    • If more than 60% of advisors are bears, contrarians are bulls
    • Less than 20% are bearish, advisors are bulls, so contrarians are bears
  • OTC vs. NYSE volume (ratio)
    • OTC is more speculative, rises in market peaks
    • Ratio increasing, market are bulls, contrarians bears
    • Ratio decreasing, market bears, contrarians bulls
  • CBOE Put/Call Ratio
    • Put/call above 0.6, market bear, contrarian bull
    • Put/call below 0.4, market bull, contrarian bear
  • Stock index futures
    • When futures speculators are bullish, contrarians bear
    • And vice versa
2) Smart Money Rules - do what smart investors are doing.  Note: Some people have hard time distinguishing smart money vs. contrarian - so memorize these three, and the rest are the contrarian.
  • Confidence index
    • CI = average yield of 10 top grade bonds / dow jones yield average of 40 bonds
    • Always less than 1
    • In periods of confidence, investors go to riskier bonds to get more yield - price on high grade drops and yields increase, where price on low grade increases and yield decreases
      • CI increases in period of confidence
  • T-bill - eurodollar yield spread
    • Spreads widen in times of intl crisis as money flows to safe haven in US
    • Increasing 'TED' spread is a bearish indicator
  • Debit balances in brokerage accounts (margin debt)
    • Margin trading usually only done by skilled investors
    • Increase in debit balances is a bull indicator - good investors are very confident
    • Decline in debit balances - bearish sign
3) Momentum indicators
  • Breadth of market - Indices are just a small section of whole market
    • Compare advance/decline with market index
    • If in line, movement is based with market
    • Divergence indicates market has hit a peak or trough
  • Stocks above their 200-day moving average
    • Stocks are overbought when over 80% of stocks are selling above their 200 day moving avgs
    • Oversold if this is less than 20% are selling above said measure
4) Stock price and volume techniques
  • Dow Theory - stock prices move in trends.  Three types: major, intermediate, and short run.
  • Volume - Price changes on low volume tell little.
    • Upside/downside ratio: vol of stocks that increased/vol of stocks that decreased
      • If 1.75 or higher, overbought (bearish); 0.75 or lower, oversold (bullish)
  • Support/resistance level
    • Stock prices fluctuate around true value
    • Support is lower limit of fluctuation (initiate buy), upper limit is called resistance (initiate sell)
  • Moving average lines
    • Tell better story of long term trend and get rid of fluctuation
  • Relative strength
    • Is stock price move stock specific or caused by market move?
    • relative strength = stock price/mkt value index
    • If increases over time, stock outperforming
    • Vice versa
  • Graphs
    • Chartists - extensive reliance on charts and graphs
    • History repeats, so past trends can identify beginning of new trend
End of reading
11:30 pm
0.75 hours

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