Technical Analysis Level I Quantitative Methods. IFT Notes for the CFA exam

Transcription

1 Technical Analysis 2014 Level I Quantitative Methods IFT Notes for the CFA exam

2 Contents 1. Introduction Technical Analysis: Definition and Scope Technical Analysis Tools Elliot Wave Theory Inter-market Analysis Summary Next Steps This document should be read in conjunction with the corresponding reading in the 2014 Level I CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute. Copyright Irfanullah Financial Training. All rights reserved. Page 2

3 1. Introduction Technical analysis has long been used by traders and analysts but has only recently received acceptance from regulators and the academic community. Although certain aspects of technical analysis, such as the calculation of indicators, have specific rules, the interpretation of findings is often subjective. 2. Technical Analysis: Definition and Scope Technical analysis is a form of security analysis that uses price and volume data in decision making. The data is often graphically displayed. Technical analysis can be used for securities in a freely traded market, where buyers and sellers face no external intervention in trading. Technical analysis is based on the following logic: Supply and demand determine prices. Changes in supply and demand can cause changes in prices. Prices can be projected with charts and other technical tools. Technical analysis of any financial instrument does not require detailed knowledge of that instrument. In addition, technical analysis can also be applied over any time frame, from short term to long term. Investors and traders often prefer technical analysis over fundamental analysis in the short term because fundamental analysis is more time consuming. 2.1 Principles and Assumptions Technical analysis can be thought of as the study of collective investor psychology or sentiment. Prices are set by human beings or their automated proxies (such as computerized trading programs). Fundamental theorists believe that markets are rational and efficient. On the other hand, technicians believe that human behavior is often erratic and driven by emotion. Therefore, they believe that market trends and patterns reflect this irrational human behavior. They rely on recognition of such trends and patterns in the past to project future patterns of security prices. Copyright Irfanullah Financial Training. All rights reserved. Page 3

4 Another principle of technical analysis is that the market reflects the collective knowledge and sentiment of many participants such as investors, hedgers, insiders and other stakeholders. Market participants, who buy and sell securities, have an impact on price. The greater the volume of a participant s trades, the more impact the participant will have on price. By studying market technical data (price and volume trends) technicians seek to understand investor sentiment. In contrast, the fundamental analyst must wait for the release of financial statements to conduct financial analysis, resulting in a time lag between the market s activities and the analyst s conclusions. Some financial instruments have an associated income stream that adds to the security s intrinsic value such as coupon payments for bonds and dividends for equity shares. A fundamental analyst can use these cash flows to arrive at a present value of the security. However, for other assets such as commodities, currencies and futures, which do not have underlying income streams or financial statements, technical analysis is the only form of analysis possible. 2.2 Technical and Fundamental Analysis Technical and fundamental analyses approach the market in different ways but are both useful. Key differences between the two are listed below: Technicians focus solely on analyzing markets and the trading of financial instruments. Fundamental analysis on the other hand, focuses on financial and economic analysis as well as societal and political trends analysis. Technical analysis is based on price and volume data, while fundamental analysts incorporate external market data with company s financial statements to predict security price movements. It is important to note that company s financial statements are often subjective while price and volume data are objective. Fundamental analysis is considered a more theoretical approach, while technical analysis is considered a more practical approach. Copyright Irfanullah Financial Training. All rights reserved. Page 4

5 Drawbacks of technical analysis are: Technicians are limited to studying market movements and do not use other predictive analytical methods. Market movements and trends may take some time to become evident. Therefore, technicians may be late in identifying changes in trends and patterns. In illiquid markets and markets that are subject to large outside manipulation (such as actions of central banks), the application of technical analysis is limited. 3. Technical Analysis Tools The primary tools used in technical analysis are charts and indicators. These are discussed in detail in the following sections: 3.1 Charts Charts provide information about past price behavior and provide a basis for inferring likely future price behavior. We will now discuss the various types of charts used in technical analysis Line Chart Line charts are a simple graphic display of price trends over time. Usually, the chart is a plot of data points, such as share price, with a line connecting these points. The vertical axis (y axis) represents price level and the horizontal axis (x axis) is time. An example of a line chart is shown below: Copyright Irfanullah Financial Training. All rights reserved. Page 5

6 3.1.2 Bar Chart A line chart has one data point per time interval. A bar chart, in contrast, has four bits of data in each entry. These are the high and low price encountered during the time interval and the opening and closing prices. Such charts are customarily constructed from daily data. An example of a bar chart is shown in the figure below: Bar Chart Notation: The figure on the left shows how the data point for each interval is constructed. A vertical line connects the high and low price for the day. A cross-hatch to the right indicates the closing price, and a cross-hatch to the left indicates the opening price. The bar chart is useful to quickly get an idea of the nature of the day s trading. A short bar indicates little price movement while a long bar indicates a wide divergence between the high and the low for the day Candlestick Chart. A candlestick chart also provides four prices per data entry point: the opening and closing price and the high and low prices during the period. These are reflected in the shape of a candle for each data point as shown below. Copyright Irfanullah Financial Training. All rights reserved. Page 6

7 Each candle has two elements the wick/shadow and the body. The line extending from the top and bottom is known as the wick or shadow and represents the range through which the security price traveled during the period. The body of the candle is either white or shaded. A white body means that the opening price was lower than the closing price i.e. the market closed up. A shaded body means that the opening price was greater than the closing price i.e. market closed down. An example of a candlestick chart is shown below: An advantage of the candlestick chart over the bar chart is that price moves are much more visible which allows for faster analysis Point and Figure Chart A point and figure chart is drawn on a grid and consists of columns of X s alternating with columns of O s. X represents an increase in price while an O represents a decrease in price. Copyright Irfanullah Financial Training. All rights reserved. Page 7

8 Neither time nor volume is represented on this chart. Instead, the focus is on change in prices. The horizontal axis represents the number of price changes while the vertical axis measures discrete increments in price, for example, an analyst can construct a chart with a price increment of US$1 or 1. An example of a point and figure chart is given below: The following steps need to be followed in order to construct a point and figure chart: Analyst must first determine the box size. Box size refers to the change in price represented by the height of each box. For example, an entry will be made only if the stock price increases or decreases by $1. Next, the analyst must determine the reversal size. If there are no significant changes in the stock price, the analyst stays in the same column. Only if there is a substantial reversal, the analyst moves to another column. The reversal size is used to define the significant change and to determine when to create a new column. For example, if the reversal size is 3, a new column will be created only where there is a reversal in price of three or more boxes. A technician fills in a box with X every time the security price closes up by the amount of the box size. If the price increases by twice the box size, the technician fills in two boxes, one on top of the other. If the price does not increase by at least the box size, no indication is made on the chart. For price decreases, a technician uses the reversal size to determine when to make an indication on the chart. If our reversal size is 3, the box size is $1, and there is a price decline of $3, then the technician will shift to the next column and begin a column of O s. Copyright Irfanullah Financial Training. All rights reserved. Page 8

9 Point and figure charts are particularly useful for making trading decisions because they clearly illustrate price levels that may signal the end of a decline or advance Scale For any chart (line, bar or candlestick) the vertical axis can be constructed using either a linear scale or a logarithmic scale. With a logarithmic scale, equal vertical distances on the chart correspond to an equal percentage change. It is appropriate if the data move through a range of values (e.g. from 10 to 10,000). Logarithmic Scale In contrast, a linear scale is appropriate if the data has a narrow range (e.g. prices from $40 to $100). For both types of charts the horizontal axis shows the passage of time Volume and Time Intervals If volume and price are both increasing during a time frame, technicians consider this positive and the two indicators are said to confirm each other. The signal would be interpreted to mean that over time, more and more investors are buying the security and are doing so at higher and higher prices. Charts can be constructed using any time interval. For short-term trading, analysts can create charts with time intervals of one-minute or shorter intervals. For long-term investing, the analyst can use weekly, monthly or even annual intervals. Copyright Irfanullah Financial Training. All rights reserved. Page 9

10 3.1.8 Relative Strength Analysis Relative strength analysis is used to compare the performance of a particular asset, such as common stock, with that of some benchmark or the performance of another security. Typically, the analyst prepares a line chart of the ratio of the two prices, with the asset under analysis as the numerator and with the benchmark or other security as the denominator. A rising line shows that the asset is performing better than the benchmark; a declining line shows the opposite. A flat line shows neutral performance. 3.2 Trend Trend analysis is based on the observation that market participants tend to act in herds and that trends tend to stay in place for some time. A security can be considered to be in an upward, downward, sideways, or no apparent trend. An uptrend for a security is when the price goes to higher highs and higher lows. This means that when the security s price is increasing, each subsequent new high is higher than the prior high. Each time there is a retracement, which is a reversal in the movement of the security s price, it must stop at a higher low than the prior lows in the trend period. To draw an uptrend line, a technician draws a line connecting the lows of the price chart. A downtrend is when a security makes lower lows and lower highs. As the security moves down in price, each subsequent new high must be lower than the prior high and each time there is a retracement, it must stop at a lower low than the prior lows in the trend period. To draw a downtrend line, a technician draws a line connecting the highs of the price chart. A security may trade in a fairly narrow range, moving sideways on the price chart without much upward or downward movement. This pattern indicates a relative balance between supply and demand. The figure below shows examples of uptrends and downtrends. Copyright Irfanullah Financial Training. All rights reserved. Page 10

11 Three concepts related to trend are support, resistance and polarity. Support: It is defined as a low price range in which buying activity is sufficient to stop the decline in price. Resistance: It is defined as a price range in which selling activity is sufficient to stop the rise in price. Polarity: The change in polarity principle states that once a support level is breached, it becomes a resistance level. The same holds true for resistance levels; once breached, it becomes the support level. For example, if the price of a security never rises above a certain level over a long period of time and begins to decline each time it reaches this level, but then finally breaks through this level by a significant amount, the new point to which the price rises becomes a support level. Support and resistance levels are commonly round numbers. The fact that these price points tend to be round numbers strongly suggests that human sentiment is at work. 3.3 Chart Patterns Chart patterns are formations that create a recognizable shape; common patterns appear repeatedly and lead to similar subsequent price movements. The repeating patterns can be used as a basis for market forecasting. This is because the patterns are graphic representations of human trading activity and human behavior is frequently repeated. Copyright Irfanullah Financial Training. All rights reserved. Page 11

12 Chart patterns can be divided into two categories reversal patterns and continuation patterns Reversal Patterns A reversal pattern signals the end of a trend, a change in direction of the financial instrument s price. We now discuss four kinds of reversal patterns: Head and Shoulders Pattern This is one of the most widely recognized reversal patterns. For this pattern, the prior trend must be an uptrend. This pattern consists of three segments: the left shoulder, the head, and the right shoulder. The graph below illustrates a head and shoulders pattern. Rarely will an analyst see a perfectly formed head and shoulders pattern. What is important is that the head should rise to a higher price level than either shoulder. The neckline, usually a horizontal line, is the price level at which the left shoulder begins and ends. However, the neckline may not always be a horizontal line Inverse Head and Shoulders Pattern The head and shoulders pattern can also form upside down and act as a reversal pattern for a preceding downtrend. It also has three parts: the left shoulder, head and right shoulder. An example of an inverse head and shoulders pattern is shown in the figure below: Copyright Irfanullah Financial Training. All rights reserved. Page 12

13 Setting Price Targets with Head and Shoulders Pattern The head and shoulders pattern is a bearish indicator and a technician would expect to profit by shorting the security under analysis. For this purpose, the technician will set a price target based on the head and neckline. The price target is: Price Target = Neckline (Head Neckline) Setting Price Targets with Inverse Head and Shoulders Pattern The inverse head and shoulders pattern is a bullish indicator because the pattern predicts the end of a downtrend. In this case, the technician needs to calculate how high the price is expected to rise once it breaches the neckline. This price target can be calculated by using the following formula: Price Target = Neckline + (Neckline Head) Double Tops and Bottoms A double top is when an uptrend reverses twice at roughly the same high price level. Typically, volume is lower on the second high than on the first high, signaling a diminishing of demand. Price targets can be calculated for this pattern in a manner similar to the head and shoulders pattern i.e. Price Target = Neckline (Head Neckline) A double bottom is formed when the price reaches a low, rebounds and then sells off back to the first low level. This is shown in the figure below: Copyright Irfanullah Financial Training. All rights reserved. Page 13

14 Technicians use a double bottom to predict a change from a downward trend to an upward trend in security prices Triple Tops and Bottoms Triple tops consist of three peaks at roughly the same price level, and triple bottoms consist of three troughs at roughly the same price level. An example of a triple top pattern is shown in the figure below: One of the challenges in double-top and triple-top patterns is that an analyst cannot know which pattern will result until after the fact. Moreover, traders have no way to determine whether a double top or bottom will be followed by a third top or bottom Continuation Patterns A continuation pattern is used to predict the resumption of a market trend that was in place prior to the formation of a pattern. From a supply and demand standpoint, a continuation pattern indicates a change in ownership from one group of investors to another. The thought process here is that the fundamental economics doesn't change; the stock's demand simply moves from one set of investors to another. We now discuss some common types of continuation patterns. Copyright Irfanullah Financial Training. All rights reserved. Page 14

15 Triangles Triangle patterns are a type of continuation patterns and come in three forms: symmetrical triangles, ascending triangles and descending triangles. In a triangle, a trendline connects the highs and a trendline connects the lows. As the distance between the highs and lows narrows, the trendlines meet, forming a triangle. In an ascending triangle, the trendline connecting the high prices is horizontal and the trendline connecting the low prices forms an uptrend. What this pattern means is that market participants are selling the stock at the same price level over a period of time, but that buyers are getting more and more bullish and buying at increasingly high prices. This is shown in the figure below: In a descending triangle, the low prices form a horizontal trendline and the high prices form a series of lower and lower highs. This pattern means that buyers appear with enough demand to halt sell-offs each time they occur, at around the same price. An example of a descending triangle is shown in the figure below: In a symmetrical triangle, the trendline formed by the highs angles down and the trendline formed by the lows angles up, both at roughly the same angle, forming a symmetrical pattern. Copyright Irfanullah Financial Training. All rights reserved. Page 15

16 This triangle indicates that buyers are becoming more bullish while, simultaneously, sellers are becoming more bearish, so they are moving toward a point of consensus. This is illustrated in the figure below: The difference in price from the two trendlines at the start of the triangle is known as measuring implication. This is shown as the thick black line in the figure above Rectangle Patterns A rectangle is a continuation pattern formed by two parallel trendlines, one formed by connecting the high prices during the pattern, and the other formed by the lows. The figure below shows two examples of rectangle patterns - one bullish and one bearish pattern. The horizontal resistance line that forms the top of the rectangle shows that investors are repeatedly selling shares at a specific price level, bringing rallies to an end. The horizontal Copyright Irfanullah Financial Training. All rights reserved. Page 16

17 support line that forms the bottom of the rectangle indicates that traders are repeatedly making large enough purchases at the same price level to reverse declines Flags and Pennants Flags and pennants are considered minor continuation patterns because they form over short periods of time on a daily price chart and typically over a week. A flag is formed by parallel trendlines, in the same way that most countries flags are rectangular and create a parallelogram. A pennant formation is similar except the trend lines converge to form a triangle, similar to the pennants of many sports teams. The key difference between a triangle and pennant is that a pennant is a short term formation whereas a triangle is a long-term formation. The expectation for both flags and pennants is that the trend will continue after the pattern in the same direction it was going prior to the pattern. 3.4 Technical Indicators A technical indicator is a measure based on price, market sentiment, or funds flow that can be used to predict changes in price. There are four kinds of technical indicators that we will discuss; price-based indicators, momentum oscillators, sentiment indicators and flow-of-funds indicators Price-based Indicators These indicators incorporate information contained in the current and past history of market prices Moving Average A moving average is the average of the closing price of a security over a specified number of periods. Moving averages smooth out short-term price fluctuations, giving the technician a clearer image of market trend. A simple moving average is where each price is weighted equally in the calculation of the average price. An exponential moving average gives the greatest weight to recent prices while exponentially less weight to older prices. Copyright Irfanullah Financial Training. All rights reserved. Page 17

18 Two or more moving averages can be used in conjunction. Investors often use moving average crossovers as a buy or sell signal. When a short-term moving average crosses from underneath a longer-term average, this movement is considered bullish and is known as a golden cross. When a short-term moving average crosses from above a longer-term average, this movement is considered bearish and is known as a dead cross. Moving averages are easy to construct, and simple trading rules can be derived for using them Bollinger Bands Bollinger bands consist of a moving average plus a higher line representing a set number of standard deviations and a lower line representing a set number of standard deviations. The figure below shows a Bollinger band and a moving average. The more volatile the security becomes, the wider the range becomes between the two outer lines or bands. A common use of a Bollinger band is to create trading strategies such as a contrarian strategy. In this strategy, an investor sells when a security price reaches the upper band and buys when it reaches the lower band. Copyright Irfanullah Financial Training. All rights reserved. Page 18

19 3.4.2 Momentum Oscillators Momentum oscillators help determine whether change in market sentiment is out of the ordinary. They are indicators based on market prices and are calculated so that they oscillate around a given value or between two values. Extreme highs or lows are easily discernible due to this construction. Technicians also look for convergence or divergence between oscillators and price. Convergence is when the oscillator moves in the same manner as the security being analyzed and it suggests the price trend will continue. Divergence is when the oscillator moves differently from the security and implies a change in price trend. Oscillators also alert a trader to overbought or oversold conditions. In an overbought condition, market sentiment is unsustainably bullish. In an oversold condition, market sentiment is unsustainably bearish. Oscillators have three main uses: They can be used to determine the strength of a trend. When oscillators reach historically high or low levels, they may be signaling a pending trend reversal. In a non-trending market, oscillators can be used for short-term trading decisions i.e. to sell at overbought levels and buy at oversold levels. We now discuss four types of momentum oscillators: 1. rate of change oscillator 2. relative strength index 3. stochastic oscillator 4. moving-average convergence/divergence oscillator. The ROC oscillator is calculated by using the following formula: M = 100 * (V Vx) Copyright Irfanullah Financial Training. All rights reserved. Page 19

20 where M = momentum oscillator (ROC) value V = last closing price Vx = closing price x days ago, typically 10 days When the ROC oscillator crosses zero in the same direction as the direction of the trend, this movement is considered a buy or sell signal. For example, if the ROC oscillator crosses into positive territory during an uptrend this is a buy signal. If the ROC oscillator crosses into negative territory during a downtrend this is a sell signal. An alternative method of constructing this oscillator is to set it so that it oscillates above and below 100, instead of 0, by using the following formula: M = 100 * (V / Vx) The Relative Strength Index (RSI) is computed over a rolling time period and graphically compares a security s gains with its losses over the set period. The recommended time period is 14 days. RSI is a momentum oscillator and should not be confused with the charting method called relative strength analysis. The RSI provides information on whether or not an asset is overbought. An example of a RSI oscillator is given below: The formula for RSI is: RSI = /(1 + RS) where RS = Summation of up changes for the period / Summation of down changes for the period Copyright Irfanullah Financial Training. All rights reserved. Page 20

21 The value of the RSI, using this formula, has always been 0 and 100. A value above 70 represents an overbought situation while a value below 30 suggests that an asset is oversold. It usually stays in the range but for less volatile stocks it may trade in a much narrower range. Similarly, more volatile stocks may trade in a much wider range. The stochastic oscillator is based on the observation that in uptrends, prices tend to close at or near the high end of their range and in downtrends, they tend to close near the low end. The stochastic oscillator oscillates between 0 and 100 and has a default setting for a 14-day period. The oscillator is composed of two lines, called %K and %D. These are calculated as follows: %K = 100 * (C L14) / (H14 L14) and %D = Average of last 3 daily %Ks where: C = latest closing price, L14 = lowest price in the last 14 days, H14 = highest price in the last 14 days. %D can be considered similar to a long-term moving average. It is a slower moving, smoothing line and is also called the signal line. The %K is the faster moving line. The %K value means that the latest closing price (C) was in the %K percentile of the high-low range (L14 to H14). A value of the oscillator above 80 represents an oversold situation while a value below 20 suggests that an asset is overbought. The MACD is the difference between a short-term and a long-term moving average of the security s price. The MACD is constructed by calculating two lines: (i) the MACD line (difference between two exponentially smoothed moving averages, generally 12 and 26 days) Copyright Irfanullah Financial Training. All rights reserved. Page 21

22 (ii) the signal line (exponentially smoothed average of MACD line, generally 9 days) The indicator oscillates around 0 and has no upper or lower limit. Rather than using a set overbought-oversold range for MACD, the analyst compares the current level with the historical performance of the oscillator for a particular security to determine when a security is out of its normal sentiment range. MACD is used in technical analysis in three ways: Crossovers of the MACD line and the signal line indicate a change in trend. Look for times when the MACD is outside its normal range for a given security Use of the trendlines on the MACD. When the MACD is trending in the same direction as the price, this pattern is convergence. When the MACD and price are trending in opposite directions, the pattern is divergence. The figure below shows an example of a MACD oscillator Sentiment Indicators Sentiment indicators gauge investor activity for signs of increasing bullishness or bearishness. They come in two forms investor polls and calculated statistical indices Opinion Polls Periodic polls are conducted of either individual investors or investment professionals to gauge their sentiment about the equity market. By regularly polling, these services provide technicians with a snapshot of investor sentiment over time. Copyright Irfanullah Financial Training. All rights reserved. Page 22

23 Calculated Statistical Indices These are indicators calculated from market data, such as security prices. The two most commonly used are the put/call ratio and the volatility index. The put/call ratio is the volume of put options traded divided by the volume of call options traded for a particular financial instrument. Investors who buy put options are presumably bearish and investors who buy call options are presumably bullish. Therefore, the ratio is considered to be a contrarian indicator because higher values are considered bearish and lower values are considered bullish. The CBOE Volatility Index (VIX) is a measure of near-term market volatility calculated by the Chicago Board Options Exchange. The VIX rises when market participants become fearful of an impending market decline. High volatility suggests that investors fear a decline. Margin debt is often used as an indication of sentiment. When the market is rising and indices reach new highs, investors are motivated to buy more equities in the hopes of participating in the market rally. A margin account permits an investor to borrow part of the investment cost from the brokerage firm. This debt magnifies the gains or losses arising from the investment. Hence, when stock margin debt is increasing, investors are aggressively buying and the stock prices will rise because of increased demand. When margin traders use all of their available credit, buying power decreases which fuels a price decline. Short interest is another sentiment indicator. Investors sell shares short when they believe the share price will decline. The number of shares of a particular security that are currently sold Copyright Irfanullah Financial Training. All rights reserved. Page 23

24 short is called short interest. The short interest ratio represents the number of days of trading activity represented by short interest. It is calculated as: Short interest ratio = Short Interest / Average Daily Trading Volume Some people believe that if the short interest ratio is high, the market should expect a falling price for the shares because of so much negative sentiment about them. On the other hand, some people believe that since the security has been shorted already, the short seller s next action will be to buy shares back to cover their short positions. This will boost the share price Flow-of-Funds Indicators Technicians look at fund flows to gauge potential supply and demand for equities. The Arms Index (also known as TRIN) is applied to a broad market to measure the relative extent to which money is moving into or out of rising and declining stocks. The index is a ratio of two ratios: Arms Index = Number of advancing issues Number of declining issues Volume of advancing issues Volume of declining Issues When this index is near 1, the market is in balance. A value above 1 means that there is more volume in declining stocks and that the market is in a selling mood. A value below 1 means that there is more volume in increasing stocks and that the market is in a buying mood. Margin debt is also used as a flow-of-funds indicator because margin loans may increase the purchases of stocks and declining margin balances may force the selling of stocks. Mutual Funds Cash Position: Mutual funds must hold some of their assets in cash in order to pay bills and send redemption checks to account holders. Cash increases when a fund manager sells a position and holds the funds before reinvesting them. During a bullish market, the manager wants to buy shares as quickly as possible to avoid cash drag hurt the fund s Copyright Irfanullah Financial Training. All rights reserved. Page 24

25 performance. If prices are trending lower, however, the manager may hold funds in order to improve the fund s performance. When the mutual funds cash position is low, fund managers have already bought, and the effects of their purchases are reflected in security prices. When the cash position is high, however, that money represents buying power that will move prices higher when the money is used to add positions to the portfolio. New Equity Issuance: The new equity issuance indicator suggests that as the number of initial public offerings (IPOs) increases, the upward price trend may be about to turn down. The investment community has a finite quantity of cash to spend, so an increase in IPOs may be considered a bearish indicator. Secondary Offerings: Technicians also monitor secondary offerings to gauge potential changes in supply of equities. Although secondary offerings do not increase the supply of shares, they do increase the supply available for trading or the float. 3.5 Cycles Technicians use various cycles to predict future movements in security prices; even cycles in fields such as astronomy and climate can influence the economy and hence capital markets. Commonly referenced cycles are discussed below. Kondratieff Wave: This is the longest of the widely recognized cycles, discovered by Nikolai Kondratieff in the 1920s. He suggested that Western economies have a 54-year old cycle. This cycle is known as the Kondratieff Wave or K Wave. 18-year Cycle: Three 18-year cycles make up the longer 54-year Kondratieff Wave. The 18-year cycle is most often mentioned in connection with real estate prices, but it can also be found in equities and other markets. Copyright Irfanullah Financial Training. All rights reserved. Page 25

26 Decennial Pattern: This pattern connects average stock market returns with the last digit of the year. Years ending in 0 have shown poor performance while years ending in 5 have shown good performance. Presidential Cycle: This cycle in the United States connects the performance of the market with presidential elections. In this theory, the third year following an election shows the best performance. 4. Elliot Wave Theory According to this theory, the market moves in regular, repeated waves or cycles. It describes how the market moves in patterns of five waves in a bull market in the following pattern: 1 = up, 2 = down, 3 = up, 4 = down and 5 = up. This wave is known as the impulse wave. Each wave can be broken into smaller and smaller sub-waves. A basic Elliott wave is shown in the figure below. It is important to note that the market waves follow patterns that are ratios of the numbers in the Fibonacci sequence. The Fibonacci sequence starts with the numbers 0, 1, 1 and then each subsequent number is the sum of the two preceding numbers. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34 It was found that the ratio of size of subsequent waves is generally a Fibonacci ratio: 1/2, 2/3, 3/5, 5/8, 8/13 Copyright Irfanullah Financial Training. All rights reserved. Page 26

27 The Elliott Wave Theory can be used in both very short-term trading as well as in very long-term economic analysis. 5. Inter-market Analysis Inter-market analysis is based on the principle that all markets are interrelated and influence each other. In this, technicians look for inflection point in one market as a warning sign to start looking for a change in another related market. To identify these inter-market relationships, a commonly used tool is the relative strength analysis. The relative strength analysis can also be used to identify the strongest performing securities in a sector and to identify the sectors of the equity market to invest in. Lastly, observations based on inter-market analysis can also help in allocating funds across securities from different countries. Summary (Note: This summary has been taken from the curriculum.) Technical analysis is a form of security analysis that uses price and volume market data, often graphically displayed. Technical analysis can be used for any freely traded security in the global market and is used on a wide range of financial instruments, such as equities, bonds, commodity futures, and currency futures. Technical analysis is the study of market trends or patterns and relies on recognition of patterns that have worked in the past in an attempt to predict future security prices. Technicians believe that market trends and patterns repeat themselves and are somewhat predictable because human behavior tends to repeat itself and is somewhat predictable. Another tenet of technical analysis is that the market brings together the collective wisdom of multiple participants, weights it according to the size of the trades they make, and allows analysts to understand this collective sentiment. Technical analysis relies on knowledgeable Copyright Irfanullah Financial Training. All rights reserved. Page 27

28 market participants putting this knowledge to work in the market and thereby influencing prices and volume. Technical analysis and fundamental analysis are equally useful and valid, but they approach the market in different ways. Technical analysis focuses solely on analyzing markets and the trading of financial instruments, whereas fundamental analysis is a much wider ranging field encompassing financial and economic analysis as well as analysis of societal and political trends. Technical analysis relies primarily on information gathered from market participants that is expressed through the interaction of price and volume. Fundamental analysis relies on information that is external to the market (e.g., economic data, company financial information) in an attempt to evaluate a security s value relative to its current price. The usefulness of technical analysis is diminished by any constraints on the security being freely traded, by large outside manipulation of the market, and in illiquid markets. Charts provide information about past price behavior and provide a basis for inferences about likely future price behavior. Various types of charts can be useful in studying the markets: line charts, bar charts, candlestick charts, and point and figure charts. Relative strength analysis is based on the ratio of the prices of a security to a benchmark and is used to compare the performance of one asset with the performance of another asset. Many technicians consider volume information to be very important and watch for the confirmation in volume of a price trend or the divergence of volume from a price trend. The concept of trend is perhaps the most important aspect of technical analysis. An uptrend is defined as a security making higher highs and higher lows. To draw an uptrend line, a technician draws a line connecting the lows of the price chart. A downtrend is defined as a security making lower highs and lower lows. To draw a downtrend line, a technician draws a line connecting the highs of the price chart. Copyright Irfanullah Financial Training. All rights reserved. Page 28

29 Support is defined as a low price range in which the price stops declining because of buying activity. It is the opposite of resistance, which is a price range in which price stops rising because of selling activity. Chart patterns are formations appearing in price charts that create some type of recognizable shape. Reversal patterns signal the end of a trend. Common reversal patterns are the head and shoulders, the inverse head and shoulders, double tops and bottoms, and triple tops and bottoms. Continuation patterns indicate that a market trend in place prior to the pattern formation will continue once the pattern is completed. Common continuation patterns are triangles, rectangles, flags, and pennants. Price-based indicators incorporate information contained in market prices. Common pricebased indicators are the moving average and Bollinger Bands. Momentum oscillator indicators are constructed from price data, but they are calculated so that they fluctuate either between a high and low, typically 0 and 100, or around 0 or 100. Some examples are momentum (or rate of change) oscillators, the RSI, stochastic measures, and MACD. Sentiment indicators attempt to gauge investor activity for signs of increasing bullishness or bearishness. Sentiment indicators come in two forms -- investor polls and calculated statistical indices. Opinion polls to gauge investors sentiment toward the equity market are conducted by a variety of services. Commonly used calculated statistical indices are the put/call ratio, the VIX, margin debt, and the short interest ratio. Flow-of-funds indicators help technicians gauge potential changes in supply and demand for securities. Some commonly used indicators are the ARMS Index (also called the TRIN), margin debt (also a sentiment indicator), mutual fund cash positions, new equity issuance, and secondary equity offerings. Copyright Irfanullah Financial Training. All rights reserved. Page 29

30 Many technicians use various observed cycles to predict future movements in security prices; these cycles include Kondratieff waves, decennial patterns, and the U.S. presidential cycle. Elliott Wave Theory is an approach to market forecasting that assumes that markets form repetitive wave patterns, which are themselves composed of smaller and smaller subwaves. The relationships among wave heights are frequently Fibonacci ratios. Intermarket analysis is based on the principle that all markets are interrelated and influence each other. This approach involves the use of relative strength analysis for different groups of securities (e.g., stocks versus bonds, sectors in an economy, and securities from different countries) to make allocation decisions. Next Steps Work through the examples presented in the curriculum. Solve the practice problems in the curriculum. Solve the IFT Practice Questions associated with this reading. Review the learning outcomes presented in the curriculum. Make sure that you can perform the implied actions. Copyright Irfanullah Financial Training. All rights reserved. Page 30