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Introduction
► The two main types of investment analysis used in ‘traditional’ investing
► Last time: Fundamental analysis
► Today: Technical analysis
► Next time: Quantitative analysis
► Used in quantitative/systematic/algorithmic trading
► “Searching for patterns”
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Warren Buffet “Oracle of Omaha”, one of the most successful investors
of all time, uses simple concepts from fundamental analysis
Fundamental vs Technical
Fundamental analysis
► Assumption: markets may misprice a security in the short run but the “correct” price will eventually be reached
► Determine price by looking at “fundamentals”
► Example measures:
► Equities: company’s financial statements
► Bonds: credit ratings
► Currencies: interest rates
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Technical analysis
► Assumption: all information is factored into the price
► Study past market data, primarily price and volume
► Example measures:
► Trend lines
► Moving averages
► Many, many more
Assumptions
► Technical analysis is based on three main principles:
1. The market discounts everything
► Fundamental factors already priced in
2. Prices move in trends
► “The trend is your friend”
3. History tends to repeat itself
► Market psychology provides consistent reactions to similar market stimuli
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Chart types
Line chart
► Usually plot the Close price vs time
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Chart types
Bar chart
► Offers more insight – Open, High, Low, Close
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Chart types
Candlestick chart
► Colour identifies bullish/bearish periods
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Volume
► Volume = number of shares/contracts traded in a given period
► i.e. the amount of trading activity
► Gives a measure of liquidity
► The higher the volume, the more important a price change/trend/chart pattern
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Trend
► The trend is the direction in which the market is moving
► There are three main types of trends:
► Uptrend: higher highs, higher lows
► Downtrend: lower highs, lower lows
► Sideways trend
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Trend length ► Long-term: ~years
► Medium-term: ~months
► Short-term: ~days
► A long-term trend is often composed of several intermediate trends in the opposite direction, also called “corrections”
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Trendlines
► Uptrend line is a straight line drawn at the lows of an upward trend
► Represents the support
► Downtrend line is a straight line drawn at the highs of a downward trend
► Represents the resistance
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Support and resistance
► Support and resistance levels act as floor and ceiling for price
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► Support
► Price level that a security seldom falls below
► Price level at which a lot of traders are willing to buy
► Resistance
► Price level that a security seldom surpasses
► Price level at which a lot of traders are willing to sell
Support and resistance
► Support and resistance can reverse their roles if the price “breaks through” one of these levels
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Chart patterns
Head and shoulders
► Reversal pattern
► Usually after a long rally – because nothing lasts forever
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Neckline
Chart patterns
Double top/bottom (or triple top/bottom)
► Reversal pattern
► After a sustained trend, price tests support/resistance level twice and is unable to break through
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Chart patterns Cup and handle
► Continuation pattern
► Temporary fall perhaps due to bad news, but fundamentals eventually improve
► Handle forms as those who bought at the old high and who felt burned by the long decline take their money and get out
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Chart patterns
Flags and pennants
► Continuation patterns
► Short-term retracement from the main trend
► Difference is whether trendlines converge or not
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Chart patterns
Gaps
► A large difference in prices between two sequential trading periods, usually accompanied by high volume
► Usually occur after significant news (e.g. earnings announcement)
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Moving averages
► Moving average = average price over previous N periods
► Smooths out some of the noise that is found in day-to-day price movements, giving a clearer view of the price trend
► The longer the time span, the less sensitive the moving average to price changes
► Simple moving average (SMA): equal weighting
► Exponential moving average (EMA): exponential function weighting with greater weight to most recent periods
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Moving averages
► Example trading signals
► Price moves above (bullish) or below (bearish) MA line
► A shorter MA crosses a longer MA from below (bullish) or above (bearish)
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Indicators Moving average convergence/divergence (MACD)
► Momentum indicator
► MACD = difference between two EMAs (usually EMA12 - EMA26)
► Signal = EMA of the MACD (usually 9 days)
► Used to spot changes in the strength and direction of a trend
► As before, trading signal is given by a MACD/Signal line crossover
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MACD Signal
Indicators
Bollinger Bands
► Bands plotted two standard deviations away from a MA
► Give a measure of volatility
► Security is overbought (or oversold) when price moves above (or below) the band
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Indicators
Relative strength index (RSI)
► Momentum oscillator
► Measures velocity and magnitude of price movement
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► Security is considered overbought when RSI > 70
► Security is considered oversold when RSI < 30
(“up” days)
(“down” days)
Bibliography
► John J. Murphy
► Technical Analysis of the Financial Markets
► Charles D. Kirkpatrick, Julie R. Dahlquist
► Technical Analysis: The Complete Resource for Financial Market Technicians
► Investopedia
► http://www.investopedia.com/university/technical/
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Backup
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Fundamental analysis
► Definition: Fundamental analysis involves analysing a business, its industry/competitors and the economy in order to make financial forecasts
1. Analyse the underlying factors
2. Determine the intrinsic value
3. Compare the intrinsic value to the current market price
► The various fundamental factors can be grouped into two categories:
► Qualitative factors – e.g. quality of management, brand-name
► Quantitative factors – e.g. revenues, profits
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► Market price < Intrinsic value: BUY
► Market price > Intrinsic value: SELL
Fundamental analysis
► Qualitative factors
► Business model, market share, competition, industry, regulation, management, corporate governance
► Quantitative factors
► Financial statements: balance sheet, income statement, cash flow statement
► Financial ratios: profitability, debt, liquidity, valuation
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