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IFT Notes for Level I CFA® Program

R56 Technical Analysis

Part 1


 

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 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. 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

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.

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.

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, which do not have underlying income streams or financial statements, technical analysis is commonly used.

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 (i.e. trading data), while fundamental analysts incorporate external market data, with company’s financial statements, to predict security price movements. It is important to note that the 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.

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

 

3.1.     Charts

The various types of charts used in technical analysis are:

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. The line chart shows that the price of the stock during the first upward movement of the price is higher than the second high.

 

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Bar chart

A line chart has only one data point per time interval. A bar chart, in contrast, has four bits of data in each entry – the opening and closing prices, and the high and low prices during the period.

 2TA 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.

A short bar indicates little price movement while a long bar indicates a wide divergence between the high and the low for the day. An example of a bar chart is shown in the figure below:

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Candlestick chart

A candlestick chart also provides four prices per data entry point: the opening and closing prices, and the high and low prices during the period.

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The body of the candle is either white or shaded. A white body means that the market closed up. A shaded body means that the market closed down. An example of a candlestick chart is shown below:

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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. Neither time nor volume is represented on this chart. Instead, the focus is on change in prices, which is represented on the horizontal axis. An example of a point and figure chart is given below.

 

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The following steps need to be followed in order to construct a point and figure chart:

  • The analyst must first determine the box size. Box size refers to the change in price represented by the height of each box.
  • 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.
  • A technician fills in a box with X every time the security’s 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.

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

The vertical axis can be constructed with either:

  • Linear/Arithmetic scale: Suitable for narrower ranges, for example, prices from $20 to $35
  • Logarithmic scale: Suitable for range of values representing several orders of magnitude, for example, $10 to $10,000.

The horizontal axis usually shows the passage of time. The appropriate time interval depends on the nature of the underlying data. We can have 5-min, 30-min, 1-hour, daily, weekly or even monthly charts.

Volume charts

They are often displayed below a line, bar or candlestick chart. The number of units of the security traded is plotted on the Y-axis and time on the X-axis.

Relative strength analysis

Relative strength analysis is used to compare the performance of a particular asset, such as a stock, with that of some benchmark index or the performance of another stock. Typically, the analyst prepares a line chart of the ratio of the two prices, with the asset under analysis as the numerator and 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 that the asset is underperforming. 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.

Uptrend

A security is said to be in an uptrend if prices are reaching higher highs and higher lows. An upward trendline can be drawn by connecting the increasing low points with a straight line. An uptrend indicates that the demand is more than supply.

Downtrend

A security is said to be in a downtrend if prices are reaching lower highs and lower lows. A downward trendline can be drawn by connecting the decreasing high points with a straight line. A downtrend indicates that the supply is more than demand.

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Support

It is the price level at which there is sufficient buying pressure to stop a further decline in prices.

Resistance

It is the price level at which there is sufficient selling pressure to stop a further increase in prices.

Change in polarity

Once a support level is breached, it often becomes a new resistance level. Similarly, once a resistance level is breached; it often becomes a new support level.

 

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3.3. Chart Patterns

Chart patterns are formations that create a recognizable shape; common patterns appear repeatedly and lead to similar subsequent price movements. Chart patterns can be divided into two categories: reversal patterns and continuation patterns.

Reversal patterns

They signal the end of a trend. The four kinds of reversal patterns are:

Head and shoulders pattern:

It consists of the left shoulder, the head, and the right shoulder. This pattern indicates the end of an uptrend. You can profit by going short on the security, the price target is:

Price target = neckline – (head – neckline)

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Inverse head and shoulders pattern:

It is a mirror image of the head and shoulders pattern. This pattern indicates the end of a downtrend. You can profit by going long on the security, the price target is:

Price target = neckline + (neckline – head)

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Example

In an inverted head and shoulders pattern, if the neckline is at €125, the shoulders at €80, and the head at €95, the price target is closest to which of the following?

  1. A. €155.
  2. B. €110.
  3. C. €95.

Solution:

Inverted Head and shoulder patter target price = Neckline + (Neckline – Head)

Target Price = 125 + (125 – 95)

Target Price = 155

Double tops and bottoms:

A double top is formed when prices hit the same resistance level twice and fall down. It indicates the end of an uptrend.

A double bottom is formed when prices bounce back from the same support level twice. It indicates the end of a down-trend.

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Triple tops and bottoms:

Triple tops are formed when prices hit the same resistance level thrice.

Triple bottoms are formed when prices bounce back from the same support level thrice.

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Continuation patterns

They signal a temporary pause in the trend, and that the trend will continue in the same direction as before. The four kinds of continuation patterns are:

Triangles:

One trendline connects the highs and a second trendline connects the lows. As the distance between the highs and lows narrows, the trendlines converge, forming a triangle. There are three forms – ascending triangles, descending triangles, and symmetric triangles.

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Rectangles:

One trendline connects the highs and a second trendline connects the lows. As the distance between the highs and lows is constant, the trendlines are parallel to each other and form a rectangle.

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Flags:

They are similar to a rectangle and are formed by two parallel trendlines. However, they form over a much shorter time interval.

Pennants:

They are similar to a triangle and are formed by two converging trend lines. However, they form over a much shorter time interval.

 


Portfolio Management Technical Analysis Part 1