Question

5. Briefly describe how technical analysis is used as part of the stock valuation process. What role does it play in an investor’s decision to buy or sell a stock?

6. Describe each of the following approaches to technical analysis and note how it would be used by investors.

1. Confidence index

2. Arms index

3. Trading action

4. Odd-lot trading

5. Charting

6. Moving averages

7. On-balance volume
   
   Which of these approaches is likely to involve some type of mathematical equation or ratio?

7. Briefly define each of the following and note the conditions that would suggest the market is technically strong.

1. Breadth of the market

2. Short interest

3. Relative strength index

4. Theory of contrary opinion

5. Head and shoulders

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Answer 1

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Technical analysis is a method of evaluating securities that involves a statistical analysis of market activity, such as price and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but rather, use charts and other tools to identify patterns that can be used as a basis for investment decisions.

There are many different forms of technical analysis- Some rely on chart patterns, others use technical indicators and oscillators, and most use a combination of techniques. In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don’t concern themselves with a stock’s valuation. The only thing that matters are past trading data and what information the data might provide about future price movements.

Technical analysis is based on three assumptions:

1. The Market Discounts Everything

Many experts criticize technical analysis because it only considers price movements and ignores fundamental factors. The counterargument is based on the Efficient Market Hypothesis, which states that a stock’s price already reflects everything that has or could affect a company including fundamental factors. Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology is already priced into the stock. This removes the need to consider the factors separately before making an investment decision. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.

2. Price Moves in Trends

Technical analysts believe that prices move in short, medium, and long-term trend. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.

3. History Tends to Repeat Itself

Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many form of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

In technical analysis, there are three golden rules according to consensus in the market which helps the investors decide whether to buy or sell the stock in the market-

Rule 1- Stock prices reflect everything that has and might affect a company. All the information an investor needs is reflected in the market price.

Rule 2- Movements in pricing are not random. Stock prices move in trends, don’t fight them.

Rule 3- Price patterns always repeat if given enough time. The repetitive nature of price movements is down to market psychology: Investors are consistent in their reactions.