ACE 427, University of Illinois 11-1

ACE 427

Spring 2013

Lecture 11

Technical Analysis by

Professor Scott H. Irwin

Required Reading: “Technical Analysis.” Wikipedia. [http://en.wikipedia.org/wiki/Technical_analysis]

Purcell, W.D. and S.R. Koontz. “Ch. 4: Technical Analysis: The Bar Chart, Ch. 5: Technical Analysis: Alternatives to Bar Charts,” Agricultural Futures and Options: Principles and Strategies, Second Edition, Prentice Hall: Upper Saddle River, New Jersey. (ACE 427 Class Website) Ch. 5: Technical Analysis: Alternatives to Bar Charts,” Agricultural Futures and Options: Principles and Strategies, Second Edition, Prentice Hall: Upper Saddle River, New Jersey. (ACE 427 Class Website) Purcell, W.D. and S.R. Koontz. “Ch. 6: Psychology of the Markets,” Agricultural Futures and Options: Principles and Strategies, Second Edition, Prentice Hall: Upper Saddle River, New Jersey. (ACE 427 Class Website)

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Introduction Fundamental analysis: Definition: An assessment of _____ based on the

underlying ______ and _______ factors and the changes in those relationships

Goal: Estimate ____________________ and

compare to _______________

Bullish: Value > Price

Bearish: Value < Price Technical analysis:

A forecasting method for price movements using ______________________________

No explicit use of the “fundamentals”

Typically based on _____________ arguments

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Pring (2002, p. 2), a leading technical analyst, provides a more specific definition:

The technical approach to investment is essentially a reflection of the idea that prices move in trends that are determined by the changing attitudes of investors toward a variety of economic, monetary, political, and psychological forces. The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.

Technical analysis includes a variety of forecasting techniques

_______ analysis _________ recognition analysis ___________________ indicators Seasonal tendencies _______ analysis Computerized ______________

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Numerous surveys indicate that market practitioners attribute a ______________ to technical analysis

Smidt

Surveyed trading activities of amateur traders in the US commodity futures markets in 1961

About _____ of respondents claimed that they

used _____ either exclusively or moderately in order to identify ________

Group of Thirty

Surveyed the views of market participants on

the functioning of the foreign exchange market in 1985

Results indicated that ______ of bank

respondents and _____ of the securities houses believed that the use of technical analysis had a significant impact on the market

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More recent surveys:

Commodity trading advisors and hedge fund managers rely heavily on computer-guided __________________

About ______________ of foreign exchange

traders around the world believe that technical analysis is the major _________ determining exchange rates in the short-run up to six months

Technical methods are highly ______________!

Group of Thirty study conclusion: “Technical trading systems, involving computer models and charts, have become the vogue, so that the market reacts more sharply to short term trends and less attention is given to basic factors”

In this lecture we will focus only on learning

the technical methods

Assessment of their usefulness is left to the next lecture

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Charting

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Overbought/Oversold Indicators

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Positive NegativeClosing Price Price Price

Price Day Change Change ChangeSX04 4/2/2004 784.5SX04 4/5/2004 782.5 1 -2 2SX04 4/6/2004 779 2 -3.5 3.5SX04 4/7/2004 786 3 7 7 SX04 4/8/2004 778.5 4 -7.5 7.5SX04 4/12/2004 752 5 -26.5 26.5SX04 4/13/2004 738 6 -14 14SX04 4/14/2004 765.5 7 27.5 27.5 SX04 4/15/2004 717 8 -48.5 48.5SX04 4/16/2004 732.5 9 15.5 15.5 SX04 4/19/2004 735.25 10 2.75 2.75 SX04 4/20/2004 734.75 11 -0.5 0.5SX04 4/21/2004 721 12 -13.75 13.75SX04 4/22/2004 734.5 13 13.5 13.5 SX04 4/23/2004 739.75 14 5.25 5.25

5.1 8.3 13.4

0.38RSI 38

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Contrary Opinion Indexes

Another form of overbought/oversold indicator

Designed to measure the ____________ of market participants regarding future price trends

Various _____________ indicators are widely

followed in financial markets

Bullish Consensus Market Vane

Construction of Consensus Indicators

A sample of market analysts, traders, or investors is surveyed for their __________ on price trends

Reading newsletters, conducting mail surveys,

or by personal interview

Each of the individuals surveyed is then placed in a category indicating the _____________ ______________of their market view

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The rating scale can be as simple as either

bullish or bearish, or some type of numerical scale of the degree of bullishness

In the first case, the consensus indicator is

simply the ___________ of individuals with a bullish market view

In the second case, the consensus indicator is

the ____________ of the individual ratings. Use of Contrary Opinion Indicators

______________________________

High percentage of traders ________________

High percentage of traders ________________

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Trading Systems A technical trading system consists of a set of _____ that result from parameterizations, and each trading rule generates _____________ (long, short, or out of the market) according to their parameter values Popular technical trading systems include

Moving averages Channels Momentum oscillators

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Literally thousands of technical trading systems!

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Market Efficiency Nothing more than the application of ___________ competition to the determination of ____ over _____ Key: With sufficient competition, price in an efficient market will never be higher or lower than the “true” equilibrium value Two sources of _____________ in efficient markets: 1. Temporary Small, short-term price movements due to

________ supply-demand __________ between buyers and sellers

_________ effect through time

Occurs over very _____ time intervals, typically

by the minute or, at most, the hour

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2. New information

New data on ________________ factors, such as crop size, exports, etc.

New information changes ___________ price

_______________ in content, timing and importance

If it is not unpredictable, then it _____ be ____

information!

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Bottom Line: Equilibrium price is a _____________ because market information changes

Prices respond __________ to bullish new information

Prices respond __________ to bearish new

information

Arrival of new information must be ______, if not, information is not new

Implies ____________ must be ________

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Coin Flipping Experiment

1. Start graph at $5.00/bu.

2. Flip coin one time

heads: daily high up 10 cents from previous close

tails: daily low down 10 cents from previous

close

3. Setting the close

heads: market closes at high of daily range tails: market closes at low of daily range

4. Generate 30 “days” (one flip/day)

Fun with random numbers: http://www.dartmouth.edu/~chance/teaching_aids/books_articles/probability_book/bookapplets/chapter1/HTSimulation/HTSimulation.html

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Random Walks and Commodity Prices Price _______ in an efficient market from day to day are __________

Behave as if generated by ____________

Called a ___________ by statisticians

Analogy to the path of a drunk walking home from a bar (I am not making that up!)

After the fact, _______ and ____________ may appear

No _______ power whatsoever

Purely _______ information

Similar to “patterns” in ____________

Outcome of a ______________

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A Warning

Do not interpret the coin-flipping exercise as proving that commodity prices follow a random walk and that technical analysis is worthless

Market efficiency is a theory that may or may

not describe the movement of actual prices Technical analysts respond Two ____________ explanations usually offered in defense of technical analysis:

Works because so many people _____

Works because it takes advantage of natural __________________ in people (e.g. waves of irrational optimism and pessimism)

More _______ explanations have been offered in the finance and economics literature in recent years

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Price may adjust ________ to ______________ due to:

Noise Market frictions Market power Trader sentiments Herding behavior Chaotic dynamics

____________________ allows technical methods to profit