Question

Technical Analysis & EMH

(a) Select any one of the 30 companies that comprise the Dow Jones Industrial Average.

Suppose that you wish to use technical analysis to analyse the stock price over the past month and 1-year horizons.

• Explain briefly any two (2) differences between how investors apply technical analysis compared to fundamental analysis.                                                                                                                                   
• Using your chosen company, select any three (3) indicators

Explain the underlying logic behind each indicator.

Using any standard website, download the relevant technical charts for both the past month and also 1-year period.

Critically evaluate how you would interpret each technical indicator in terms of its ability to add value to investors or send clear trading signals in each of the relevant time periods.                                                                             

Answer 1

(a) There are basically two methods for technical analysis:

1.Top-Down. The top-down approach is a macroeconomic analysis that looks at the overall economy before focusing on individual securities. A trader would first focus on economies, then sectors, and then companies in the case of stocks. Traders using this approach focus on short term gains as opposed to long term valuations. For example, a trader may be interested in stocks that broke out from their 50-day moving average as a buying opportunity.

2. Bottom-Up. The bottom-up approach focuses on individual stocks as opposed to a macroeconomic view. It involves analyzing a stock that appears fundamentally interesting for potential entry and exit points. For example, an investor may find an undervalued stock in a downtrend and use technical analysis to identify a specific entry point when the stock could be bottoming out. They seek value in their decisions and intend to hold a long term view on their trades.

2.  The difference between the two approaches comes down to what determines a stock’s value and price. Fundamental analysis considers the value of the company. This ultimately depends on the value of its assets and the profits it can generate. Fundamental analysts are concerned with the difference between a stock’s value, and the price at which it is trading.

Technical analysis is concerned with price action, which gives clues as to the stock’s supply and demand dynamics – which is what ultimately determines the stock price. Patterns often repeat themselves because investors often behave in the same way in the same situation. Technical analysis is concerned with price and volume data alone.

3.

Technical indicators are heuristic or mathematical calculations based on the price, volume, or open interest of a security or contract used by traders who follow technical analysis.

By analyzing historical data, technical analysts use indicators to predict future price movements. Examples of common technical indicators include the Relative Strength Index, Money Flow Index, Stochastics, MACD and Bollinger Bands.

1. The relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100.

2. The Money Flow Index (MFI) is a technical oscillator that uses price and volume for identifying overbought or oversold conditions in an asset. It can also be used to spot divergences which warn of a trend change in price. The oscillator moves between 0 and 100.

Unlike conventional oscillators such as the Relative Strength Index (RSI), the Money Flow Index incorporates both price and volume data, as opposed to just price. For this reason, some analysts call MFI the volume-weighted RSI.

3. The stochastic oscillator is an indicator that measures the current price relative to the price range over a number of periods. Plotted between zero and 100, the idea is that, when the trend is up, the price should be making new highs. In a downtrend, the price tends to makes new lows. The stochastic tracks whether this is happening.

The stochastic moves up and down relatively quickly as it is rare for the price to make continual highs, keeping the stochastic near, 100 or continual lows, keeping the stochastic near zero. Therefore, the stochastic is often used as an overbought and oversold indicator. Values above 80 are considered overbought, while levels below 20 are considered oversold.