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
- 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
- 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
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