Technical Analysis Explained

Patterns (Elliott wave) TECHNICAL ANALYSIS EXPLAINED Trend (Moving average) Momentum (Rate-of-change) February 1999 Technical analysis - is governed by a system of rules and guidelines - provides objectiveness in the decision-making process - is fast to apply (once skills are learned) - is applicable across all time frames - is applicable to all markets - generally pre-empts fundamental data - has been proven in the market for over 200 years - is FUN and can earn you MONEY. Technical Analysis - Explained - 2 - Contents What is technical analysis? . . . . . . . . . . . . . . . . . . . . 3 Technical analysis pre-empts fundamental data . . . 4 Mood is stronger than ratio . . . . . . . . . . . . . . . . . . . . . 5 Optimism, pessimism, greed and fear . . . . . . . . . . . . 6 Chart types & chart construction . . . . . . . . . . . . . . . . . 7 Support and resistance . . . . . . . . . . . . . . . . . . . . . . . . . 8 Trendlines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Investment horizons . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 What trend? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Moving averages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 The simple moving average . . . . . . . . . . . . . . . . . . . . . 13 Long-, medium- and short-term averages . . . . . . . . . 14 Moving average crossover . . . . . . . . . . . . . . . . . . . . . . 15 Momentum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Momentum, indicator signals . . . . . . . . . . . . . . . . . . . . . 17 Long-, medium- and short-term indicators . . . . . . . . . 18 Trend and momentum combination . . . . . . . . . . . . . . . 19 Reversal & redistribution . . . . . . . . . . . . . . . . . . . . . . . . 20 Equity analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Cycle phase distribution . . . . . . . . . . . . . . . . . . . . . . . . . 22 The Elliott Wave Principle . . . . . . . . . . . . . . . . . . . . . . . 23 Catalog of impulsive waves . . . . . . . . . . . . . . . . . . . . . 24 Catalog of corrective patterns . . . . . . . . . . . . . . . . . . . 25 Impulsive wave patterns, example. . . . . . . . . . . . . . . . 26 Corrective wave patterns, example . . . . . . . . . . . . . . 27 Head and shoulder reversal pattern . . . . . . . . . . . . . 28 Fascinating Fibonacci . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Wave correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Fibonacci correlation - more than coincidence . . . . 31 Diploma in basic technical analysis . . . . . . . . . . . . . . 32 P.O. Box 500, 8070 Zurich Rolf P. Bertschi, Tel. +41 1 333 2405; e-mail: rolf.bertschi@cspb.com c copyright 1999, Credit Suisse Private Banking, Zurich Technical Analysis - Explained - 3 - What is technical analysis? Technical analysis is the study of financial market action. The technician looks at price changes that occur on a day-to-day or week-to-week basis or over any other constant time period displayed in graphic form, called charts. Hence the name chart analysis. A chartist analyzes price charts only, while the technical analyst studies technical indica- tors derived from price changes in addition to the price charts. Technical analysts examine the price action of the financial markets instead of the funda- mental factors that (seem to) effect market prices. Technicians believe that even if all relevant information of a particular market or stock was available, you still could not pre- dict a precise market "response" to that information. There are so many factors interacting at any one time that it is easy for important ones to be ignored in favor of those that are considered as the "flavor of the day." The technical analyst believes that all the relevant market information is reflected (or dis- counted) in the price with the exception of shocking news such as natural distasters or acts of God. These factors, however, are discounted very quickly. Price chart Technical indicators Technical Analysis - Explained - 4 - Technical analysis pre-empts fundamental data Fundamentalists believe there is a cause and effect between fundamental factors and price changes. This means, if the fundamental news is positive the price should rise, and if the news is negative the price should fall. However, long-term analyses of price changes in financial markets around the world show that such a correlation is present only in the short-term horizon and only to a limited extend. It is non-existent on a medium- and long- term basis. In fact, the contrary is true. The stock market itself is the best predictor of the future funda- mental trend. Most often, prices start rising in a new bull trend while the economy is still in recession (position B on chart shown above), i.e. while there is no cause for such an uptrend. Vice versa, prices start falling in a new bear trend while the economy is still growing (position A), and not providing fundamental reasons to sell. There is a time-lag of several months by which the fundamental trend follows the stock market trend. Moreover, this is not only true for the stock market and the economy but also for the price trends of individual equities and company earnings. Stock prices peak ahead of peak earnings while bottoming ahead of peak losses. The purpose of technical analysis is to identify trend changes that precede the fundamen- tal trend and do not (yet) make sense if compared to the concurrent fundamental trend. -Economic recession- -Economic recession- --------Economic growth-------- Stock market A B B Technical Analysis - Explained - 5 - Mood is stronger than ratio Know yourself and knowledge of the stock market will soon follow. Ego and emotions determine far more of investors´ stock market decisions than most would be willing to admit. For years, we have dealt with professional money managers and investment committees and found they were as much subject to crowd following and other irrational emotional mistakes as any novice investor. They were, for the most part, better informed, but facts alone are not enough to make profitable decisions. The human element, which encom- passes a range of emotions from fear to greed, plays a much bigger role in the decision- making process than most investors realize. In a practical sense, most investors act exactly opposite to the rational wisdom of buying low and selling high based on very predictable emotional responses to rising or falling prices. Falling prices that at first appear to be bargains generate fear of loss at much lower prices when opportunities are the greatest. Rising prices that at first appear to be good opportunities to sell ultimately lead to greed-induced buying at much higher levels. Reason is replaced by emotion and respective rationalization with such cyclical regularity, that those who recognize the symptoms and the trend changes on the charts can profit very well from this knowledge. Historically, this has always been indicative of the markets. G R E E D F E A R Technical Analysis - Explained - 6 - Price trend Optimism, pessimism, greed and fear Why aren´t more people making more money in the stock market? Because, as we have seen, people are motivated by greed (optimism) when buying and by fear (pessimism) when selling. People are motivated to buy and sell by changes in emotion from optimism to pessimism and vice versa. They formulate fundamental scenarios based on their emo- tional state (a rationalization of the emotions), which prevents them from realizing that the main drive is emotion. The chart above shows that if investors buy based on confidence or conviction (optimism) they BUY near or at the TOP. Likewise, if investors act on concern or capitulation (pessi- mism) they SELL near or at the BOTTOM. Investors remain under the bullish impression of the recent uptrend beyond the forming price top and during a large part of the bear trend. Vice versa, they remain pessimistic under the bearish impression from the past downtrend through the market bottom and during a large part of the next bull trend. They adjust their bullish fundamental scenarios to bearish AFTER having become pessimistic under the pressure of the downtrend or AFTER having become optimistic under the pressure of the uptrend. Once having turned bearish, investors formulate bearish scenarios, looking for more weakness just when it is about time to buy again. The same occurs in an uptrend when mood shifts from pessimism to optimism. Investors formulate bullish scenarios AF- TER having turned bullish, which is after a large part of the bull trend is already over. Emotions are the drawback of fundamental analysis. Investors must learn to buy when they are afraid (pessimistic) and sell when they feel euphoric (optimstic). This may sound easy (simple contrary opinion), but without charts it is hard to achieve. The main purpose of technical analysis is to help investors identify turning points which they cannot see because of individual and group psychological factors. Contempt Caution Confidence Complacency Concern Capitulation (Pessimism) Emotional trend follows the price trend (Optimism) Conviction Technical Analysis - Explained - 7 - Hourly HLC bar chart Daily HLC bar chart Weekly HLC bar chart Monthly HLC bar chart Bar charts Four bar charts of the Swiss Market Index are shown above. They are the most widely used chart types. The bar charts are: High-low charts or High-low-close charts or Open-high-low-close charts One single bar shows the high and the low of the respective trading period. A vertical bar is used to connect the high and the low. Horizontal lines are used to show the open- ing price (left) of that specific trading period and the closing price (right) at the end of High High Low Low Open Close the period. For example, on the monthly chart a bar indicates the high and the low at which the dollar traded during that single month. Line charts Sometimes we use line charts, especially for Elliott wave analysis. A line chart is the simplest of all methods. It is constructed by joining together the closing price of each session. Daily closing line chart Technical Analysis - Explained - 8 - Support and resistance Resistance lines are horizontal lines that start at a recent extreme price peak with the line pointing horizontally into the future. Support lines are horizontal lines that start at a recent extreme of a correction low and also point toward the future on the time axis. An uptrend continues as long as the most recent peak is surpassed and new peak levels are reached. A downtrend continues as long as past lows are broken, sustaining a series of lower lows and lower highs. Notice that the previous support often becomes resistance and resis- tance becomes support. A resistance or a support line becomes more important and its break gains more credibility as the number of price extremes (peaks for resistance; or lows for support) that can be connected by a single line increases. Some examples for Microsoft are shown on the chart above. Microsoft reached a high of 76 in July 1997. The price started to correct from there and Microsoft remained below this level until February 1998. The 76 level became the resistance, meaning that only if 76 (the highest peak so far in the uptrend) had been broken on the upside could the stock have confirmed its uptrend. The same is true for the peak at 120 in July 1998. The uptrend was confirmed when the price rose above this resistance in November 1998. Support levels are positioned at 20, 27, 43, 59, 82 and 87. As long as the price pushes above past peaks (resistance levels) and holds above past support levels (does not break them) the uptrend remains intact. The same is true for the bear trend. The downtrend re- mains intact as long as the price falls below the recent lows (support levels) and fails to rise above past resistance levels. A bearish trend reversal occurs when the price breaks the most recent support after having failed to rise above the most recent resistance. A bullish trend reversal occurs when the price penetrates the most recent resistance after having held above the most recent support. Last peak becomes resistance Last peak becomes resistance Last peak becomes resistancebreak of resistance Last low becomes support Last low becomes support Last low becomes supportbreak of support Breakout above resistance level Support becomes resistance Resistance becomes support 76 120 Technical Analysis - Explained - 9 - Trendlines Resistance levels can either be drawn by vertical lines (as discussed on the previous page) or can be uptrending or downtrending lines. The trendline is nothing more than a straight line drawn between at least three points. In an upmove the low points are connected to form an uptrend line. For a downtrend the peaks are connected. The important point is that it should not be drawn over the price action. Trendlines must encorporate all of the price data, i.e. connect the highs in a downtrend and the lows in an uptrend. The closing prices are not connected. The trend line becomes more important and gains credibility as the number of price ex- tremes that can be connected by a single line increases. The validity and viability of a line that connects only two price extremes (for example the starting point and one price low) is questionable. The trend is broken when the price falls below the uptrend line or rises above the downtrend line. Some analysts use a 2-day rule, meaning that the trend is only seen as broken if the price closes above/below the trendline for at least two days. Others use a 1% stop (could be higher depending on market volatility), meaning the trend is only seen as broken if the price closes over 1% above/below the trendline. The chart above shows Intel´s rise from July 1996 to March 1997. Based on the uptrend line, investors would have held onto the position from around 38/40 until 66 or even 74/76. Most often investors take profits much too early. Stay with a trend until it is broken. Trendline is broken Trendline is broken Technical Analysis - Explained - 10 - 6 9 2 3 5 8 10 11 7 SECONDS Short-term trend (lasts about 2-6 weeks) HOURS Long-term trend (lasts about 12 months) MINUTES Intermediate-term trend (lasts about 3-6 months) 1 4 Investment horizons The charts on the previous pages show that investors require perspective. It is imperative to differentiate between a short-term, a medium-term and a long-term trend. If somebody tells you to buy the US dollar because it is likely to rise, make sure you understand whether the dollar is expected to rise over a few days or a few months and if you should buy the dollar with the intention to hold it for several days, several weeks or several months. For a technician on the trading floor, the long-term horizon is entirely different from that of an institutional investors. For a trader long-term can mean several days, while for the investor it can mean 12 to 18 months. We can compare the charts and indicators to a clock (shown above). Short-term trends (the seconds) are best analyzed on daily bar charts. Medium-term trends (the minutes) are best seen on weekly bar charts and long-term trends (the hours) are best seen on monthly bar charts. Some investors only want to know the hour, some want to know the seconds and some want to know the exact time. The best investment results are achieved when all three trends on the daily, weekly and monthly charts point in the same direction. 12 Technical Analysis - Explained - 11 - What trend? The chart above shows three US dollar/Ger- man mark trends. Medium-term trends Long-term trends Short-term trends Uptrend: Higher peaks and higher troughs Downtrend: Lower peaks and lower troughs Sideways trend or consolidation: Horizontal peaks and troughs 1) The uptrend from 1995 to 1997 is long term. It is also called the PRIMARY trend. It was broken by the 1998-decline. The long- term uptrend is not a straight line, but is in- terrupted by corrections of a smaller degree. 2) These corrections are the medium-term or intermediate-term trends. They are also called SECONDARY trends. The medium- term correction is also not a straight line but is made up of smaller corrections. 3) These smaller trends are the short-term trends. They are also called MINOR trends. A minor downtrend can be part of an inter- mediate-term uptrend which itself can be part of a longer-term primary downtrend. Sometimes it is difficult to differentiate be- tween a short- and a medium-term or a long- term trend. Therfore, we need support from the technical indicators. 1) 2) 3) Technical Analysis - Explained - 12 - Price & 5-day moving average 10 20 30 40 50 60 70 80 1 4 7 10 13 16 19 22 25 28 31 34 37 40 5-day moving average Price Moving averages Moving averages are popular and versatile for identifing price trends. They smooth out fluctuations in market prices thereby making it easier to determine underlying trends. Their other function is to signal sig- nificant changes in direction as early as possible. The simple moving average is the most widely used. Its calculation is shown above in mathematical form and displayed in the chart on the right. For a 5-day moving average you simply add the closing prices of the last five closings and divide this sum by 5. You add each new clos- ing and skip the oldest. Thus, the sum of closings always remains constant at 5 days. Whether you choose a 10-day average or a 40-week av- erage the calculation is the same; instead of adding five days you add 10 days or 40 weeks and divide the sum by 10 or 40, respectively. Day Close 5-day Total 5-day Average Day Close 5-day Total 5-day Average 1 50 x x 21 48 171 34.2 2 55 x x 22 40 186 37.2 3 57 x x 23 43 199 39.8 4 60 x x 24 41 205 41 5 65 287 57.4 25 35 207 41.4 6 70 307 61.4 26 39 198 39.6 7 66 318 63.6 27 35 193 38.6 8 60 321 64.2 28 37 187 37.4 9 50 311 62.2 29 25 171 34.2 10 54 300 60 30 18 154 30.8 11 45 275 55 31 35 150 30 12 43 252 50.4 32 50 165 33 13 33 225 45 33 40 168 33.6 14 40 215 43 34 45 188 37.6 15 35 196 39.2 35 50 220 44 16 30 181 36.2 36 70 255 51 17 25 163 32.6 37 70 275 55 18 30 160 32 38 60 295 59 19 35 155 31 39 75 325 65 20 33 153 30.6 40 70 345 69 Price & 5-day moving average P r i c e Time Technical Analysis - Explained - 13 - The simple moving average The simple moving average yields a mean of data for a given period. For example: a 21- day simple moving average (SMA) would include the last 21 days of data divided by 21 resulting in an average (see chart above for the Dow Industrial Index). This can be calcu- lated at any given time using the last 21 days, hence, the average moves foreward with each trading day. The moving average is usually plotted on the same chart as price move- ments so a change in direction of trend can be indicated by the penetration/crossover of the SMA. Generally a buy signal is generated when a price breaks above the moving average and a sell signal is generated by a price break below the moving average. It is added confirmation when the moving average line turns in the direction of the price trend. The moving average naturally lags behind price movement, and the extent by which it lags (or its sensitivity) is a function of the time span. Generally, the shorter the moving average the more sensitive it is. A 5-day moving average will react more quickly to a change in price than a 20-day moving average for example. However, the 5-day moving average is more likely to give false signals and "whipsaw" than the 20-day one, which gives signals later and suffers from opportunity loss. Generally, if the market is trending (in an uptrend or downtrend) a longer time period would b