Chapter 1: Intro to Investment

 

All of us have our own goals in life, even though the goal may be just as simple as buying a watch on the next pay rise. The question pondering many bewildered working adults - how are we going to achieve them all with the limited resources we have got?

 

Table Of Contents

 

1. Introduction

2. Fundamental Vs. Technical Analysis

3. The Use Of Trend

4. Support And Resistance

5. The Importance Of Volume

6. What Is A Chart?

7. Chart Types

8. Chart Patterns

9. Moving Averages

10. Indicators And Oscillators

11. Strengths of Technical Analysis

12. Weaknesses of Technical Analysis

•1. Introduction

There are two main methods in analyzing securities to facilitate investment decisions making.

Fundamental Analysis

Technical Analysis

v Analyze characteristics of a company to estimate its value. (e.g. Future potential, brand perception) •v Uses qualitative methods (E.g. industry performance, management, competitive advantage, industry growth) and •v Use quantitative methods (E.g. balance sheet, cash flow statement, brand valuation)

•v Only interested in the price movements in the market •v Technicians aka ‘chartists' •v Analyze supply and demand of market in a market to determine what direction, or trend, will continue in the future. •v Use quantitative methods (e.g. past prices, sales volume) •v Often utilizes a variety of tools to track the changes, such as charts, technical indicators and oscillators •v Utilizes historical price and volume •v Attempts to understand the emotions in the market by studying the market itself. •v Can be used on any security with historical trading data. E.g. stocks, futures and commodities, fixed-income securities, forex, etc

However, for this report we will focus our attention on Technical Analysis.

If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

1.1 The Basic Assumptions

1.1.1 What Is Technical Analysis?

• v A method of evaluating and understanding of securities by analyzing the statistics/data generated by market activity, such as past prices and volume.
• v Does not attempt to measure a security's intrinsic value (aka real value)
• v Analyze historical and present price and volume to identify patterns to predict future stocks movement.
• v Various method to conduct technical analysis:
• § Analyzing chart patterns to derive trends and movement
• § Using technical indicators, which are mathematical calculation to determine areas such as moving average convergence-divergence (MACD) indicator and the relative strength index (RSI) of securities.
• § Using oscillators which calculates averages between two extreme values use with a trend indicator for discovering short-term overbought or oversold conditions.
• v Not concern whether a stock is undervalued - only concern is a security's past trading data and the information it provides in enabling predicting of the security's movement in the future.
• v The field of technical analysis is based on three assumptions:

•1. The market discounts everything.

•2. Price moves in trends.

•3. History tends to repeat itself.

1.1.2 Three assumptions of technical analysis

1. The Market Discounts Everything

Price movement chosen to be the core of technical analysis is because technical analysts believe that the price is already reflective of all the company's fundamentals, along with broader economic factors and market psychology. Thus there is no need to consider the other factors separately unlike that of fundamental analysis. Where price movement as seen as a product of the supply and demand for a particular stock in the market.

Critics of technical analysis often criticize the exclusive analysis of price factors only, ignoring the fundamental factors of the company such as its future, its management, its brand value.

2. Price Moves in Trends

Most technical trading strategies are based on the assumption that price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it.

3. History tends to repeat itself

Another assumption is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, investors are likely to provide a consistent or similar response towards similar market stimuli over time.

Chart patterns are used to analyze market movements and understand trends, where it illustrates patterns in price movement.

2. Fundamental Vs. Technical Analysis

Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. The following will look at the criticism against technical analyst, and discuss how they differ and how they can be utilized together.

2.1. Differences between Technical Analysis and Fundamental Analysis

Differences between Technical Analysis and Fundamental Analysis
	Technical Analysis	Fundamental Analysis
Charts vs. Financial Statements	v Uses charts, technical indicators to determine securities' price movement v Believes that all company's fundamental are accounted for in the stock's price.	v Uses financial statements to determine a company's value. v Attempt to measure company's intrinsic value (real value) v Fairly easy to make investment decision - stock with price lower than the intrinsic value are good investments
Time Horizon	v Used only within a timeframe or weeks, days v Examines data stretching all the way into past history v Takes on more of a short-term approach to investing and analyzing stocks.	v Takes a relatively long-term approach to analyzing the market v Examines data of recent past and potential future. v Aka value investing v Assumes short-term investing is wrong, that price of a particular stock will correct itself over the long run. v Information to conduct FA is often released over long period of time, e.g. quarterly financial statements, cashflow v The long-term timeframe is also due to the slower release of information to Fundamental Analysts.
Trading vs. Investing	v TA is used for a trade v Traders buy stocks as they believe they can sell the stock at a higher price to someone else.	v FA is used to make an investment decisions v Investors buy stocks as they believe they can increase in value.

2.2 The Critics

• v Technical analysis is often criticized by academics
• v One of the main criticism is the efficient market hypothesis (EMH). There are three versions of EMH, but the focus would be on one of them called the ‘weak form efficiency'
• v ‘Weak form efficiency' states that technical analysis can't predict future movements because all past information has already been accounted for and, therefore, analyzing the stock's past price movements will provide no insight into its future movements.

2.3 Can They Co-Exist?

• v Despite the vast differences among the two analysis methods, it has brought substantial success to market participants who utilize both methods.
• v For example, Fundamental Analysts can use TA techniques to determine the optimal time to enter into an undervalued security. This is particularly beneficial when security is severely oversold. By timing entry into a security, the gains on the investment can be greatly improved.
• v For example, Technical traders can refer to fundamentals to backup a technical signal. Such as if a sell signal is given through technical patterns and indicators, a technical trader might look to reaffirm the decision by looking at some key fundamental data.
• v Often times, using both the FA and TA can help to provide the best-case scenario for a trade thorough better coverage and understanding.

3. The Use Of Trend

Definition of trends: "A general direction in which something tends to move" (dictionary.com). In our application, trend would be reflective of the general direction of where a security is heading.

The following charts with provide a basic insight on what would a trend constitute:

Chart 1: Singapore Straits Times Index

Discussion:

The frame on the upper half, is indicative of the stock's prices compiled over the years from 2003 to 2007. As seen in Chart 1, the overall trend is upwards going. The bottom frame reflects the frequency and intensity of the fluctuation in volume of the STI. Overall, the direction of this security is clear.

Chart 2: Singapore Straits Time Index

Discussion:

This chart presents captures a shorter time frame (May - Aug 2007) of the stock price movements. As seen in the chart, there are numerous ups and downs within this short frame of time, making it a very unstable stock at present. Thus at present, there isn't a clear indication of which direction this security is headed.

3.1 A More Formal Definition

Unfortunately, trends are not always easy to see. Defining a trend goes well beyond the obvious. In any given chart, prices tend not to move in a straight line in any direction, but rather in a series of highs and lows.

In TA, it is the movement of the highs and lows that constitutes a trend. For example, an uptrend is classified as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs.

Figure 1

Figure 1 is an example of an uptrend. Point 2 in the chart is the first high, which is determined after the price falls from this point. Point 3 is the low that is established as the price falls from the high. For this to remain an uptrend, each successive low must not fall below the previous lowest point or the trend is deemed a reversal.

3.2 Types of Trend

There are three types of trend:

v Uptrends	When each successive peaks and trough is higher than the previous high
v Downtrends	When the peaks and troughs are getting lower than the previous low
v Sideways/ Horizontal trends	When there are no definite/clear trends in either direction. Aka nowhere.

3.3 Trend Lengths

Chart 3: Indication of various trend lengths

v Long-term trend - longer the trend, the more important it is	A major trend is generally referred as lasting longer than a year Made up of several intermediate trends which are moved against the direction of the major trend A break in the trend, aka correction, would make it a intermediate trend LT trends are identified through compilations of weekly charts or daily charts spanning of an average of a five-year
v Intermediate trend	Last between one and three months If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the correction is considered to be an intermediate trend Daily data charts are best used when analyzing both intermediate and short-term trends.
v Short-term trend	Anything less than a month Made up of both major and intermediate trends Daily data charts are best used when analyzing both intermediate and short-term trends.

3.4 Trendlines

A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock.

• v Drawing a trendline is as simple as drawing a straight line that follows a general trend.
• v An upward trendline is drawn at the lows of an upward trend.
• v A downward trendline is drawn at the highs of the downward trend.
• v Used to clearly show the direction of a trend and used in the identification of trend reversals.
• v Helps traders to anticipate the point at which a stock's price will begin moving upwards again.

.

Chart 4: United Overseas Bank Ltd

Discussion:

The chart above indicates an upward trendline, which is drawn at the lows of an upward trend.

3.5 Channels

An extended use of trendlines is the channel, or channel lines. Channel lines are the addition of two parallel trendlines. The channel lines acts as a guide to trade between the two levels of support and resistance until it breaks beyond one of the levels, in which case there is a likely chance to expect a sharp move in the direction of the break.

The upper trendline connects a series of highs, while the lower trendline connects a series of lows. Like a trend, it can slope upward, downward or sideways.

Chart 5: United Overseas Bank Ltd

Discussion:

Chart 5 above illustrates an ascending channel on a stock chart; the upper trendline has been placed on the highs and the lower trendline is on the lows. The price has veers off of these lines several times but with minimal significance, and has remained in the range for several months.

Thus as long as the price does not fall significantly below the lower line or move beyond the upper resistance, the range-bound upwards trend is expected to continue.

4. Support And Resistance

Another major concept is ‘support and resistance'. This is referred as the consistent battle between the bulls and the bears, which is the struggle between buyers (demand) and sellers (supply) of a market.

As such, prices of a security seldom move above (resistance) or below (support).

Chart 6: Illustration of Resistance and Support

Discussion:

As shown in the Chart above, the upperline indicates the Resistance level, where price level of the stock is not likely to surpass. While the lowerline indicates the Support level, at a level at which prices are not likely to fall below.

4.1 Why Does it Happen?

These support and resistance levels are important as they reflect the market psychology, supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in the case of a support) or sell it (in the case of resistance).

When these trends are veers off, this likely indicates a change in the supply, demand and the market psychology. It will eventually lead to new levels of support and resistance being established.

4.2 Role Reversal

Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support.

For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.

Image 2: Illustration of role reversal

Discussion:

The dotted line above represents a level of resistance that prevented two occasions from exceeding it (point 1 and 2). However, once the resistance is broken, it becomes a level of support (shown by Points 3 and 4) by acting as the lowest price level which prevents it from heading lower again.

Chart 7: Illustration of the phenomena of role reversal

Discussion:

In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels. This is most often seen when a stock is trading in a generally sideways manner, if you draw the trendlines, as the price moves through successive peaks and troughs, testing resistance and support.

4.3 The Importance of Support and Resistance

Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if an important level of resistance has overtime prove to be stable and strong and never broken, one would take advantage of the situation to take profit when the security is moving up and exits before it climbs down.

A break beyond a level of support or resistance does not always have to be a reversal. For example, if prices moved above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price increase is expected to be faster than it was in the channel.

As such, support and resistance points influence the way people buy stocks. For e.g. avoid placing orders at major points, as the area around them is usually marked by a lot of volatility. Do not place orders directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number.

5. The Importance Of Volume

While price is the primary item of concern in technical analysis, volume is also extremely important.

5.1 What is Volume?

Volume is simply the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume exchanged hands, the more active the security.

To determine the movement of the volume (up or down), chartists look at the volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show trends in the same way that prices do.

Chart 8: Chart of the STI from Nov 2006 to Sept 2007

5.2 Why Volume is Important

Volume is an important aspect of TA, used to double confirm trends and chart patterns, indicated by prices. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume.

For example, if a stock jumps 5% in one trading day after being in a long downtrend. To confirm if this is the trend reversal, traders analyze the volume. If the day's trading of stocks remains around the average daily volume, then it is a sign that the reversal is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true trend reversal.

Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the link between volume and price movement is poor, it is often indicative of weakness in the trend.

When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators. The simplest example of divergence is a clear upward trend on declining volume.

Usage of Volume
Volume and Chart Patterns	v Volume is used to reaffirms chart patterns v Patterns such as head and shoulders, triangles, flags, and other price patterns can be confirmed with volume v When volume is in sync with the pivotal movement in the chart, the signal is thus stronger, i.e. Pivotal point (peak), Volume (up), increases the likelihood of an upcoming upward trend v When volume contradicts pivotal movement, the qualify of the signal would thus be considered weak
Volume precedes price	v Price is preceded by volume v Volume can help to provide ideas on possible upcoming trends reversal, e.g. slowing down in volume, or big volume being sold v For e.g., if volume starts to decrease in an uptrend, it usually signals that an upward run is about to end.

6. What Is A Chart?

A chart is a graphical representation of a series of prices over a period of time. For example, a chart may show a stock's price movement over a one-year period, where each point on the graph represents the closing price for each day the stock is traded.

6.1 Chart Properties

There are several considerations when attempting to understand a chart. Such as time scale, the price scale and the price point properties used.

Properties	Descriptions
The Time Scale	v Refers to the range of dates at the bottom of the chart, which can vary from decades to seconds v Most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually v Shorter time frame used to analyze short-term or intermediate trends, while longer time frame are used to analyze long-term trends v The shorter the time frame, the more detailed the chart. v Each data point can represent the closing price of the period or show the open, the high, the low and the close depending on the chart used. v Intraday charts plot price movement within the period of one day. Time scale ranging from five minutes frame or the entire day. v Each data point in these graphs will be a condensed version of what happened over the specified period.
The Price Scale and Price Point Properties	v The price scale is on the right-hand side of the chart. v It shows a stock's current price and compares it to past data points. v However, it is important to note the structure of the scale. v E.g. Chart 9 - Linear scale, the space between each price point (10, 20, 30, 40) is separated by an equal amount. A price move from 10 to 20 on a linear scale is the same distance on the chart as a move from 40 to 50. In other words, the price scale measures moves in absolute terms and does not show the effects of percent change. v E.g. Chart 9 - Logarithmic Scale, If a price scale is in logarithmic terms, then the distance between points will be equal in terms of percent change. A price change from 10 to 20 is a 100% increase in the price while a move from 40 to 50 is only a 25% change, even though they are represented by the same distance on a linear scale. On a logarithmic scale, the distance of the 100% price change from 10 to 20 will not be the same as the 25% change from 40 to 50.

Chart 9: Linear Scale Chart and Logarithmic Scale Chart

Linear Scale Logarithmic Scale

7. Chart Types

There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. They are the line chart, the bar chart, the candlestick chart and the point and figure chart.

Each of the following charts is created based on the S&P 500 Index during the period of January 2006 through May 2006. Note that despite the same information, but the way the data is plotted and shown in the charts is different.

Charts are one of the most fundamental aspects of technical analysis. It is important to have a clear understanding of what is being shown on a chart and the information that it provides.

Types	Description	Examples
Line Chart	v The most basic chart v It represents only the closing prices over a set period of time. v The line is formed by connecting the closing prices over the time frame. v Does not provide visual information of the trading range for the individual points such as the high, low and opening prices. v As closing prices are deem the most important data to compare on the high and lows, thus it is the only value used in line charts.
Bar Charts	v Expands on the line chart by adding several more key pieces of information to each data point. v Made up of a series of vertical lines that represent each data point, which represents the high and low for the trading period, and the closing price. v The close and open are represented on the vertical line by a horizontal dash. v The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. While the close is represented by the dash on the right. v If the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. v A bar that is colored red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).
Candlestick Charts	v Similar to a bar chart, but it differs in the way that it is visually constructed. v Similar to the bar chart, it also has a thin vertical line showing the period's trading range. v The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. v Rely on the use of colors to explain what has happened during the trading period. There are no universal standard on the colours used, thus one should configure to suit your personal needs.
Point and Figure Charts	v Not well known or used by the average investor but it has had a long history of use v Reflects price movements and is not as concerned about time and volume v Removes the noise, or insignificant price movements, in the stock, which can distort traders' views of the price trends. v Also try to neutralize the skewing effect that time has on chart analysis. v The Xs represent upward price trends and the Os represent downward price trends. v The numbers and letters represent the months, and give investors an idea of the date. v The reversal criteria set how much the price has to move away from the high or low in the price trend to create a new trend or, in other words, how much the price has to move in order for a column of Xs to become a column of Os, or vice versa

8. Chart Patterns

•v Distinct formation on a stock chart that creates a trading signal, or a sign of future price movements that are used to identify current trends and trend reversals and to trigger buy and sell signals.

•v Theory behind chart patterns is that history repeats itself, and that certain patterns are seen many times, signaling a certain high probability move in a stock

•v Chartists look for these patterns to identify trading opportunities, though there are no chart patterns that will tell you with 100% certainty where a security is headed.

•v There are two types of patterns within this area of technical analysis, reversal and continuation.

•v A reversal pattern signals that a prior trend will reverse upon completion of the pattern.

•v A continuation pattern, on the other hand, signals that a trend will continue once the pattern is complete. These patterns can be found over charts of any timeframe.

8.1 Head and Shoulders

•v One of the most popular and reliable chart patterns in technical analysis.

•v A reversal chart pattern that when formed, signals that the security is likely to move against the previous trend.

•v Head and shoulders top is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end.

•v Head and shoulders bottom, also known as inverse head and shoulders, is the lesser known of the two, but is used to signal a reversal in a downtrend.

Charting Test - Identify the inverse Head and Shoulders found below:

Chart 10: Inverse Head and Shoulders

The head and shoulders chart pattern illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows.

8.2 Cup and Handle

•v A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.

•v As you can see above, this price pattern forms what looks like a cup, which is preceded by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price.

•v Once price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year.

8.3 Double Tops and Bottoms

•v This chart pattern signals a trend reversal

•v It is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.

Charting Test - Identify the double bottom and double top below:

Chart 11: Double top and double bottom

 

•v In the case of the double top pattern, the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom, the price movement has tried to go lower twice, but has found support each time. After the second bounce off of the support, the security enters a new trend and heads upward.

8.4 Triangles

There are 3 types of triangles, which vary in construct and implication, the symmetrical triangle, ascending and descending triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months.

Charting Test - Identify the triangle

 

Chart 12: Triangle

•v The symmetrical triangle in chart 12 is a pattern in which two trendlines converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction.

•v In an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout.

•v In a desce