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2021 Curriculum CFA Program Level I EconomicsFinancial Reporting and Analysis

Technical Analysis

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Introduction

Technical analysis has been used by traders, analysts, and investors for centuries and has achieved broad acceptance among regulators and the academic community—particularly with regard to its behavioral finance aspects. This reading gives a brief overview of the field, compares technical analysis with other schools of analysis, and describes some of the main tools used in technical analysis. Although technical analysis follows predefined rules and principles, the interpretation of results is generally subjective. That is, although certain aspects, such as the calculation of indicators, follow specific rules, the interpretation of findings is often based on a melding of techniques that suit the style and approach of the individual analyst. In this respect, technical analysis is similar to fundamental analysis, which has specific rules for calculating ratios, for example, but introduces increased subjectivity in the evaluation phase.

 

Learning Outcomes

The member should be able to:

  1. explain principles and assumptions of technical analysis;

  2. describe potential links between technical analysis and behavioral finance;

  3. compare principles of technical analysis and fundamental analysis;

  4. describe and interpret different types of technical analysis charts;

  5. explain uses of trend, support, and resistance lines;

  6. explain common chart patterns;

  7. explain common technical indicators;

  8. describe principles of intermarket analysis;

  9. explain technical analysis applications to portfolio management.

Summary

  • Technical analysis is a form of security analysis that uses price data and volume data, typically displayed graphically in charts. The charts are analyzed using various indicators in order to make investment recommendations.
  • Technical analysis has three main principles and assumptions: (1) The market discounts everything, (2) prices move in trends and countertrends, and (3) price action is repetitive, with certain patterns reoccurring.
  • Increasingly, analysts, fund managers, and individual investors are studying the basic principles of technical analysis to support their decision making in financial markets.  Behavioral finance, which is the study of the influence of psychology on the behavior of investors, focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases. This relatively new field of finance is motivating more practitioners to consider technical analysis as a tool for understanding and explaining irrationalities in financial markets.
  • Technical analysis can be used on any freely traded security in the global market and is used on a wide range of financial instruments, such as equities, bonds, commodities, currencies, and futures. However, in general, technical analysis is most effectively applied to liquid markets. Therefore, technical analysis has limited usefulness for illiquid securities, where a small trade can have a large impact on prices.
  • The primary tools used in technical analysis are charts and indicators. Charts are graphical displays of price and volume data. Indicators are approaches to analyzing the charts. While the tools can be used on a standalone basis, many analysts, fund managers, and investors will find added value in combining the techniques of chart analysis with their own research and investment approach.
  • Charts provide information about past price behavior and provide a basis for inferences about likely future price behavior. Basic charts include line charts, bar charts, and candlestick charts.
  • Charts can be drawn either to a linear scale or to a logarithmic scale. A logarithmic scale is appropriate when the data move through a range of values representing several orders of magnitude (e.g., from 10 to 10,000), whereas a linear scale is better suited to narrower ranges (e.g., $35 to $50).
  • Volume is an important element of technical analysis and is often included on charts. Volume can be viewed as a confirmation in that it indicates the strength or conviction of buyers and sellers in determining a security’s price.
  • One of the most important steps in successfully applying technical analysis is to define the time period being analyzed. Technical analysis and charting become more reliable as the time scale increases from intraday to daily, weekly, and even monthly. Analysts and investors whose primary research method is fundamental analysis will find more value in charting instruments on a weekly and/or a monthly scale. Longer time frames will allow analysts and investors to better identify the consolidation and trend periods and time their purchases or sales of securities.
  • Several basic concepts can be applied to charts. These include relative strength analysis, trend, consolidation, support, resistance, and change in polarity.
  • Relative strength analysis is based on the ratio of the prices of a security and a benchmark and is used to compare the performance of one asset with the performance of another asset.
  • The concept of trend is an important aspect of technical analysis. An uptrend is defined as a sequence of higher highs and higher lows. To draw an uptrend line, a technician draws a line connecting the lows on the price chart. A downtrend is defined as a sequence of lower highs and lower lows. To draw a downtrend line, a technician draws a line connecting the highs on the price chart.
  • Support is defined as a low price range in which the price stops declining because of buying activity. It is the opposite of resistance, which is a price range in which price stops rising because of selling activity.
  • Chart patterns are formations appearing on price charts that create some type of recognizable shape. There are two major types of chart patterns: reversal patterns and continuation patterns.
  • Reversal patterns signal the end of a trend. Common reversal patterns are head and shoulders (H&S), inverse H&S, double top, double bottom, triple top, and triple bottom.
  • Continuation patterns indicate that a market trend that was in place prior to the pattern formation will continue once the pattern is completed. Common continuation patterns are triangles (symmetrical, ascending, and descending), rectangles (bullish and bearish), flags, and pennants.
  • Technical indicators are used to derive additional information from basic chart patterns. An indicator is any measure based on price, market sentiment, or fund flows that can be used to predict changes in price. Mathematically calculated indicators usually have a supply and demand underpinning. Basic types of indicators include price-based indicators, momentum oscillators, and sentiment indicators.
  • Price-based indicators incorporate information contained in market prices. Common price-based indicators include the moving average and Bollinger Bands.
  • The moving average is the average of the closing prices of a security over a specified number of periods. Moving averages are a smoothing technique that gives the technical analyst a view of market trends. So, a moving average can be viewed as a trend filter. Long-term moving averages can provide important signals. A price move above the long-term moving average is a sign of an uptrend. A price move below the long-term moving average is a sign of a downtrend.
  • When a short-term moving average crosses over a longer-term moving average from underneath, this movement is considered a bullish indicator and is called a “bullish crossover.” When a short-term moving-average crosses over a longer-term moving average from above, this movement is a bearish indicator and is called a “bearish crossover.”
  • Bollinger Bands combine the concept of a moving average with standard deviations around the moving average. This tool is useful in defining a trading range for the security being analyzed. The Bollinger Band width indicator provides an indication of volatility. The idea is that periods of low volatility are followed by periods of high volatility, so that relatively narrow band width can foreshadow an advance or decline in the security under analysis.
  • Momentum oscillators are constructed from price data, but they are calculated so that they fluctuate between a low and a high, typically between 0 and 100. Some examples of momentum oscillators include rate of change (ROC) oscillators, the relative strength index (RSI), stochastic oscillators, and the MACD (moving-average convergence/divergence oscillator).
  • Momentum oscillators can be viewed as graphical representations of market sentiment that show when selling or buying activity is more aggressive than usual. Technical analysts also look for convergence or divergence between oscillators and price. For example, when the price reaches a new high, this outcome is usually considered “bullish.” But if the momentum oscillator does not also reach a new high, this scenario is considered divergence and an early warning sign of weakness.
  • Momentum oscillators also alert the technical analyst to overbought or oversold conditions. For example, in an oversold condition, market sentiment is considered unsustainably bearish.
  • Sentiment indicators attempt to gauge investor activity for signs of increasing bullishness or bearishness. Commonly used calculated statistical indexes are the put/call ratio, the VIX, and margin debt.
  • Intermarket analysis combines technical analysis of the major categories of securities—namely, equities, bonds, currencies, and commodities—to identify market trends and possible inflections in trends. Intermarket analysis also looks at industry subsectors and their relationship to sectors and industries. In addition, it measures the relative performance of major equity benchmarks around the globe.
  • Technical analysis can use either a top-down approach or a bottom-up approach to analyze securities. The top-down method is useful for identifying outperforming asset classes, countries, or sectors. This approach can add value to asset allocation decisions. Allocation shifts can occur within an asset class or across asset classes. The bottom-up method is useful for identifying individual stocks, commodities, or currencies that are outperforming, irrespective of market, industry, or macro trends.
  • The technical analyst can add value to an investment team by providing trading/ investment ideas through either top-down or bottom-up analysis, depending on the nature of the investment firm or fund. In addition, technical analysis can add value to a fundamental portfolio approach by providing input on the timing of the purchase or sale of a security.