Advanced Portfolio Management
ADMS 4501 – Winter 2012 – Lois King
Lecture 6 – Chapter 10 – Technical Analyses – Feb 09
Underlying Assumptions of Technical Analysis
- The market value of any good or service is determined solely by the interaction of
supply and demand.
- Supply and demand are governed by numerous factors, both rational and
- Disregarding minor fluctuations, the prices for individual securities and the overall
value of the market tend to move in trends, which persist for appreciable lengths
- Prevailing trends change in reaction to shifts in supply and demand relationships.
These shifts, no matter why they occur, can be detected sooner or later in the
action of the market itself.
Advantages of Technical Analysis
- Technical analysis is not heavily dependent on financial accounting statements.
The technician contends that there are several major problems with accounting
o Lack information needed by security analysts.
o GAAP allows firms to select reporting procedures, resulting in difficulty
comparing statements from two firms.
o Non-quantifiable factors do not show up in financial statements.
- Fundamental analyst must process new information and quickly determine a new
intrinsic value, but technical analyst merely has to recognize a movement to a
- Technicians trade when a move to a new equilibrium is underway but a
fundamental analyst finds undervalued securities that may not adjust their prices
Challenges to Technical Analysis
- For assumptions of technical analysis
o Empirical tests of efficient market hypothesis (EMH) show that prices do
not move in trends.
- For technical trading rules
o The past may not be repeated.
o Patterns may become self-fulfilling prophecies.
o A successful rule will gain followers and become less successful.
o Rules require a great deal of subjective judgement.
Technical Trading Rules and Indicators
- The rationale
o A typical stock price cycle of the market or a stock goes through a peak
and through as well as trends. o By analyzing the trend patterns (rising trend, flat trend, declining trend)
and the change in trend, a technical analyst would be able to decide what
trade is needed.
- Technical trading rules
o Contrary-opinion rules
o Follow the smart money
o Momentum indicators
o Stock price and volume techniques
Contrary – Opinion Rules
- Many analysts rely on rules developed from the premise that the majority of
investors are wrong as the market approaches peaks and troughs.
- Technicians try to determine whether investors are strongly bullish or bearish and
then trade in the opposite direction.
- These positions have various indicators.
- Mutual fund cash positions
o Buy when the mutual fund cash position is high, sell when low.
o Assumes that mutual fund managers are poor judges of market turning
- Credit balances in brokerage accounts
o Buy when credit balances increase, sell when credit balances fall.
- Investment advisory opinions
o Buy when advisory firms become more bearish.
- OTC versus NYSE volume
o If OTC volume increases relative to NYSE volume, sell since speculation
increases at peaks.
- Put-Call Ratio
o Buy when option purchasers are bearish (When the put/call ratio
- Futures traders bullish on stock index futures
o Sell when speculators are bullish.
Follow the Smart Money
- While contrary-opinion rules assume that most investors are not smart, these
indicators seek to follow the path of a few sophistic