A handbook of the basics

Transcription

1 Primer Market Analysis United States 14 May 2013 A handbook of the basics Market Analysis Technical Handbook We cover the basics of Trend, Momentum and other technical indicators and methods. Stephen Suttmeier, CFA, CMT Technical Research Analyst MLPF&S stephen.suttmeier@baml.com Jue Xiong, CFA Research Analyst MLPF&S jue.xiong@baml.com MacNeil Curry, CFA, CMT Technical Strategist MLPF&S macneil.curry@baml.com Table of Contents Introduction 3 Trends 5 Relative Price Analysis 14 Price Momentum Indicators 16 Reversals 20 The importance of volume 27 Support and Resistance 35 Market Breadth 38 Market Sentiment 46 The Fibonacci Concept 50 Putting it together 56 Unauthorized redistribution of this report is prohibited. This report is intended for dino.bate@citiseconline.com. c58da9b710df662c BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 59 to 60. Link to Definitions on page

2 Contents Introduction 3 Trends 5 Relative Price Analysis 14 Price Momentum Indicators 16 Reversals 20 The importance of volume 27 Support and Resistance 35 Market Breadth 38 Market Sentiment 46 The Fibonacci Concept 50 Putting it together 56 2

3 Introduction Price action of stocks or financial markets in general is a reflection of human nature. Price trends seem to be determined by investors decisions in response to a complex mix of psychological, sociological, political, economic and monetary factors. Technical analysis attempts to measure the strength of these trends and to forewarn of potential changes in these trends. Technical analysis focuses on the status and prospects of a company's stock performance. Technical analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in "the averages" and then deducing from that pictured history the probable future trend. Edwards & Magee Technical Analysis of Stock Trends At any given time, the price of a company's stock is determined by the forces of supply and demand. Supply and demand indications are typically mirrored into transactions data. The market price reflects not only the differing value opinions of many orthodox security appraisers, but also all the hopes and fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers, as well as their needs and the resources in total, factors which defy analysis and for which no statistics are obtainable, but which are nevertheless all synthesized, weighed and finally expressed into one precise figure at which the buyer and the seller get together and make a deal. Edwards & Magee Technical Analysis of Stock Trends The art of technical analysis... is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed. Martin J. Pring Technical Analysis Explained Thus, technical analysis is generally a less time consuming method of stock selection than is fundamental analysis and is based more on the actual performance of a stock than on its prospects for performance. This benefits investors and/or traders because they can broaden their pool of potential investment vehicles as technical analysis is less time consuming. They can participate in a trend as it is unfolding because it is more timely. They are more likely to sell a stock that begins to go against them because of less emotional attachment. Technical analysis has undergone a major transformation since its early years. It began when traders noticed recurring price patterns in the securities that they traded and evolved into the art of visually inspecting price charts for such patterns. Through time, more scientific disciplines contributed to technical analysis. Mathematical expressions were devised to describe momentum, acceleration and changes of trend. Physics weighed in with many of its 3

4 contributions from mechanics (vector analysis) to electro-magnetism (cycle studies and spectral analysis). Throughout its development, technical analysis has been monitored by statistical concepts that keep tabs on what seems to be working and what doesn t. In its optimal form, technical analysis involves a great deal of scientific concepts and discipline. The indicators that we will bring to your attention have mathematical expressions. They have been back-tested to show statistical validity. Even visual price patterns can be identified by computer algorithms, to a great degree, and tested for their validity. The area of neural network study and the advent of abundant computing power have enabled us recently to test a wide variety of indicators on each stock that we wish to follow. We are able to tweak the parameters of these indicators so that they best express the performance of each stock. Indeed, the future of technical analysis seems to be trending toward customizing indicators to best predict individual stock performance. Most traders do not have the software resources or the time to do the extensive optimization that we alluded to in the previous paragraph. So, for practical purposes, we will discuss a few indicators and the parameters that seem to work best across most stocks. In such a context, we need to realize that technical indicators are nothing more than tools, and their reliability varies over time. The more indicators that agree on a certain direction, the more likely it is that the signal will be valid. The tools that follow should be thought of as inputs that will eventually be used in forming a larger consensus regarding market opinion or specific buy and sell decisions on individual stock issues. These concepts have withstood rigorous testing over many years. There will be times when they will mesh together and work flawlessly. There will also be times when there will be no clear consensus among indicators or they will simply fail. We must stress at the outset that technical analysis is an exercise in probabilities. As such, there will be times when we will have to accept losing trades. But through judicious use of the indicators and some prudent money management, we're confident that the concepts discussed here will help in your investment decisions. 4

5 Trends A trend simply put is the direction in which the price trend is heading. Typically, there are three choices: Positive or advancing trend. Negative or declining trend. Neutral or sideways trading range. Making an assessment of the prevailing trend is important because most of the money to be made is by positioning trading with the trend. We want to be buying big in up-trends and selling big in downtrends. In the case of neutral trends, we want to identify the upper and lower limits so that we might buy close to the lows and sell close to the highs. Positive Trend Characterized by higher highs and higher lows In a positive trend, each up move extends to new price highs, while the sell-offs in between do not decline as far as the price levels of previous sell-offs. Drawing a line through the lows yields the positive trend line. Positive trend Negative Trend Characterized by lower highs and lower lows In a negative trend, each down move extends to new price lows, while rallies in between do not advance as far as the price levels of previous rallies. Drawing a line through the highs yields the negative trend line. 5

6 Negative trend Neutral Trend Characterized by a sideways trading range In a neutral trend, the price pattern typically oscillates between an upper limit and a lower limit. Drawing lines through these upper limits and lower limits identifies the trading range. Neutral trend When speaking of trends, it is important to specify the relevant timeframe. It is possible for single chart to show all three trend types, depending on the time scale. The chart below shows why specifying a timeframe in describing a trend is important. This particular chart can show a negative, neutral, or positive trend, depending on the relevant period of time at which one is looking. For example, from December 1998 to December 1999, the stock underwent a long-term downtrend. Between October 1999 and the end of the chart, the price pattern is range-bound, indicating an intermediate-term neutral trend or trading range. Short term, between January 26, 2000 and the end of the chart, the daily pattern of higher highs and higher lows indicates an up trend. 6

7 SWY chart The description of time varies among traders. What an aggressive trader sees as long term, a more conservative trader might see as short term. For practical purposes, we will structure our working definitions of time as follows: Short term: typically a few weeks in duration. Intermediate term: typically a few months in duration. Long term: typically a year or more in duration. It has been our experience that most valid interpretations, and the most useful and accurate indicators, are geared toward the intermediate term. When our expectations fall somewhere between the short and intermediate term, we might say shorter term. When our expectations fall somewhere between the intermediate and long term, we might say longer term. Trend Lines In defining the trend, we mentioned that drawing lines through relevant highs or lows gives rise to a trend line. A trend line is among the simplest of technical momentum indicators, and it serves a very important function. It is usually an indication of potential support in the price pattern, and its violation is one of the first indications that the prevailing trend may be coming to an end. Breaking a trend line, either positive or negative, should serve only as a warning and not as an outright signal to trade heavily in the opposite direction. Simple consolidation patterns usually interrupt the prevailing trend, only to have the price pattern resume its previous course after a brief pause. Invariably, waiting for confirmation of the new trend minimizes unpleasant surprises and is likely to be more profitable. Remember: a positive trend is defined as a pattern of higher highs and higher lows, while a negative trend is defined as a pattern of lower highs and lower lows. Despite its tentative nature, a trend line violation should be noted. Trend line breaks should encourage traders to lock in at least some profits. 7

8 Three basic criteria for assessing the importance of a trend line 1. Length of the line. Generally, the longer the trend line remains in force, the more significant its violation becomes. That is, the louder the alarm bells should sound when it is broken. 2. Number of times the line has been tested. The greater the number of times that the trend line is tested, the greater its significance. The greater the number of hits that a trend line can take and still remain intact, the greater its strength is perceived to be. We would therefore expect the breaking of a stronger trend line to be the result of greater selling pressure, and consequently greater downside potential. 3. Angle of ascent or descent. The more gradual the rate of ascent (or descent) of a trend line, the more significant its violation. This is so because very steep advances (or declines) are not sustainable for a very long time and are likely to be broken very quickly, even by just trending sideways. Sharp advances are usually a short-term phenomenon, and the resulting correction is usually short term in nature as well. The violation of a more gradually advancing (or declining) trend line is likely to signal a potentially longer-term trend change. Moving Averages As a descriptive trend tool, the moving average attempts to reduce the effects of erratic price fluctuations by drawing a "smoothed" picture of the prevailing trend. There are different types of moving averages, the most complicated of them using mathematical formulations to more heavily weight more recent data over older data. For simplicity's sake, we will focus on the simple moving average, which is most widely used. The simple moving average is constructed by calculating the average price value of the price data taken over a specified interval of time, and assigning that value to the last observation in that time interval. For example, in constructing a 30-day moving average for each day on our chart, we would look back 29 days, calculate the average price over the 30-day interval (including a specified day) and assign that value for that given day. This calculation is done for every day that is represented in the chart. 8

9 GM Price chart with 30-day moving average Many technicians would look for a "crossover", that is, a crossing of the price pattern over its moving average to signal a potential trend change. For example, as a price pattern which has recently been in a positive trend crosses below its moving average, a potential negative trend change is signaled. Moving averages are typically late in identifying trend changes. They might be used in confirming that the trend change has already occurred. Beyond the general, descriptive sense, we would not encourage placing great emphasis on moving averages in making buy or sell decisions, as they relate to a simple chart of price data. Moving averages are most useful in filtering or smoothing other indicators, or when they are used in combination with other moving averages. We often use a combination of moving averages to confirm that a trend is in effect. Some popular intervals for moving averages follow: Moving Average intervals Very short term Short term Intermediate term Long term 10 day 25 or 30 day 50 day 200 day Compound moving averages: Short term: 10-day crossing the 21-day or 30-day. Intermediate term: 25-day crossing 50-day. Consolidation Patterns Prices hardly ever continue straight up or straight down for very long. There are usually corrections within the major trend, which carry prices either sideways or slightly against the trend. These interruptions are known as consolidations, because price patterns pause to consolidate, or digest, their gains (or losses in downtrends). Consolidation patterns are also known as continuation patterns because they are usually an indication that prices will continue to move in the direction of the major trend, following a short pause. Key to interpreting consolidation patterns is a noticeable drop in volume during the pause. 9

10 Triangles The triangle consolidation patterns are drawn from very short-term trend lines, connecting the relevant tops and bottoms of very short-term price swings. Two trend lines typically define a triangle. The third side is usually the first leg of the consolidation pattern. Because two points define the line, we would need at least four short-term price swings to define a triangle. Initial price objectives following a breakout in the direction of the previous trend are typically measured by the height of the triangles, in cases of symmetrical and right triangles. The distance measuring the height of the triangle is projected from the breakout area to indicate a price objective. For wedges, the initial price objective would be just beyond point (1) of the consolidation, usually measured by a Fibonacci relationship (discussed later). Again, volume plays the significant role. The breakouts from consolidation patterns are usually accompanied by a significant increase in volume. Symmetrical Triangles (Pennants) Right Triangles 10