Investment Theory - Technical Analysis
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Technical Analysis Copyright 1996-2006 Investment Analytics
Copyright © 1996 – 2006 Investment Analytics
Slide: 1
Technical Analysis ¾
Technical Analysis: Study of past market action to forecast prices Looks for patterns in historical data
Copyright © 1996 – 2006 Investment Analytics
Slide: 2
Technical Analysis Tools Charting ¾ Gann ¾ Elliot Wave ¾ Cycle Theory ¾ Oscillators & Indicators ¾ Japanese Candlesticks ¾ Market Profile ¾ Computerized Trading Systems ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 3
Classical Charting Trend Lines ¾ Support/Resistance ¾ Continuation Patterns ¾ Reversal Patterns ¾ Gaps & Spikes ¾ Moving Averages ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 4
Trends ¾
Trend Direction
• Uptrend: higher highs, higher lows ¾
Downtrend: lower lows, lower highs
Trend timeframe: • 3 Trends: (e.g. weekly, daily, hourly)
¾
Main technical analysis tools: • Trend Lines • Moving Averages
Copyright © 1996 – 2006 Investment Analytics
Slide: 5
Trendlines ¾
Drawing Trendlines: • Connect highs to highs, lows to lows • Draw through congestion areas • Ignore ‘tails’ or ‘spikes’
¾
Trends are stronger . . . . • The longer the trendline • The more contacts between prices and the trendline • When volume expands in the direction of the trend
Copyright © 1996 – 2006 Investment Analytics
Slide: 6
Trendline Examples 74
72
70
68
Trend B is more significant than trend A . . . 1. More contact points 2. Longer trendline 3. Rising volume
A
`
B
66
64
g n i s Ri
e m u Vol
62 Copyright © 1996 – 2006 Investment Analytics
Slide: 7
Trading Rules for (UP)Trends ¾
Trade only in the direction of the trend • Ignore all signals to short a bull market
¾
Wait for a pullback to the trendline to get long • Wait! If no pullback - forget it!
¾
Use a trailing stop to get aboard the trend: • As pullback nears trendline, place an order to buy on a stop one tick above previous day’s high
¾
Set protective stop • Once you are long the market • Place a stop loss order just below the trendline • Move your stop up as trend progresses
Copyright © 1996 – 2006 Investment Analytics
Slide: 8
Trading Rule Illustrated 74
72
1. 2. 3. 4.
Pullback approaches trendline at point A Order to buy on a stop, 1 tick above high at A Get stopped in at next day’s open - point B Place an order to sell on a stop at level C
70
B 68
`
C
66
64
A
62 Copyright © 1996 – 2006 Investment Analytics
Slide: 9
Trendlines Breaks Trendlines provide support & resistance ¾ Steep trendlines (over 45 degrees) precede sharp breaks ¾ A pullback to the trendline after a break is often a good shorting opportunity ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 10
Copyright © 1996 – 2006 Investment Analytics 10/19/90
09/28/90
09/07/90
08/17/90
07/27/90
07/06/90
06/15/90
360.0
05/25/90
05/04/90
04/13/90
03/23/90
03/02/90
02/09/90
01/19/90
12/29/89
12/08/89
11/17/89
10/27/89
10/06/89
09/15/89
340.0
08/25/89
08/04/89
07/14/89
06/23/89
06/02/89
05/12/89
04/21/89
310.0
03/31/89
320.0
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02/17/89
380.0
01/27/89
390.0
01/06/89
12/16/88
11/25/88
Trading Trendline Breaks
400.0
S&P 500 Futures
370.0
Selling Opportunity
350.0
Buying Opportunity
330.0
Buying Opportunity
300.0
Slide: 11
Channel Lines A line running parallel to the trendline ¾ Drawn through tops of rallies (bottoms of declines) ¾ Marks maximum power of bulls (bears) ¾ The wider the channel the stronger the trend ¾ Trading Rules: ¾
• Go long in lower quarter of channel • Take profits in upper quarter Copyright © 1996 – 2006 Investment Analytics
Slide: 12
Copyright © 1996 – 2006 Investment Analytics 10/19/90
09/28/90
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360.0
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03/02/90
02/09/90
01/19/90
12/29/89
12/08/89
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340.0
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08/04/89
07/14/89
06/23/89
06/02/89
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04/21/89
310.0
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320.0
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02/17/89
380.0
01/27/89
390.0
01/06/89
12/16/88
11/25/88
Channel Lines
400.0
Take Profits
S&P 500 Futures
370.0
Selling Opportunity
350.0
Buying Opportunity
330.0
Buying Opportunity
300.0
Slide: 13
Moving Average ¾
Shows the average price during a given time window • E.g. a 5-day MA shows the average price over the last 5 days • 20-day MA shows the average price over the last 20 days
Averages the price series to smooth out effect of extreme highs or lows ¾ Reveals underlying trend
¾
• Longer MA’s show longer term trend • Shorter MA’s react more quickly to recent prices
Copyright © 1996 – 2006 Investment Analytics
Slide: 14
Copyright © 1996 – 2006 Investment Analytics 06/25/93
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95.8
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Moving Average Example Eurodollars
95.6
95.4
95.2
95
94.8
Formula: MN(t) = (X(t)+X(t-1)+...+X(t-N+1))/N
94.4
3 per. Mov. Avg.
94
Slide: 15
Moving Average Formula Formula: MA = P1 + P2 + . . . + PN N ¾ Example: Price • Time ¾
t1 t2 t3 t4
Copyright © 1996 – 2006 Investment Analytics
17 16 19 22
3-Day MA
N/A N/A (17+16+19)/3 = 17.3 (16+19+22)/3 = 19.0
Slide: 16
Using Moving Averages in Trading ¾
As Trend Indicators • Trend direction indicated by the slope of the MA • Short, medium, or long term trend • Similar trading rules as for trendlines – trade with the MA trend – buy on pullbacks to moving average
Copyright © 1996 – 2006 Investment Analytics
Slide: 17
Donchian’s MA Crossover System ¾
Method • Plot short and long term MA on same chart • Example: 9 day MA and 21 day MA
¾
Trading Signals • Buy when short MA crosses above long MA • Sell when short MA crosses below long MA
¾
When to use: • Works well in trending markets • Loses money in whipsaw markets
¾
Optimization • You can find the ‘optimal’ short and long MA
Copyright © 1996 – 2006 Investment Analytics
Slide: 18
Example: Moving Average Crossover 105
SELL
100
95
9 Day MA 90
21 Day MA
85
80
BUY
75
BUY 70
65
Copyright © 1996 – 2006 Investment Analytics
Slide: 19
Copyright © 1996 – 2006 Investment Analytics 06/25/93
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Example: Moving Average Crossover Eurodollars Sell
Sell
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95
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Buy 3 per. Mov . Av g. 6 per Mov . Av g
94
Slide: 20
Copyright © 1996 – 2006 Investment Analytics 07/18/86
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Slide: 21
08/08/86
BUY
06/06/86
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SELL
03/14/86
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BUY
01/10/86
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11/08/85
10/18/85
SELL
09/27/85
09/06/85
08/16/85
BUY
07/26/85
07/05/85
540
06/14/85
05/24/85
05/03/85
480
04/12/85
03/22/85
03/01/85
02/08/85
01/18/85
560
12/28/84
12/07/84
11/16/84
10/26/84
10/05/84
Whipsaw Market
580
Gold Futures SELL
520
500
18 Per. Mov. Avg. 9 per. Mov. Avg.
460
440
Exponential Moving Averages Similar to simple moving average ¾ Gives more weight to recent observations ¾ Formula: EMAt = wPt + (1 - w) EMAt-1 ¾
• W is the ‘weight’ • Large w gives more weight to current price • Makes EMA more responsive • Typical w: 2/(N+1) where N is length of MA ¾
EMA is more responsive to recent trends than simple MA
Copyright © 1996 – 2006 Investment Analytics
Slide: 22
Exponential & Simple MA’s Compared 105
100
13 Day EMA 95
13 Day MA
90
85
80
75
70
65
Copyright © 1996 – 2006 Investment Analytics
Slide: 23
Lab: Self-Assessment Test Load Excel spreadsheet: technic.xls ¾ Restart test ¾ Work through trend & moving average sections ¾ MA data worksheet ¾
• Charts EMA & MA • Charts MA Crossover • Try different length MA’s for crossover system • Is there a better choice than 9 and 21 ? Copyright © 1996 – 2006 Investment Analytics
Slide: 24
Support & Resistance ¾
Support: • Price where buying power is sufficient to halt downtrend • Bears are hurting, start buying
¾
Resistance: • Price where selling power is sufficient to halt uptrend • Bulls are hurting, start selling
¾
Support & Resistance Lines • Draw horizontal lines through congestion areas • At upper and lower limits of trading range
Copyright © 1996 – 2006 Investment Analytics
Slide: 25
Copyright © 1996 – 2006 Investment Analytics 08/17/90
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400.0
02/16/90
02/02/90
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01/05/90
12/22/89
12/08/89
11/24/89
11/10/89
10/27/89
10/13/89
410.0
09/29/89
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08/04/89
Support & Resistance Lines
420.0
S&P 500 Futures
Resistance
390.0
380.0
370.0
360.0
350.0
Support
340.0
Slide: 26
Support & Resistance Levels ¾
Levels are strongest: • The longer they continue • The more contacts between prices & the level • The wider the range • The greater the volume at the level
¾
If you are riding a trend: • Tighten protective stops as prices near levels
Copyright © 1996 – 2006 Investment Analytics
Slide: 27
Support & Resistance Contrarian Trading ¾
As Prices Approach Support: • Place stop order to buy above yesterday’s high • Place protective sell stop below support • If market bounces off support you will be stopped in long
¾
As Prices Approach Resistance: • Place stop order to sell below yesterday’s low • Place protective buy stop above resistance • If market bounces off resistance you will be stopped in short
Copyright © 1996 – 2006 Investment Analytics
Slide: 28
340.0
buy
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400.0
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sell
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12/22/89
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410.0
09/29/89
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08/18/89
08/04/89
Support & Resistance Trading
420.0
S&P 500 Futures
Resistance
390.0
380.0
370.0
360.0
350.0
Support
Slide: 29
Trading Ranges ¾
NAKED (No view on volatility): • Go long at Support • Reverse & go short at Resistance
¾
GAMMA TRADE (volatility cheap/rising): • Buy Straddles or Strangles (strikes at S/R levels) • Rebalance Delta Neutral at Support/Resistance
¾
VEGA TRADE (volatility rich/falling): • Sell Straddles or Strangles, or • Sell Calls at Resistance, Sell Puts at Support • Roll up(down) or buy back options on breakout
Copyright © 1996 – 2006 Investment Analytics
Slide: 30
Gaps ¾
Occur when market is stampeded • Caused by news, panic • Breakdown of trend • Breakout of trading range • Losers dumping positions
¾
Breakaway Gap • Prices leap out of congestion area • Signifies start of new trend • Followed by several days of new highs (lows) • Usually market by high volume • Almost never gets closed by subsequent prices
Copyright © 1996 – 2006 Investment Analytics
Slide: 31
Gaps ¾
Continuation Gap • Occurs in middle of powerful trend • Accompanied by upsurge in volume • Measure distance from start of trend to gap • Gives target measured move
¾
Exhaustion Gap • Occurs towards the end of a trend • Market fails to follow through with new highs (lows) • Volume may be thin
Copyright © 1996 – 2006 Investment Analytics
Slide: 32
Gaps - Illustrated 87 87 86 86 85 85 84
Congestion Area
Breakaway Gap Sell short, with stop above rim Continuation Gap Add to shorts, with stop above rim
Distance to Continuation Gap
88
Target
Exhaustion Gap Target achieved - take profits
Copyright © 1996 – 2006 Investment Analytics
Island Reversal Slide: 33
Spikes & Tails ¾
Spikes & Tails
• Extreme price move up or down • Occurs in middle of congestion area • No follow-through • A failed ‘test’ of new trend direction • Market often reacts in opposite direction
Copyright © 1996 – 2006 Investment Analytics
Slide: 34
Continuation Patterns Bull
Bear Flag
Pennant
Volume Copyright © 1996 – 2006 Investment Analytics
Slide: 35
Triangles Bull
Bear
Descending
Ascending Symmetric
Volume Copyright © 1996 – 2006 Investment Analytics
Slide: 36
Copyright © 1996 – 2006 Investment Analytics 03/26/93
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450.0
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12/20/91
12/06/91
Example: Flag & Triangle
470.0
460.0
S&P 500
440.0
430.0
420.0
410.0
400.0
390.0
380.0
Slide: 37
Trading Continuations These are trend continuation signals ¾ Add to positions on breakout ¾ Buy (sell) stop 1 tick above pattern boundary, or ¾ Buy(sell) on close outside boundary ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 38
Reversal Patterns Indications of trend ending ¾ Most common patterns ¾
Double Tops Head & Shoulders
Price and Volume confirmation required ¾ Give indication of new price target ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 39
Copyright © 1996 – 2006 Investment Analytics 10/07/88
09/16/88
08/26/88
08/05/88
07/15/88
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620
04/01/88
500
03/11/88
Volume lower on right peak, and declining
02/19/88
01/29/88
01/08/88
12/18/87
11/27/87
560
11/06/87
10/16/87
09/25/87
09/04/87
520
08/14/87
07/24/87
07/03/87
06/12/87
05/22/87
05/01/87
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03/20/87
02/27/87
02/06/87
Double Top
640
Comex Gold Futures
600
580
Measured Move
540
Short on pullback to resistance on Big pickup in low volume volume on breakdown
480
Slide: 40
Reversal Patterns Head & Shoulders Head
Left Shoulder
Right Shoulder
N e c k li n e
D ecl in Volu ing me
Target Copyright © 1996 – 2006 Investment Analytics
Slide: 41
Trading Head & Shoulders Scale down position as pattern emerges ¾ Look for confirmation in declining volume ¾ Get short on right shoulder, with stop above head ¾ Add to short on break of neckline, with stop above neckline ¾ Add to short on pullback to neckline ¾ Place buy limit order at distance of measured move ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 42
Lab: Self Assessment Test Continue with test ¾ Worksheets: ¾
• Support & resistance • Gaps • Spikes • Continuations • Head & Shoulders
Copyright © 1996 – 2006 Investment Analytics
Slide: 43
Oscillators Measure extremes of market sentiment ¾ Oscillator: fluctuates between two extreme values ¾
• When market is overbought or oversold • Market likely to reverse
Oscillators work well in trading ranges ¾ Can also be used when market trends:
¾
• To time trades in direction of trend • Nb. must filter out trades against the trend • In trending markets oscillators can stay overbought/oversold for many periods Copyright © 1996 – 2006 Investment Analytics
Slide: 44
Classic Oscillators Momentum ¾ Stochastics ¾ Relative Strength Indicator (RSI) ¾ Williams %R ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 45
Momentum Measures trend acceleration ¾ When Trend is Up ¾
• If oscillator reaches new high, shows uptrend is continuing • When oscillator traces lower peak, shows uptrend may be weakening ¾
Formula: MN(t) = Pt - Pt-N • Pt is today’s price • Pt-N is price N days ago
¾
E.g 7 Day Momentum • Pt = 24; Price 7 days ago = 18 – 7 day Momentum = (24 - 18) = 6
Copyright © 1996 – 2006 Investment Analytics
Slide: 46
Momentum Chart 80
Double Top
75 70 65 60 55
Bearish Divergence: Sell short
50 45 10 405
BUY
0 -5 -10
Trendline break - take profits
Copyright © 1996 – 2006 Investment Analytics
Slide: 47
Momentum Trading Rules ¾
When Momentum crosses center line & ticks back up • Stock is oversold • Trend has slowed for a moment • Opportunity to get on board - Buy!
¾
Momentum is a leading indicator • Early warning of downturn in trend
¾
Apply charting techniques to the oscillator • Trendline break: take profits
Copyright © 1996 – 2006 Investment Analytics
Slide: 48
Divergence ¾
Bearish Divergence
Bullish Divergence
Prices
Prices
Oscillator
Oscillator ¾
Trading Rule: • Scale back / go short
Copyright © 1996 – 2006 Investment Analytics
Trading Rule: Scale back / go long Slide: 49
Stochastics Tracks relationship of closing price to recent HiLo range ¾ Formula: %K = Ct - Ln x 100 H n - Ln ¾ %D = 3 day sum of (Ct - Ln) x 100 3 day sum of (Hn - Ln) ¾
• Hn is the high of the last n days • Ln is the low of the last n days • Ct is today’s closing price • n = 5, or 9 is popular choice Copyright © 1996 – 2006 Investment Analytics
Slide: 50
Stochastics ¾
Stochastics fluctuates in range +/- 100 • Overbought range: 75-80 • Oversold range : 25-30
¾
Plot both %K and %D • Also plot overbought/oversold regions
¾
Sell signal: • %K, %D both in overbought region • %K crosses back down over %D
¾
Buy signal - the reverse
Copyright © 1996 – 2006 Investment Analytics
Slide: 51
Stochastics in Trading Range 115.0
110.0
Sell 105.0
100.0
Buy
95.0
100
Buy Overbought
75 90.0
50 25 0
Copyright © 1996 – 2006 Investment Analytics
Oversold
Bullish Divergence Slide: 52
Trading with Stochastics Ideal for range trading ¾ In Trends: ¾
• Tends to stay overbought/oversold for long periods • Ignore sell signals in uptrend • Wait for oversold signal on pullback to get on board • Ignore buy signals in downtrends • Wait for overbought signal on pullback to get on board
Charting: look for trendlines on the oscillator ¾ Divergence: trade same way as Momentum
¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 53
Indicators These are trend following tools ¾ Usually based on moving averages ¾ Popular indicators ¾
• MACD (Moving Average ConvergenceDivergence) • Wilder’s ADX system
Copyright © 1996 – 2006 Investment Analytics
Slide: 54
MACD Histogram ¾
A variation on the MA crossover idea: • Uses two EMA’s (12 and 26 day) • The difference between them is the fast MACD line • Calculate a 9 day EMA of the fast MACD line (the Signal) • MACD histogram = (Fast MACD - Signal) Fast MACD Signal MACD Histogram
Copyright © 1996 – 2006 Investment Analytics
Slide: 55
How to use MACD Fast MACD reflects short term consensus ¾ The signal indicates consensus over a longer period ¾ When the fast MACD rises above the signal, bulls are in control: trade from the long side ¾ When the fast MACD falls below the signal, bears are winning: trade from the short side ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 56
The MACD Histogram ¾
Histogram Positive, rising • Meaning: trend strengthening • Trading rule: hold longs
¾
Histogram Positive, falling • Meaning: trend weakening / pullback ahead • Trading rule: (i) tighten protective stops (ii) place order to buy above yesterdays’ high
¾
Histogram Negative: reverse of above
Copyright © 1996 – 2006 Investment Analytics
Slide: 57
The MACD Histogram ¾
Histogram Crosses Zero Line • Meaning: trend change imminent • Trading rule: (i) liquidate position, if not stopped out (ii) reverse and go short (long)
Copyright © 1996 – 2006 Investment Analytics
Slide: 58
MACD Divergence
Bearish
Copyright © 1996 – 2006 Investment Analytics
Bullish
Slide: 59
Lab: Self Assessment Test Continue with tests ¾ Worksheets: ¾
• Momentum • Stochastics • MACD
Copyright © 1996 – 2006 Investment Analytics
Slide: 60
Summary: Technical Analysis ¾
Most useful techniques: • Trendlines, channel lines, moving averages • Support & resistance
¾
Charting: • Continuation & reversal patterns • Gaps, spikes
¾
Indicators • MACD & other trend indicators
¾
Oscillators • Momentum, Stochastics • Ideal for range trading, timing trend entry
Copyright © 1996 – 2006 Investment Analytics
Slide: 61
Problems with Technical Trading ¾
Trends • Identifying new trends • Deciding when trend is over • When to get in/out?
¾
Ranges • Sometimes support & resistance holds, sometimes not • False breakouts
¾
Charting • We tend to see the patterns we want to see • Even random prices show chart patterns & trends
Copyright © 1996 – 2006 Investment Analytics
Slide: 62
Trends in Random Prices 1240.0
1040.0
Ln(St+1 / St ) =εt ~ Niid ⇒ Ln(St+1) = M+P*Ln(St ) +εt
840.0
640.0
440.0
240.0
40.0
Copyright © 1996 – 2006 Investment Analytics
Slide: 63
Copyright © 1996 – 2006 Investment Analytics 07/11/95
07/06/95
07/03/95
06/28/95
06/23/95
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106
05/22/95
108
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116
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02/22/95
Linear Behavior in Markets
118
Sept Bond Futures
114
112
110
y = 0.1571x + 100.09 R2 = 0.9142
104
102
100
Slide: 64
A Foolproof Way to Make Money Using Systems Devise a trading rule ¾ Test it - make sure it loses money ¾ Reverse the signals ¾ Optimize the parameters ¾ Ignore commission & slippage ¾ SELL THE SYSTEM! ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 65
Technical Analysis & EMH ¾
EMH: All information is incorporated in current prices Prices only change when new information arrives
¾
CONCLUSION: Technical Analysis is pointless BUT most traders use it - WHY?
Copyright © 1996 – 2006 Investment Analytics
Slide: 66
Rationale for Technical Analysis ‘Rational prices’ argument ¾ Psychological factors ¾ Market anomalies ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 67
‘Rational prices’ argument ¾
Technical analysts argue EMH is wrong on at least two counts: • it says prices are random • it says trends and chart patterns aren't real
¾
BUT: EMH does NOT say prices are random • EMH: price changes are random
¾
EMH does NOT say trends, chart patterns cannot occur • EMH: patterns occur by random chance & you have no way of knowing in advance which pattern is going to arise
Copyright © 1996 – 2006 Investment Analytics
Slide: 68
Psychological factors Technical analysis is easy ¾ ‘Working’vs. gambling ¾ Comfort factor ¾
• To back up a trading decision • To trade with the crowd
Copyright © 1996 – 2006 Investment Analytics
Slide: 69
Market Anomalies ¾
Small firm in January effect (Banz, 1981) • Abnormally high returns in first 2 weeks of January • Reasons: tax-loss selling, poor liquidity • ‘Neglected firm’ effect
¾
The Weekend effect (French, 1980) • A negative abnormal return on Mondays • Not large enough to overcome transaction costs • Nonetheless, don’t buy stocks on Fridays!
¾
Value Line (Black, 1971) • Portfolio 1 abnormal +ve returns, Portfolio 5 abnormal negative returns • Reranked stocks (esp. small) show abnormal returns
Copyright © 1996 – 2006 Investment Analytics
Slide: 70
Copyright © 1996 – 2006 Investment Analytics
Slide: 1
Technical Analysis ¾
Technical Analysis: Study of past market action to forecast prices Looks for patterns in historical data
Copyright © 1996 – 2006 Investment Analytics
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Technical Analysis Tools Charting ¾ Gann ¾ Elliot Wave ¾ Cycle Theory ¾ Oscillators & Indicators ¾ Japanese Candlesticks ¾ Market Profile ¾ Computerized Trading Systems ¾
Copyright © 1996 – 2006 Investment Analytics
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Classical Charting Trend Lines ¾ Support/Resistance ¾ Continuation Patterns ¾ Reversal Patterns ¾ Gaps & Spikes ¾ Moving Averages ¾
Copyright © 1996 – 2006 Investment Analytics
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Trends ¾
Trend Direction
• Uptrend: higher highs, higher lows ¾
Downtrend: lower lows, lower highs
Trend timeframe: • 3 Trends: (e.g. weekly, daily, hourly)
¾
Main technical analysis tools: • Trend Lines • Moving Averages
Copyright © 1996 – 2006 Investment Analytics
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Trendlines ¾
Drawing Trendlines: • Connect highs to highs, lows to lows • Draw through congestion areas • Ignore ‘tails’ or ‘spikes’
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Trends are stronger . . . . • The longer the trendline • The more contacts between prices and the trendline • When volume expands in the direction of the trend
Copyright © 1996 – 2006 Investment Analytics
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Trendline Examples 74
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Trend B is more significant than trend A . . . 1. More contact points 2. Longer trendline 3. Rising volume
A
`
B
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g n i s Ri
e m u Vol
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Trading Rules for (UP)Trends ¾
Trade only in the direction of the trend • Ignore all signals to short a bull market
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Wait for a pullback to the trendline to get long • Wait! If no pullback - forget it!
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Use a trailing stop to get aboard the trend: • As pullback nears trendline, place an order to buy on a stop one tick above previous day’s high
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Set protective stop • Once you are long the market • Place a stop loss order just below the trendline • Move your stop up as trend progresses
Copyright © 1996 – 2006 Investment Analytics
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Trading Rule Illustrated 74
72
1. 2. 3. 4.
Pullback approaches trendline at point A Order to buy on a stop, 1 tick above high at A Get stopped in at next day’s open - point B Place an order to sell on a stop at level C
70
B 68
`
C
66
64
A
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Trendlines Breaks Trendlines provide support & resistance ¾ Steep trendlines (over 45 degrees) precede sharp breaks ¾ A pullback to the trendline after a break is often a good shorting opportunity ¾
Copyright © 1996 – 2006 Investment Analytics
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Trading Trendline Breaks
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Selling Opportunity
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Buying Opportunity
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Buying Opportunity
300.0
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Channel Lines A line running parallel to the trendline ¾ Drawn through tops of rallies (bottoms of declines) ¾ Marks maximum power of bulls (bears) ¾ The wider the channel the stronger the trend ¾ Trading Rules: ¾
• Go long in lower quarter of channel • Take profits in upper quarter Copyright © 1996 – 2006 Investment Analytics
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Copyright © 1996 – 2006 Investment Analytics 10/19/90
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Channel Lines
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Take Profits
S&P 500 Futures
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Selling Opportunity
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Buying Opportunity
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Buying Opportunity
300.0
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Moving Average ¾
Shows the average price during a given time window • E.g. a 5-day MA shows the average price over the last 5 days • 20-day MA shows the average price over the last 20 days
Averages the price series to smooth out effect of extreme highs or lows ¾ Reveals underlying trend
¾
• Longer MA’s show longer term trend • Shorter MA’s react more quickly to recent prices
Copyright © 1996 – 2006 Investment Analytics
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Moving Average Example Eurodollars
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Formula: MN(t) = (X(t)+X(t-1)+...+X(t-N+1))/N
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3 per. Mov. Avg.
94
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Moving Average Formula Formula: MA = P1 + P2 + . . . + PN N ¾ Example: Price • Time ¾
t1 t2 t3 t4
Copyright © 1996 – 2006 Investment Analytics
17 16 19 22
3-Day MA
N/A N/A (17+16+19)/3 = 17.3 (16+19+22)/3 = 19.0
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Using Moving Averages in Trading ¾
As Trend Indicators • Trend direction indicated by the slope of the MA • Short, medium, or long term trend • Similar trading rules as for trendlines – trade with the MA trend – buy on pullbacks to moving average
Copyright © 1996 – 2006 Investment Analytics
Slide: 17
Donchian’s MA Crossover System ¾
Method • Plot short and long term MA on same chart • Example: 9 day MA and 21 day MA
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Trading Signals • Buy when short MA crosses above long MA • Sell when short MA crosses below long MA
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When to use: • Works well in trending markets • Loses money in whipsaw markets
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Optimization • You can find the ‘optimal’ short and long MA
Copyright © 1996 – 2006 Investment Analytics
Slide: 18
Example: Moving Average Crossover 105
SELL
100
95
9 Day MA 90
21 Day MA
85
80
BUY
75
BUY 70
65
Copyright © 1996 – 2006 Investment Analytics
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Example: Moving Average Crossover Eurodollars Sell
Sell
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95
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Buy 3 per. Mov . Av g. 6 per Mov . Av g
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Copyright © 1996 – 2006 Investment Analytics 07/18/86
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BUY
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SELL
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BUY
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SELL
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BUY
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540
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480
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560
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Whipsaw Market
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Gold Futures SELL
520
500
18 Per. Mov. Avg. 9 per. Mov. Avg.
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440
Exponential Moving Averages Similar to simple moving average ¾ Gives more weight to recent observations ¾ Formula: EMAt = wPt + (1 - w) EMAt-1 ¾
• W is the ‘weight’ • Large w gives more weight to current price • Makes EMA more responsive • Typical w: 2/(N+1) where N is length of MA ¾
EMA is more responsive to recent trends than simple MA
Copyright © 1996 – 2006 Investment Analytics
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Exponential & Simple MA’s Compared 105
100
13 Day EMA 95
13 Day MA
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85
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Copyright © 1996 – 2006 Investment Analytics
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Lab: Self-Assessment Test Load Excel spreadsheet: technic.xls ¾ Restart test ¾ Work through trend & moving average sections ¾ MA data worksheet ¾
• Charts EMA & MA • Charts MA Crossover • Try different length MA’s for crossover system • Is there a better choice than 9 and 21 ? Copyright © 1996 – 2006 Investment Analytics
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Support & Resistance ¾
Support: • Price where buying power is sufficient to halt downtrend • Bears are hurting, start buying
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Resistance: • Price where selling power is sufficient to halt uptrend • Bulls are hurting, start selling
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Support & Resistance Lines • Draw horizontal lines through congestion areas • At upper and lower limits of trading range
Copyright © 1996 – 2006 Investment Analytics
Slide: 25
Copyright © 1996 – 2006 Investment Analytics 08/17/90
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Support & Resistance Lines
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Resistance
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Support
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Support & Resistance Levels ¾
Levels are strongest: • The longer they continue • The more contacts between prices & the level • The wider the range • The greater the volume at the level
¾
If you are riding a trend: • Tighten protective stops as prices near levels
Copyright © 1996 – 2006 Investment Analytics
Slide: 27
Support & Resistance Contrarian Trading ¾
As Prices Approach Support: • Place stop order to buy above yesterday’s high • Place protective sell stop below support • If market bounces off support you will be stopped in long
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As Prices Approach Resistance: • Place stop order to sell below yesterday’s low • Place protective buy stop above resistance • If market bounces off resistance you will be stopped in short
Copyright © 1996 – 2006 Investment Analytics
Slide: 28
340.0
buy
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Support & Resistance Trading
420.0
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Resistance
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370.0
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Support
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Trading Ranges ¾
NAKED (No view on volatility): • Go long at Support • Reverse & go short at Resistance
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GAMMA TRADE (volatility cheap/rising): • Buy Straddles or Strangles (strikes at S/R levels) • Rebalance Delta Neutral at Support/Resistance
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VEGA TRADE (volatility rich/falling): • Sell Straddles or Strangles, or • Sell Calls at Resistance, Sell Puts at Support • Roll up(down) or buy back options on breakout
Copyright © 1996 – 2006 Investment Analytics
Slide: 30
Gaps ¾
Occur when market is stampeded • Caused by news, panic • Breakdown of trend • Breakout of trading range • Losers dumping positions
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Breakaway Gap • Prices leap out of congestion area • Signifies start of new trend • Followed by several days of new highs (lows) • Usually market by high volume • Almost never gets closed by subsequent prices
Copyright © 1996 – 2006 Investment Analytics
Slide: 31
Gaps ¾
Continuation Gap • Occurs in middle of powerful trend • Accompanied by upsurge in volume • Measure distance from start of trend to gap • Gives target measured move
¾
Exhaustion Gap • Occurs towards the end of a trend • Market fails to follow through with new highs (lows) • Volume may be thin
Copyright © 1996 – 2006 Investment Analytics
Slide: 32
Gaps - Illustrated 87 87 86 86 85 85 84
Congestion Area
Breakaway Gap Sell short, with stop above rim Continuation Gap Add to shorts, with stop above rim
Distance to Continuation Gap
88
Target
Exhaustion Gap Target achieved - take profits
Copyright © 1996 – 2006 Investment Analytics
Island Reversal Slide: 33
Spikes & Tails ¾
Spikes & Tails
• Extreme price move up or down • Occurs in middle of congestion area • No follow-through • A failed ‘test’ of new trend direction • Market often reacts in opposite direction
Copyright © 1996 – 2006 Investment Analytics
Slide: 34
Continuation Patterns Bull
Bear Flag
Pennant
Volume Copyright © 1996 – 2006 Investment Analytics
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Triangles Bull
Bear
Descending
Ascending Symmetric
Volume Copyright © 1996 – 2006 Investment Analytics
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Copyright © 1996 – 2006 Investment Analytics 03/26/93
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450.0
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Example: Flag & Triangle
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S&P 500
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390.0
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Trading Continuations These are trend continuation signals ¾ Add to positions on breakout ¾ Buy (sell) stop 1 tick above pattern boundary, or ¾ Buy(sell) on close outside boundary ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 38
Reversal Patterns Indications of trend ending ¾ Most common patterns ¾
Double Tops Head & Shoulders
Price and Volume confirmation required ¾ Give indication of new price target ¾
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Slide: 39
Copyright © 1996 – 2006 Investment Analytics 10/07/88
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620
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500
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Volume lower on right peak, and declining
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560
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Double Top
640
Comex Gold Futures
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Measured Move
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Short on pullback to resistance on Big pickup in low volume volume on breakdown
480
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Reversal Patterns Head & Shoulders Head
Left Shoulder
Right Shoulder
N e c k li n e
D ecl in Volu ing me
Target Copyright © 1996 – 2006 Investment Analytics
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Trading Head & Shoulders Scale down position as pattern emerges ¾ Look for confirmation in declining volume ¾ Get short on right shoulder, with stop above head ¾ Add to short on break of neckline, with stop above neckline ¾ Add to short on pullback to neckline ¾ Place buy limit order at distance of measured move ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 42
Lab: Self Assessment Test Continue with test ¾ Worksheets: ¾
• Support & resistance • Gaps • Spikes • Continuations • Head & Shoulders
Copyright © 1996 – 2006 Investment Analytics
Slide: 43
Oscillators Measure extremes of market sentiment ¾ Oscillator: fluctuates between two extreme values ¾
• When market is overbought or oversold • Market likely to reverse
Oscillators work well in trading ranges ¾ Can also be used when market trends:
¾
• To time trades in direction of trend • Nb. must filter out trades against the trend • In trending markets oscillators can stay overbought/oversold for many periods Copyright © 1996 – 2006 Investment Analytics
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Classic Oscillators Momentum ¾ Stochastics ¾ Relative Strength Indicator (RSI) ¾ Williams %R ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 45
Momentum Measures trend acceleration ¾ When Trend is Up ¾
• If oscillator reaches new high, shows uptrend is continuing • When oscillator traces lower peak, shows uptrend may be weakening ¾
Formula: MN(t) = Pt - Pt-N • Pt is today’s price • Pt-N is price N days ago
¾
E.g 7 Day Momentum • Pt = 24; Price 7 days ago = 18 – 7 day Momentum = (24 - 18) = 6
Copyright © 1996 – 2006 Investment Analytics
Slide: 46
Momentum Chart 80
Double Top
75 70 65 60 55
Bearish Divergence: Sell short
50 45 10 405
BUY
0 -5 -10
Trendline break - take profits
Copyright © 1996 – 2006 Investment Analytics
Slide: 47
Momentum Trading Rules ¾
When Momentum crosses center line & ticks back up • Stock is oversold • Trend has slowed for a moment • Opportunity to get on board - Buy!
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Momentum is a leading indicator • Early warning of downturn in trend
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Apply charting techniques to the oscillator • Trendline break: take profits
Copyright © 1996 – 2006 Investment Analytics
Slide: 48
Divergence ¾
Bearish Divergence
Bullish Divergence
Prices
Prices
Oscillator
Oscillator ¾
Trading Rule: • Scale back / go short
Copyright © 1996 – 2006 Investment Analytics
Trading Rule: Scale back / go long Slide: 49
Stochastics Tracks relationship of closing price to recent HiLo range ¾ Formula: %K = Ct - Ln x 100 H n - Ln ¾ %D = 3 day sum of (Ct - Ln) x 100 3 day sum of (Hn - Ln) ¾
• Hn is the high of the last n days • Ln is the low of the last n days • Ct is today’s closing price • n = 5, or 9 is popular choice Copyright © 1996 – 2006 Investment Analytics
Slide: 50
Stochastics ¾
Stochastics fluctuates in range +/- 100 • Overbought range: 75-80 • Oversold range : 25-30
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Plot both %K and %D • Also plot overbought/oversold regions
¾
Sell signal: • %K, %D both in overbought region • %K crosses back down over %D
¾
Buy signal - the reverse
Copyright © 1996 – 2006 Investment Analytics
Slide: 51
Stochastics in Trading Range 115.0
110.0
Sell 105.0
100.0
Buy
95.0
100
Buy Overbought
75 90.0
50 25 0
Copyright © 1996 – 2006 Investment Analytics
Oversold
Bullish Divergence Slide: 52
Trading with Stochastics Ideal for range trading ¾ In Trends: ¾
• Tends to stay overbought/oversold for long periods • Ignore sell signals in uptrend • Wait for oversold signal on pullback to get on board • Ignore buy signals in downtrends • Wait for overbought signal on pullback to get on board
Charting: look for trendlines on the oscillator ¾ Divergence: trade same way as Momentum
¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 53
Indicators These are trend following tools ¾ Usually based on moving averages ¾ Popular indicators ¾
• MACD (Moving Average ConvergenceDivergence) • Wilder’s ADX system
Copyright © 1996 – 2006 Investment Analytics
Slide: 54
MACD Histogram ¾
A variation on the MA crossover idea: • Uses two EMA’s (12 and 26 day) • The difference between them is the fast MACD line • Calculate a 9 day EMA of the fast MACD line (the Signal) • MACD histogram = (Fast MACD - Signal) Fast MACD Signal MACD Histogram
Copyright © 1996 – 2006 Investment Analytics
Slide: 55
How to use MACD Fast MACD reflects short term consensus ¾ The signal indicates consensus over a longer period ¾ When the fast MACD rises above the signal, bulls are in control: trade from the long side ¾ When the fast MACD falls below the signal, bears are winning: trade from the short side ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 56
The MACD Histogram ¾
Histogram Positive, rising • Meaning: trend strengthening • Trading rule: hold longs
¾
Histogram Positive, falling • Meaning: trend weakening / pullback ahead • Trading rule: (i) tighten protective stops (ii) place order to buy above yesterdays’ high
¾
Histogram Negative: reverse of above
Copyright © 1996 – 2006 Investment Analytics
Slide: 57
The MACD Histogram ¾
Histogram Crosses Zero Line • Meaning: trend change imminent • Trading rule: (i) liquidate position, if not stopped out (ii) reverse and go short (long)
Copyright © 1996 – 2006 Investment Analytics
Slide: 58
MACD Divergence
Bearish
Copyright © 1996 – 2006 Investment Analytics
Bullish
Slide: 59
Lab: Self Assessment Test Continue with tests ¾ Worksheets: ¾
• Momentum • Stochastics • MACD
Copyright © 1996 – 2006 Investment Analytics
Slide: 60
Summary: Technical Analysis ¾
Most useful techniques: • Trendlines, channel lines, moving averages • Support & resistance
¾
Charting: • Continuation & reversal patterns • Gaps, spikes
¾
Indicators • MACD & other trend indicators
¾
Oscillators • Momentum, Stochastics • Ideal for range trading, timing trend entry
Copyright © 1996 – 2006 Investment Analytics
Slide: 61
Problems with Technical Trading ¾
Trends • Identifying new trends • Deciding when trend is over • When to get in/out?
¾
Ranges • Sometimes support & resistance holds, sometimes not • False breakouts
¾
Charting • We tend to see the patterns we want to see • Even random prices show chart patterns & trends
Copyright © 1996 – 2006 Investment Analytics
Slide: 62
Trends in Random Prices 1240.0
1040.0
Ln(St+1 / St ) =εt ~ Niid ⇒ Ln(St+1) = M+P*Ln(St ) +εt
840.0
640.0
440.0
240.0
40.0
Copyright © 1996 – 2006 Investment Analytics
Slide: 63
Copyright © 1996 – 2006 Investment Analytics 07/11/95
07/06/95
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106
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108
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Linear Behavior in Markets
118
Sept Bond Futures
114
112
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y = 0.1571x + 100.09 R2 = 0.9142
104
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A Foolproof Way to Make Money Using Systems Devise a trading rule ¾ Test it - make sure it loses money ¾ Reverse the signals ¾ Optimize the parameters ¾ Ignore commission & slippage ¾ SELL THE SYSTEM! ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 65
Technical Analysis & EMH ¾
EMH: All information is incorporated in current prices Prices only change when new information arrives
¾
CONCLUSION: Technical Analysis is pointless BUT most traders use it - WHY?
Copyright © 1996 – 2006 Investment Analytics
Slide: 66
Rationale for Technical Analysis ‘Rational prices’ argument ¾ Psychological factors ¾ Market anomalies ¾
Copyright © 1996 – 2006 Investment Analytics
Slide: 67
‘Rational prices’ argument ¾
Technical analysts argue EMH is wrong on at least two counts: • it says prices are random • it says trends and chart patterns aren't real
¾
BUT: EMH does NOT say prices are random • EMH: price changes are random
¾
EMH does NOT say trends, chart patterns cannot occur • EMH: patterns occur by random chance & you have no way of knowing in advance which pattern is going to arise
Copyright © 1996 – 2006 Investment Analytics
Slide: 68
Psychological factors Technical analysis is easy ¾ ‘Working’vs. gambling ¾ Comfort factor ¾
• To back up a trading decision • To trade with the crowd
Copyright © 1996 – 2006 Investment Analytics
Slide: 69
Market Anomalies ¾
Small firm in January effect (Banz, 1981) • Abnormally high returns in first 2 weeks of January • Reasons: tax-loss selling, poor liquidity • ‘Neglected firm’ effect
¾
The Weekend effect (French, 1980) • A negative abnormal return on Mondays • Not large enough to overcome transaction costs • Nonetheless, don’t buy stocks on Fridays!
¾
Value Line (Black, 1971) • Portfolio 1 abnormal +ve returns, Portfolio 5 abnormal negative returns • Reranked stocks (esp. small) show abnormal returns
Copyright © 1996 – 2006 Investment Analytics
Slide: 70
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