BEYOND FUNDAMENTAL ANALYSIS

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What is Technical Analysis >>

Investment Analysis & Portfolio Management (FIN630)

Lesson # 7

BEYOND FUNDAMENTAL ANALYSIS

Few facets of the investment discipline generate as much controversy as technical analysis.

Some professional investors are convinced the activity is a complete waste of time and a

disservice to brokerage clients. An equal number are certain that technical analysis is

mandatory for every one who seeks above average investment results. Some fundamental

analysts will say they use technical analysis to confirm their opinions but not as a stand-

alone technique.

CHARTING:

In the mind of some people, elaborate wall charts are the classic symbol of the stock

picker's art. The experience eye can divine ups and down in the same way a soothsayer can

read tea leaves are astrological signs or so the folklore goes. Charting is a controversial part

of finance. Future research is likely to uncover things about charting that would surprise us

today. Still, even people who vehemently oppose the practice should be familiar with the

basic tents.

Much about technical analysis remains a puzzle.

The Underlying logic:

Charts are an important tool of the technical analyst. He or she believes the supply and

demand determine prices that changes in supply or demand will change prices and that

charts can be used to predict changes in supply and demand and in investor behavior. This

logic seems reasonable to many people, but it is also why charting is a trouble topic to the

fundamental analyst.

The weak link in this reasoning lies in the last point: charts can be used to predict changes

in supply and demand. The stock market seldom waits for things to completely unfold.

Market participants are continually anticipating future events are frequently err in their

anticipation.

Imagine an investment whose value is determined by a prior series of ten coins flips. A

person can buy the investment at any time, with the purchase price a function of the

previous ten coin flips. Suppose a large payoff is associated with a series of five consecutive

heads followed five consecutive tails. How will the marketplace value the investment if the

previous eight flips were five head followed by three tails? Clearly, investors will bid up the

price because of the increased likelihood of the windfall gain. By so doing, they reduce the

potential profit, because a rising price means a lower expected return, everything else being

equal.

An interesting side note to this example occurs if the investment reaches a maximum value

following a series of five heads and five tails. Once an investment reaches its maximum

possible value, why would anyone buy it? Logically it can only decline from its peak value.

Thus, a interesting interplay takes place between would-be sellers and potential buyers as

the pattern develops.

The technical analyst believes charts can be used to predict changes in supply and

demand.

Investment Analysis & Portfolio Management (FIN630)

Market participants try to anticipate events rather than merely react to them.

Types of Charts:

Three principal types of charts are used by the technical analyst: line charts. Bar charts and

point and figure charts. A forth type, the candlestick chart, has recently gained favor and

may eventually become common.

Line Chart:

The line chart is the simplest and most familiar. It consists of a line connecting a series of

data points. It may be drawn on either a linear or a logarithmic scale. Logarithmic scales are

appropriately when the data move through wide ranges. This keeps the plot from going off

the chart.

Bar Charts:

High

Open

Low

Standard

Bar Chart

The technical analyst's bar chart is different from the bar chart commonly used to present

economic data. This chart shows the periodic high, low and closing prices of a security. A

vertical line connects the period's high and low prices, with a cross mark indicating the

price at the close of the period. Bar charts are efficient in showing more detail about daily

trading than just the closing prices from a line chart.

Investment Analysis & Portfolio Management (FIN630)

Point and Figure Charts

X XO

XO O

This exotic chart impresses many a brokerage firm customer. The scattered X's and O's

make the document look like a football coach's play diagram. The layperson typically does

not understand what they present but the chart attracts attention.

Unlike most other charts, only significant price movement appears. The X represents the

prices increase and the O represents the price decline. Notice that Xs and Os never occur in

the same column. Once a price reversal of significant magnitude occurs, the analyst moves a

column to the right for the next entry.

An old feature of this chart is the fact that the horizontal axis has no units. Moving left to

right reflects the passage of time but data points are not plotted at regular interval. Only

when the price change is sufficient does a new data appear.

Some technical analyst will superimpose time information the chart.

The horizontal axis on a point and figure chart has no units.

Candlestick Chart

Japanese

Candlestick

Investment Analysis & Portfolio Management (FIN630)

A Candlestick Chart is an enhanced version of bar chart. These charts began to appear in the

United States in the mid 1980's but have been used in China for over 500 years. Such a

chart shows a stock's open, close, high and low in a modified three dimensional format. The

vertical axis shows the stock price while a horizontal axis reflects the passage of time. The

principle difference between a daily candlestick chart and a bar chart is the white and black

candles augmenting the daily trading range lines. White candles represent stock advances,

with black candle representing declines. The thick portion of an entry is called the real

body, with the vertical line representing the wick. Various clusters of candles have exotic

names, such as dark cloud cover, doji star, hanging man, harami cross, and two-day tweezer

tops.

Other Charts Annotations:

Support

Resistance

A support level is a subjective assessment of the price level below which the stock seems

disinclined to fall. A resistance level is an apparent upper bound on stock prices or a level

presenting a barrier to further price appreciation. Both concepts are purely subjective and

cannot be calculated. A congestion area is a region of the chart of the chart where a great

many data points appear. When the stock price leaves the congestion area and pierces either

a support level or a resistance level, it is called breakout. A rise through a resistance level

is a breakout on the upside; a fall through a support level is a breakout on the downside.

When someone says "the stock broke" they often refer to a decline through a support level.

Breakout on the upside are bullish; breakout on the downside a bearish. Once a breakout

occurs, the technical analyst will search for new resistance and support level. The institution

behind these levels is easy to develop.

Chartists believe investors remember missed opportunities and look for them to return.

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