Portfolio Management II
Reading 56. Technical Analysis
Learning Outcome Statements
e. describe common technical analysis indicators (price-based, momentum oscillators, sentiment, and flow of funds);
CFA Curriculum, 2020, Volume 1
Why should I choose AnalystNotes?
AnalystNotes specializes in helping candidates pass. Period.
Subject 5. Technical Indicators
Price-based indicators incorporate information contained in market prices.
A moving average is the average price of a security over a set amount of time. By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend.
Moving averages can be used to quickly identify whether a security is moving in an uptrend or a downtrend depending on the direction of the moving average. As you can see in the figure below, when a moving average is heading upward and the price is above it, the security is in an uptrend. Conversely, a downward-sloping moving average with the price below can be used to signal a downtrend.
A golden cross is a crossover involving a security's short-term moving average (such as a 15-day moving average) breaking above its long-term moving average (such as a 50-day moving average) or resistance level. As long-term indicators carry more weight, the golden cross indicates a bull market on the horizon and is reinforced by high trading volumes. Additionally, the long-term moving average becomes the new support level in the rising market.
A dead cross shows the opposite movement of the moving average.
Bollinger Bands are volatility bands placed above and below a moving average. Volatility is based on the standard deviation. The bands automatically widen when volatility increases and narrow when volatility decreases.
Generally speaking, momentum measures the rate of change of a security's price. As the price of a security rises, price momentum increases. The faster the security rises (the greater the period-over-period price change), the larger the increase in momentum. Once this rise begins to slow, momentum will also slow. As a security begins to trade flat, momentum starts to actually decline from previous high levels.
Momentum oscillators can be used to determine the strength of a trend and to signal a pending trend reversal.
A rate of change oscillator (ROC) or a momentum oscillator measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC oscillator.
- When the indicator is above 0, the percentage price change is positive (bullish).
- When the indicator is below 0, the percentage price change is negative (bearish).
A relative strength index (RSI) compares the average price change of the advancing periods with the average change of the declining periods. It is a momentum oscillator that measures the speed and change of price movements.
where RS = average gain / average loss
RSI oscillates between zero and 100. Traditionally RSI is considered overbought when above 70 and oversold when below 30.
The RSI should be used with other technical tools such as trend analysis or pattern analysis.
A stochastic oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods.
Because the stochastic oscillator is range-bound, it is also useful for identifying overbought and oversold levels. It is above 50 when the close is in the upper half of the range and below 50 when the close is in the lower half. Low readings (below 20) indicate that price is near its low for the given time period. High readings (above 80) indicate that price is near its high for the given time period.
When using the stochastic oscillator it is important to identify the bigger trend and trade in the direction of this trend. For example, securities can become overbought and remain overbought during a strong uptrend. Closing levels that are consistently near the top of the range indicate sustained buying pressure.
The moving average convergence-divergence (MACD) turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, MACD offers the best of both worlds: trend-following and momentum.
- MACD line: 12-day EMA - 26-day EMA (EMA: exponential moving average)
- Signal line: 9-day EMA of MACD
MACD fluctuates above and below the zero line as the moving averages converge, cross, and diverge.
- Convergence occurs when the moving averages move towards each other.
- Divergence occurs when the moving averages move away from each other.
Sentiment indicators attempt to gauge investor activity for signs of increasing bullishness or bearishness. They are used to quantify the levels of optimism or pessimism present in various markets.
Opinion polls to gauge investors' sentiments towards the equity market are conducted by a variety of services. Contrarians believe that if a large proportion of investment advisory services have a bearish attitude, this signals the approach of a market trough and the onset of a bull market.
Commonly used calculated statistical indices are:
- Put/call ratio. Put options are believed to be signals of bearish attitudes. Technicians reason that a higher put/call ratio indicates a more pervasive bearish attitude, which they consider a bullish indicator. The ratio typically has been substantially less than 1 since investors tend to be bullish and avoid selling short or buying puts.
- The CBOE Volatility Index, often referred to as the fear index, measures the implied volatility of S&P 500 index options. It represents one measure of the market's expectation of stock market volatility over the next 30-day period.
- Margin debt. Debt balances in brokerage accounts represent borrowing by knowledgeable investors from their brokers. These balances indicate the attitude of a sophisticated group of investors who engage in margin transactions. An increase would be a bullish sign while a decline would indicate selling as these sophisticated investors liquidate their positions (and this could indicate less capital available for investing).
- Short interest ratio. This ratio is derived by dividing the short interest by the average daily volume for a stock. It provides a number that is used by investors to determine how long it will take short sellers, in days, to cover their entire positions if the price of a stock begins to rise. The higher the ratio, the longer it will take to buy back the borrowed shares - an important factor, upon which traders or investors decide whether to take a short position.
Flow-of-funds indicators attempt to measure the ability or the financial position of different investor groups. These indicators try to measure their capacity of these groups to buy or sell stocks. They also attempt to measure where the money is going.
- An arms index, also called the TRIN, is a breadth indicator that measures the relative extent to which money is moving into or out of rising and declining stocks. A ratio of 1 means the market is in balance; above 1 indicates that more volume is moving into declining stocks and below 1 indicates that more volume is moving into advancing stocks.
- Margin debt can also be used as a flow-of-funds indicator.
- Mutual fund cash position. Mutual funds hold some part of their portfolio in cash. The cash ratios (ratios of cash as a percentage of the total assets in mutual funds' portfolio) are usually from 5-13%. A high percentage of cash is a bearish indicator, and vice versa. A high mutual fund cash position also can be considered as a bullish indicator because of potential buying power, since technicians believe that these cash funds will eventually be invested and will cause stock prices to increase (and vice versa).
- New equity issuance. This indicator suggests that as the number of IPOs increases, the upward price trend may be about to turn down.
- Secondary offerings. These increase the supply available for trading.
User Contributed Comments 9You need to log in first to add your comment.
My assumption that in any market the usable capital is relatively fixed. To push up the stock prices, capital has to be used, thus when capital is less avilable, prices will not tend to more upwards. Whereas when the capital is available, any signal of moving up will cause the capital joins in the market.
i'm sure none of these will be on the exam
You could be right, bahodir, but I'd be cautious in making too many assumptions. Even the parctice tests have been tricky...
would you bet passing on it? These would be easy to lock in for a couple of extra points, which could make all the difference in the world in my case! T-10 hours!
so many things to memorize, cant them make it like Rsi, 200 MVA etc?
bahodir, I'm sure you won't make it.
Discipline people --- just do it.
so much to learn arrrrh
@haarlemmer Disagree. New positive company information or a positive change in market sentiment could theoretically cause would be sellers to hold on to their securities anticipating higher price movement. This decrease in supply coupled with the assumed increase in demand would certainly shift the equilibrium price and cause sellers to raise their ask and buyers to raise their bid. This could theoretically occur without without a single share being traded.