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IFT Notes for Level I CFA® Program

R56 Technical Analysis

Part 2


 

3.4.     Technical Indicators

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

They incorporate the information contained in the current and past market prices. The common types are:

Moving average:

It is the average of the closing prices over a specified number of periods. They are used to smooth out short-term price fluctuations and help identify the trend. 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.

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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’s price reaches the upper band and buys when it reaches the lower band. The contrarian strategy assumes that the security’s price will stay within the bands.

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Momentum oscillators

They help to identify changes in the market sentiment. The common types are:

Rate of change (ROC) oscillator:

It oscillates around 0 (or around 100 if an alternative formula is used for calculation). When the ROC oscillator crosses zero into the positive territory, it is considered bullish. When the ROC oscillator crosses zero into the negative territory, it is considered bearish.

Relative strength index (RSI):

RSI graphically compares a security’s gains with its losses over a given period. The popular time period is 14 days. The value of the RSI is always between 0 and 100. A value above 70 represents an overbought situation while a value below 30 suggests that an asset is oversold.

Stochastic oscillator:

It is based on the observation that in uptrends, prices tend to close at or near the high end of their recent range. Similarly, in downtrends, they tend to close near the low end. It is composed of two lines, called %K and %D that are calculated as follows:

\rm \%K = 100 (\frac {C-L14}{H14-L14})

where:

C = latest closing price

L14 = lowest price in past 14 days

H14 = highest price in past 14 days

%D = average of the last three %K values calculated daily

%D is the average of three %K values. It is slower moving and is also called the signal line.

When the %K moves from below the %D line to above it, this move is considered a bullish signal. On the other hand, when %K moves from above the %D line to below it, this pattern is considered bearish.

The stochastic oscillator has a default setting of 14-days.

Moving-average convergence/divergence oscillator:

It is the difference between a short-term and a long-term moving average of the security’s price. It is composed of two lines – MACD line and signal line.

  • MACD line: difference between two exponentially smoothed moving averages, usually 12 and 26 days.
  • Signal line: exponentially smoothed average of MACD line, usually 9 days.

The indicator oscillates around 0 and has no upper or lower limit.

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MACD is used in technical analysis in three ways.

  • Crossovers of the MACD line and signal line may indicate a change in trend.
  • If the MACD is outside its normal range for a given security, then this may indicate a reversal.
  • If the MACD is trending in the same direction as price, then this indicates a convergence pattern. On the other hand, when the two are trending in opposite directions, then this indicates a divergence pattern.

Instructor’s Note:

The most known use of momentum oscillators is to indicate the overbought or oversold position of a security. Thus, they help in providing signal for buying or selling security but do not help to set the target price.

Sentiment indicators

They gauge investor activity for signs of bullishness or bearishness. The common types are:

Opinion polls:

Regular polls are conducted of investors and investment professionals to gauge the overall market sentiment.

Calculated statistical indices:

  • The put/call ratio is the volume of put options traded, divided by the volume of call options traded. A high ratio indicates that the market is bearish. Whereas, a low ratio indicates that the market is bullish.
  • The CBOE volatility index (VIX) is a measure of near-term market volatility calculated from option prices of S&P 500 stocks. The VIX rises when market participants become fearful of a market decline.
  • Margin debt is loans taken by individual investors to fund their stock purchases. When stock margin debt is increasing, investors are aggressively buying and the stock prices will rise because of increased demand.
  • Short interest refers to the number of shares of a particular security that are currently sold short. The short interest ratio is calculated as:
  • \rm Short \ interest \ ratio = \frac{Short \ Interest}{Average \ daily \ trading \ volume}
  • A high ratio suggests an overall negative outlook on the security.

Flow-of-funds indicators

They indicate the change in potential demand and supply. The common types are:

The Arms index: (also known as TRIN)

It is calculated as:

 Arms \ Index = \frac{number \ of \ advancing \ issues \div \ number \ of \ declining \ issues}{volume \ of \ advancing \ issues \div \ 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:

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 liquid assets (i.e. cash and cash equivalents) to pay for miscellaneous expenses and to fund redemptions. During a bullish market, the cash positions tend to be low. During a bearish market, the cash positions tend to be high.

New equity issuance:

IPOs are often timed with bullish markets to get the best valuations. A large number of IPOs may indicate that a market is near its peak.

Secondary offerings:

Like IPOs, technicians also monitor secondary offerings to gauge potential changes in the supply of equities.


Portfolio Management Technical Analysis Part 2