Introduction

 This class session will cover the following aspects of technical analysis:
 General background and definition
 Underlying assumptions
 Challenges to technical analysis
 Basic charts
 Background to trend analysis
 Dow theory
 Lagging vs. Leading indicators
 Line studies
 Market indicators
 General background and definition
 DEF: Technical analysis is the study of financial market action.
 Technical analysts examine the price action of the financial
markets instead of the fundamental factors that (seem to)
effect market prices.
 A chart is a mirror of the mood of the crowd and not of the
fundamental factors.
 Thus, technical analysis is the analysis of human mass
psychology. Therefore, it is also called behavioral finance.
General assumptions
Market
discounts
all
information

Assumptions

History
repeats Trends exist
itself
 General assumptions
 In order to achieve abnormal profits, technicians make the
following assumptions:
 Market value is based purely on supply and demand
 Supply and demand is governed by numerous factors, both
rational and irrational
 Disregarding minor fluctuations in the market, share prices
tend to move in trends which persist for an appreciable length
of time
 Changes in trends are caused by shifts in demand and supply
 Challenges to technical analysis
 Are abnormal profits possible on a continuous basis?
 Park & Irwin (2004) conducted a review of the profitability of
technical analysis;
 More than 130 empirical studies were reviewed over 4
decades:
 Found consistent evidence that simple technical trading
strategies were profitable in a variety of speculative markets
at least until the early 1990s.
 Challenges to technical analysis
 Why did profitability deteriorate during the 1990s?
 Level of market efficiency improved over time.
 Rather the ease of information flow – quicker reaction.
 So why do we still use technical analysis?
 Survey studies indicate that technical analysis has been widely used by
practitioners in futures markets and foreign exchange markets, and regarded
as an important factor in determining price movements at shorter time
horizons.
 Arguably most important reason – the herd effect!
The basics
 Basic charts
 Line charts
 Line charts are the simplest type of chart and shows the price of a share in
a continuous line (usually closing prices)
 Basic charts
 Bar charts
 Bar charts are more complex, but reveals more information including the:
 Open, high, low and closing prices - as well as the direction of the day’s
price movement
 Basic charts
 Japanese candle sticks
 Japanese candle sticks are also complex, but reveals the complete picture
of the day’s price movement:
 Open, high, low and close – as well as the direction of the day’s price
movement
 Volume
 Rules for interpreting volume
 If price and volume are moving in the same direction, the price trend will
continue. If they are running counter to each other, the trend will reverse.
 The fact the volume increase during an increase in the price is normal.
 Volume normally leads prices.
 Rising prices and falling volume is abnormal and indicates a weak rally.
 A parabolic rise in the price and a sharp increase in volume is unsustainable,
leading to an exhaustion move.
 A parabolic fall in the price and a sharp decrease in volume is unsustainable,
leading to a selling climax.
 When prices test an important low while volume is lower, it signifies a swing in
the price.
 An expansion of volume after a price peak indicates a bearish signal.
Volume
 Trend analysis
 Trends
 A trend represents a consistent change in prices
 BULL Trend
 A series of consistent price changes where higher highs and higher lows are
formed;
 BEAR Trend
 A series of consistent price changes where lower highs and lower lows are
formed.
Bull trend
Bear trend
 Trend theory – Dow Theory
 Interpretation and assumptions
 The averages discount everything
 The market is made up of three trends:
 Primary trends – bullish/bearish (lasts more than 1 year)
 Primary bull trends have 3 phases
 Phase 1 – aggressive buying
 Phase 2 – increased corporate earnings and improved economic conditions
 Phase 3 - record corporate earnings and peak economic conditions
 Secondary trends – corrections to primary trend
 Minor trends – short-term lasting 1 – 21 days
 Other key points
 The averages over sectors must confirm the trend
 The volume must confirm the trend
 A trends remains intact until a reversal is indicated
Trend theory – Dow Theory
Trending vs. Trading
 Trending vs. Trading prices
 Taking into account the assumptions of technical analysis:
 accurate technical analysis is dependent on whether the market is in a
trending or trading;
 different technical indicators were designed to function better in different
market conditions;
 Identifying the current type of primary market is simplified by
means of technical indicators specifically developed for this
purpose.
Trending prices
Trading prices
 Market type indicators
 Aroon indicator extremes interpretation:
 Market type indicators
 DMI by means of Average Directional Movement Index (ADX)
interpretation:
 Market type indicators
 Chande Momentum Oscillator (CMO) interpretation:
Lagging vs. Leading
 Lagging indicators
 Lagging technical indicators NOT to be confused with economic lagging
indicators: (change after the economy changes) such as:
 Change in GDP;
 Unemployment;

 Technical Lagging indicators – warns the trader regarding serious trend

reversals
 Statistically better suited to identify buying/selling signals in trending
markets
 Examples include:
 MAs
 MACD
 Lagging indicators - MA
 Moving Averages
 Def: the average price of a security at a given time
 Simple moving average (SMA)
 Exponential moving average (EMA)
 Interpreting moving averages
 Price vs. MA
 Merits of using MAs
Lagging indicators - MA
Lagging indicators - MA
 Lagging indicators - MACD
 Moving Average Convergence/Divergence (MACD)
 MACD measures the difference between two Exponential
Moving Averages (EMAs).
 Signal line = EMA(9) of MACD
Lagging indicators - MACD
Lagging indicators - MACD
 Leading indicators
 Leading technical indicators NOT to be confused with economic leading indicators:
(change before the economy changes) such as:
 Building plans approved;
 New passenger vehicles sold;

 Technical Leading indicators – indicates short-term overbought/oversold

circumstances
 Statistically better suited to identify buying/selling signals in trading markets
 Examples include:
 RSI
 Stochastics
 Leading indicator - RSI
 Relative Strength Index (RSI)
 Determines the internal strength of a single security
 Compares the magnitude of a stock's recent gains to the
magnitude of its recent losses and turns that information into a
number that ranges from 0 to 100
 Leading indicator - RSI

Overbought (sell signal)

Centreline

Oversold (buy signal)

Leading indicator - RSI
 Leading indicators - STOCH
 Stochastics
 Stochastic Oscillator is a momentum indicator that shows the location of
the current close relative to the high/low range over a set number of
periods.
 Closing levels that are consistently near the top of the range indicate
accumulation (buying pressure) and,
 Those near the bottom of the range indicate distribution (selling pressure).
 A 14-day %K (14-period Stochastic Oscillator) would use the most recent close, the highest high
over the last 14 days and the lowest low over the last 14 days.
 Number of periods will vary according to the sensitivity and the type of signals desired.
 As with RSI, 14 is a popular number of periods for calculation.
 Because %K is a percentage or ratio, it will fluctuate between 0 and 100.
 A 3-day simple moving average of %K is usually plotted alongside to act as a signal or trigger line,
called %D (dotted line).
Leading indicators - STOCH

Overbought

Oversold
LINE STUDIES
 LINE STUDIES
 Support and resistance
 Bull and bear channels
 Triangles – rising and falling
 Flags – rising and falling
 Wedges – rising and falling
LINE STUDIES - SUPPORT
LINE STUDIES - SUPPORT
LINE STUDIES - RESISTANCE
LINE STUDIES - RESISTANCE
LINE STUDIES – Bull & Bear channel
LINE STUDIES – Rising & Falling triangle
LINE STUDIES – Rising & Falling flag
LINE STUDIES – Rising & Falling wedge
LINE STUDIES – Head & Shoulders
LINE STUDIES – Fibonacci
LINE STUDIES – Fibonacci
Structured process
 Structured technical trading
1. Determine the primary/secondary trend:
 Trending market (lagging indicators – e.g. MAs & MACD)
 Trading market (leading indicators – e.g. RSI & Stoch)
2. Select the right type of indicator for the specific market identified
3. Look for indicator “triggers” / line study breakouts
4. Look for conformation in other indicators
5. Confirm timing through shorter time period
6. Money management
 Stop Loss
 Stop Profit
 Size of exposure
Class exercise
Thank you