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Investment Analysis and Portfolio Management

Investment Analysis & Portfolio Management (FIN630)
Lesson # 7
Few facets of the investment discipline generate as much controversy as technical analysis.
Some professional investors are convinced the activity is a complete waste of time and a
disservice to brokerage clients. An equal number are certain that technical analysis is
mandatory for every one who seeks above average investment results. Some fundamental
analysts will say they use technical analysis to confirm their opinions but not as a stand-
alone technique.
In the mind of some people, elaborate wall charts are the classic symbol of the stock
picker's art. The experience eye can divine ups and down in the same way a soothsayer can
read tea leaves are astrological signs or so the folklore goes. Charting is a controversial part
of finance. Future research is likely to uncover things about charting that would surprise us
today. Still, even people who vehemently oppose the practice should be familiar with the
basic tents.
Much about technical analysis remains a puzzle.
The Underlying logic:
Charts are an important tool of the technical analyst. He or she believes the supply and
demand determine prices that changes in supply or demand will change prices and that
charts can be used to predict changes in supply and demand and in investor behavior. This
logic seems reasonable to many people, but it is also why charting is a trouble topic to the
fundamental analyst.
The weak link in this reasoning lies in the last point: charts can be used to predict changes
in supply and demand. The stock market seldom waits for things to completely unfold.
Market participants are continually anticipating future events are frequently err in their
Imagine an investment whose value is determined by a prior series of ten coins flips. A
person can buy the investment at any time, with the purchase price a function of the
previous ten coin flips. Suppose a large payoff is associated with a series of five consecutive
heads followed five consecutive tails. How will the marketplace value the investment if the
previous eight flips were five head followed by three tails? Clearly, investors will bid up the
price because of the increased likelihood of the windfall gain. By so doing, they reduce the
potential profit, because a rising price means a lower expected return, everything else being
An interesting side note to this example occurs if the investment reaches a maximum value
following a series of five heads and five tails. Once an investment reaches its maximum
possible value, why would anyone buy it? Logically it can only decline from its peak value.
Thus, a interesting interplay takes place between would-be sellers and potential buyers as
the pattern develops.
The technical analyst believes charts can be used to predict changes in supply and
Investment Analysis & Portfolio Management (FIN630)
Market participants try to anticipate events rather than merely react to them.
Types of Charts:
Three principal types of charts are used by the technical analyst: line charts. Bar charts and
point and figure charts. A forth type, the candlestick chart, has recently gained favor and
may eventually become common.
Line Chart:
The line chart is the simplest and most familiar. It consists of a line connecting a series of
data points. It may be drawn on either a linear or a logarithmic scale. Logarithmic scales are
appropriately when the data move through wide ranges. This keeps the plot from going off
the chart.
Bar Charts:
Bar Chart
Bar Chart
The technical analyst's bar chart is different from the bar chart commonly used to present
economic data. This chart shows the periodic high, low and closing prices of a security. A
vertical line connects the period's high and low prices, with a cross mark indicating the
price at the close of the period. Bar charts are efficient in showing more detail about daily
trading than just the closing prices from a line chart.
Investment Analysis & Portfolio Management (FIN630)
Point and Figure Charts
This exotic chart impresses many a brokerage firm customer. The scattered X's and O's
make the document look like a football coach's play diagram. The layperson typically does
not understand what they present but the chart attracts attention.
Unlike most other charts, only significant price movement appears. The X represents the
prices increase and the O represents the price decline. Notice that Xs and Os never occur in
the same column. Once a price reversal of significant magnitude occurs, the analyst moves a
column to the right for the next entry.
An old feature of this chart is the fact that the horizontal axis has no units. Moving left to
right reflects the passage of time but data points are not plotted at regular interval. Only
when the price change is sufficient does a new data appear.
Some technical analyst will superimpose time information the chart.
The horizontal axis on a point and figure chart has no units.
Candlestick Chart
Investment Analysis & Portfolio Management (FIN630)
A Candlestick Chart is an enhanced version of bar chart. These charts began to appear in the
United States in the mid 1980's but have been used in China for over 500 years. Such a
chart shows a stock's open, close, high and low in a modified three dimensional format. The
vertical axis shows the stock price while a horizontal axis reflects the passage of time. The
principle difference between a daily candlestick chart and a bar chart is the white and black
candles augmenting the daily trading range lines. White candles represent stock advances,
with black candle representing declines. The thick portion of an entry is called the real
body, with the vertical line representing the wick. Various clusters of candles have exotic
names, such as dark cloud cover, doji star, hanging man, harami cross, and two-day tweezer
Other Charts Annotations:
A support level is a subjective assessment of the price level below which the stock seems
disinclined to fall. A resistance level is an apparent upper bound on stock prices or a level
presenting a barrier to further price appreciation. Both concepts are purely subjective and
cannot be calculated. A congestion area is a region of the chart of the chart where a great
many data points appear. When the stock price leaves the congestion area and pierces either
a support level or a resistance level, it is called breakout. A rise through a resistance level
is a breakout on the upside; a fall through a support level is a breakout on the downside.
When someone says "the stock broke" they often refer to a decline through a support level.
Breakout on the upside are bullish; breakout on the downside a bearish. Once a breakout
occurs, the technical analyst will search for new resistance and support level. The institution
behind these levels is easy to develop.
Chartists believe investors remember missed opportunities and look for them to return.