CFA Level 1 - Chapter 7 - An Introduction To Technical Analysis

INTRODUCTION TO TECHNICAL ANALYIS The fundamentals of technical analysis state that…

- Prices are determined by investor supply and demand assets - Supply and demand are driven by rational and irrational behaviour - Prices move in trends and tend to repeat

Line Chart: Bar Chart:

Candlestick

Chart:

Volume Charts Show volumes traded and also Point and Figure Charts use X’s and O’s…

- X = increase of one box size - O = decrease of one box size Uptrend “Prices are reaching higher highs and higher lows.”

- Uptrend Line: connects increasing lows with a straight line.

Downtrend “Prices are reaching lower lows and lower highs” - Downtrend Line: connects decreasing highs with a straight line.

Support and Resistance

In the price graph below the blue line has Resistance Levels at points 1 and 2. Then it breaks-out above and points 3 and 4 then become Support Levels along the same horizontal line.

Hence resistance is from below and support is from above.

Change in Polarity Is the idea that breached variance levels become support levels and vice versa, as we see in the graph above.

Head and Shoulders Looks like the curve shown here, with a blue ‘neckline’.

Reversal of an Uptrend - Head and shoulders pattern - Double tops - Triple tops Reversal of a Downtrend - Inverse head and shoulders pattern - Double bottoms - Triple bottoms Continuing Patterns Indicate that the trend in which they appear is likely to continue further in the same direction into the future.

- Triangles - Rectangles - Flags - Pennants

Overbought/Sold - Overbought Market => will decrease in the near term.

- Oversold Market => will increase in the near term.

Bollinger Bands In the diagram on the right the blue line is the asset price’s simple moving average and the red lines are Bollinger Bands, usually two standard deviations either side of it.

The reason it is closely observed is that a spike in volatility (in which the simple moving average will breach a Bollinger Band) is often believed to precede a market reversal.

Sentiment Strategies - Put/call ratio => the ratio of the markets appetite for puts and call options.

- Short Interest Ratio => the percent of the shares outstanding that are being shorted.

- Volatility Index => tells us how volatile a market has been trading over a period.

[Tip: in all three Sentiment Strategies above… higher value => a more bearish signal.]

Flow-of-Funds Index - Arms Index => looks at advancing and declining stock issues and market sentiment.

- Mutual Fund Cash Position => the more cash held is considered a bearish sign.

- New Equity Issuance => how many new companies are being listed for IPO. - Secondary Offering => how many IPO’d companies are issuing new stock.

Elliot Wave Theory Looks at market cycles; a five wave trend followed by a three wave counter.

Kondratieff Wave Theory States that the modern economy goes in cycles of 54 years.