Session 11: Technical Analysis
Summary
TLDRThe speaker explores the world of technical indicators in stock trading, acknowledging skepticism but recognizing their value for some investors. They categorize indicators into contrarian, momentum, smart investor, and mystical force-based approaches. The talk emphasizes understanding the behavioral basis of each indicator, testing their effectiveness, managing trading costs, and finding the right holding period for successful investment strategies.
Takeaways
- 😀 Technical analysis is based on the belief that stock prices reflect all available information and tend to move in trends.
- 🧐 The speaker is skeptical of technical indicators but acknowledges their effectiveness for some investors.
- 📉 Market overreactions are a common belief, suggesting that markets often overreact to news, leading to potential reversals.
- 📈 Odd lot trading, mutual fund cash positions, and investment advisor sentiment are examples of contrarian indicators used to exploit market overreactions.
- 📊 Normalized P/E ratios, market breadth, support and resistance lines, and moving averages are indicators used to detect shifts in demand and supply.
- 🌟 Momentum indicators like relative strength and trend lines are used to identify and follow market trends.
- 📊 Trading volume in conjunction with price can provide additional insights into market momentum.
- 🤓 'Smart money' indicators, such as specialist short sales and insider trading, are based on the assumption that certain investors have superior information.
- 🌀 Theories like Elliott Wave and Dow Theory suggest markets are influenced by mystical cycles and patterns, independent of fundamentals.
- ⚠️ It's important to understand the behavioral assumptions behind a technical indicator before using it.
- 📝 Testing and verification are crucial when evaluating the effectiveness of a technical indicator.
- 💰 Consideration of trading costs and time horizons is essential for successful implementation of technical indicators in a trading strategy.
Q & A
What is the foundation of technical analysis according to the script?
-The foundation of technical analysis is the belief that stock prices are determined by demand and supply, and that these prices tend to move in trends which persist for periods of time. Technical analysts also believe that by using technical indicators, they can detect shifts in demand and supply before they happen.
What is the main assumption that differentiates technical analysis from the random walk theory?
-The main assumption that differentiates technical analysis from the random walk theory is that technical analysts believe stock prices move in trends, while random walk theorists do not believe in the existence of such trends.
What is the concept of 'odd lot trading' as a technical indicator?
-Odd lot trading is a measure that looks at the buying patterns of small individual investors who are more prone to overreacting to news. If there is a significant increase in odd lot trading, it might suggest an overreaction to good or bad news, and a contrarian investor might consider selling the stock.
How do cash positions in equity mutual funds relate to technical indicators?
-Equity mutual funds holding cash instead of being fully invested can be an indicator of market sentiment. If mutual funds hold a lot of cash, it might suggest a collective bearish outlook, and a contrarian investor might choose to buy stocks in such a scenario.
What is the significance of investment advisor sentiment in technical analysis?
-Investment advisor sentiment is used as a contrarian indicator. If a high percentage of investment advisors are bullish, it might be a signal to sell stocks, as it is assumed that the majority might be overreacting for the wrong reasons.
What is the purpose of using normalized P/E ratios as a technical indicator?
-Normalized P/E ratios are used to detect if stocks are trading at a higher multiple of earnings than the historical norm. If they are, it might indicate that the stocks are overpriced, and a technical analyst might decide to sell.
What does the 'breadth of the market' refer to and how is it used in technical analysis?
-The breadth of the market refers to the number of stocks advancing compared to the number declining over a given period. A broad market indicates a healthy trend, while a narrow market where a few stocks are driving the index up might be less bullish.
What is the significance of support and resistance lines in technical analysis?
-Support and resistance lines are horizontal lines on a stock chart that represent significant price levels where the stock has historically had trouble moving above (resistance) or below (support). Breaking through these lines can signal a shift in demand and supply.
How do moving averages serve as technical indicators?
-Moving averages smooth out price data over a specific period and can indicate the trend direction. A stock moving above a moving average might be seen as bullish, while moving below it could be bearish.
What role does trading volume play in conjunction with price indicators in technical analysis?
-Trading volume, when used in conjunction with price indicators, can provide insights into the strength of a price movement. A sudden surge in volume with a price increase might signal a strong shift in demand and supply.
What are 'smart investor indicators' and how do they work in technical analysis?
-Smart investor indicators are based on the actions of investors who are believed to have superior knowledge or insight, such as specialists on the New York Stock Exchange or company insiders. Following their actions can provide clues about market sentiment and potential shifts in demand and supply.
What are the mystical forces indicators in technical analysis and how do they differ from other indicators?
-Mystical forces indicators, such as the Elliott Wave or Dow Theory, suggest that markets are driven by underlying patterns or cycles that are independent of fundamentals. They differ from other indicators as they are based on historical patterns rather than current market data or investor behavior.
What are some suggestions for using technical indicators effectively?
-To use technical indicators effectively, one should understand the behavioral basis behind the indicator, verify its effectiveness through testing, manage trading costs, and ensure the holding period is appropriate for the indicator's time horizon.
Outlines
🤔 Skepticism and the Foundations of Technical Analysis
The speaker begins with an admission of skepticism towards technical indicators and price patterns but acknowledges their potential efficacy. They set the stage for a discussion on technical analysis, highlighting its foundational belief in the influence of demand and supply on stock prices. The speaker also addresses the role of both rational and irrational factors in shaping market dynamics. A key point is the technical analyst's belief in trends and the possibility of predicting shifts in demand and supply before they occur, which is central to the value creation in technical analysis. The speaker then introduces the concept of categorizing technical indicators based on the presumption of market rationality that they exploit.
🔄 Exploiting Market Overreactions with Contrarian Indicators
This paragraph delves into the first set of technical indicators that aim to exploit the market's tendency to overreact to news, both good and bad. The speaker references psychological studies and behavioral finance research to support the existence of market overreactions. They provide three examples of such indicators: odd lot trading, which assumes small investors are prone to overreacting; mutual fund cash positions, suggesting that high cash levels indicate bearish sentiment among mutual funds; and investment advisor sentiment, where a high bullish percentage among advisors is a contrarian sell signal. The common thread is using the behavior of typical investors as a contrarian indicator to make trading decisions.
📊 Detecting Shifts in Demand and Supply with Fundamental Indicators
The speaker moves on to the second set of technical indicators designed to anticipate shifts in market demand and supply. They discuss the use of normalized P/E ratios to determine if stocks are over or undervalued relative to their historical earnings multiples. The breadth of the market, support and resistance lines, moving averages, and changes in trading volume are all cited as tools to detect such shifts. The emphasis is on using fundamental indicators to identify market trends and potential turning points, with the understanding that these indicators can signal changes in the broader market dynamics.
🚀 Harnessing Market Momentum with Momentum Indicators
In this section, the speaker discusses the third set of technical indicators that are based on the concept of market momentum, where stocks tend to continue in the direction of their recent movement. They introduce the Relative Strength Index (RSI) as a momentum indicator, along with trend lines and the significance of trading volume in conjunction with price movements. The speaker suggests that stocks with high price momentum and high trading volume are stronger momentum picks, while those with low trading volume may be less reliable. The paragraph underscores the importance of detecting and riding market momentum to make informed trading decisions.
🧙♂️ Following the 'Smart Money' with Smart Investor Indicators
The fourth paragraph explores technical indicators that rely on the actions of 'smart money' or knowledgeable investors to predict market movements. The speaker mentions specialist short sales on the New York Stock Exchange and insider trading as examples of such indicators. The assumption is that these insiders have superior information and their trading activities can signal future market trends. However, the speaker also points out the limitations, such as the legality of insider trading and the delayed information from SEC filings, which may affect the reliability of these indicators.
🌀 The Mystical Forces of Market Movements
The final paragraph addresses the fifth set of technical indicators, which are based on the belief that markets are influenced by mystical or cyclical forces, such as the Elliott Wave theory and the Doubt theory. These indicators suggest that historical patterns and cycles can predict market movements, independent of fundamental analysis. The speaker expresses some skepticism about these indicators due to their reliance on abstract concepts rather than concrete data. They conclude by emphasizing the importance of understanding the behavioral assumptions behind any technical indicator and being disciplined in testing and applying them within an investment strategy.
📝 Conclusion and Advice on Using Technical Indicators
In conclusion, the speaker summarizes the various types of technical indicators discussed and offers advice for investors considering their use. They stress the importance of understanding the behavioral basis of each indicator, verifying their effectiveness through testing, managing trading costs, and finding the right time horizon for each strategy. The speaker also cautions against blindly following technical indicators without a clear rationale and encourages investors to be disciplined and strategic in their approach to using these tools in their investment decisions.
Mindmap
Keywords
💡Technical Indicators
💡Market Overreaction
💡Contrarian Investing
💡Demand and Supply
💡Momentum
💡Support and Resistance Lines
💡Moving Averages
💡Volume
💡Insider Trading
💡Behavioral Assumptions
Highlights
Technical analysis assumes that prices are set by demand and supply, which is influenced by both rational and irrational factors.
Technical analysts believe that stock prices tend to move in trends which persist for periods of time.
The key to making money with technical analysis is detecting shifts in demand and supply before they happen using technical indicators.
Technical indicators can be categorized into buckets based on their underlying behavioral assumptions.
One assumption is that markets overreact to news, both good and bad, and this can be exploited for trading opportunities.
Contrarian indicators include odd lot trading, mutual fund cash positions, and investment advisor bullishness.
Odd lot trading is used as a contrarian indicator assuming small investors overreact to news.
High mutual fund cash positions indicate bearishness and can be used as a signal to buy stocks.
Investment advisor bullishness is used as a contrarian signal to sell stocks.
Normalized P/E ratios and market breadth are used to detect shifts in demand and supply.
Support and resistance lines are key technical indicators for predicting price movements.
Moving averages help detect shifts in demand and supply and are commonly used in technical analysis.
Momentum indicators, such as relative strength, help identify stocks that are likely to continue their current trends.
Volume indicators, combined with price movements, can provide additional insights into market momentum.
Some technical indicators rely on tracking the actions of perceived 'smart' investors, such as specialists and insiders.
Elliott Wave and Dow Theory are examples of technical indicators based on the idea that markets are driven by long-term cycles.
It's important to understand the behavioral basis of any technical indicator and verify its effectiveness through testing.
Effective use of technical indicators requires timely trading and controlling trading costs.
Transcripts
hi welcome back I'm a skeptic when it
comes to technical indicators price
patterns charts volume indicators but
that doesn't mean they don't work now
there are people out there very good at
using them to seemingly detect what will
happen to stock prices in the future so
setting aside skepticism for the moment
I'd like to look at the indicators that
get used up there and look at the basis
or try to categorize them at least on
why the people who use them may think
they work so let's set the table when
you look at the foundations of technical
analysis it's straightforward it the
technical analysts of people who believe
in technical analysis believe that
prices set by demand and supply who
disagree with that they'd also argue
that supply and demand is set by new
individually said by lots of factors
some rational and some irrational and
then markets continually weigh all these
factors that again is beyond questioning
I think everybody would agree that there
are factors in your rational and
irrational the drive supply and demand
the third assumption is what sets
technical analysis are far from the
random Walker's technical analysts
believe that stock prices tend to move
in trends which persist for periods of
time a random walk Walker on the other
hand doesn't believe that but that's the
basis for technical analysis and finally
and this I think is a key part of
technical analysis that the key to
making money is not just understanding
demand and supply but getting ahead of
shifts in demand and supply that
technical indicators can allow you to
detect those shifts before they happen
that again that is I think that the
driver of value creation in technical
analysis see that's what I'd like to do
there are hundreds and hundreds of
technical indicators out there I don't
know I'm not even familiar with many of
them but I'd like to start putting the
technical indicators that I'm familiar
with into buckets and as you start
seeing other technical indicators I
think it's well worth the effort of
putting them into buckets
what am I talking about every set of
technical indicators is built on some
presumption of more
to rationality that marketed rationality
is what you're trying to exploit with
that technical indicator and Midas will
be open about what your behavior what
behavior component you're building on
with the technical indicator so let's
cut to the chase here's the first one
there is substantial evidence and a lot
of people have believed that markets
overreact they overreact to good news
and they overreact to bad news and this
is backed up both both by psychological
studies and behavioral finance research
in markets so let's say you believe that
markets do overreact and the evidence
you sure to point it up is when you see
extreme movements in stock prices you
often see movements back in the other
direction if you remember the last
session or two sessions ago we talked
about the negative serial correlation in
very long period returns and the bigger
the drop or the increase in stock prices
the bigger the the reversal seems to be
of course the skeptic might say if
that's in fact the case that that
markets not overreacting why are there
more contrarian investors out there and
why are they able to push the price back
working why is that our drift in the
price now and if if in fact there's
overreaction is it or is it more
prevalent with some kinds of information
than others is it for instance more
likely with an acquisition announcement
and with an Onix announcement or are
there no differences so that's what
technical indicate the first set of
technical indicators look at its ways to
take advantage of market overreaction
and here are three examples there is a
measure called the odd lot trading
measure basically look at it before
brokerage houses before online brokerage
became became par for the course if you
went through a traditional broker there
was a big deal you made about whether
you bought me even lot or an odd lot
even lords are lots of a hundred shares
of peace odd lords or shares of
thirty-five forty fifty five ships
if you assume that odd lots are bought
by small individual investors and you
further assume that individual those
small individual investors are more
prone to overreacting and these are
assumptions I'm not I'm not agreeing
with any of these statements then here's
what you could do you could look for a
jump in our law trading and argue that
if there's a lot of odd lot buying of a
stock that you should be selling that
stuff because those are lot of traders
after all are more likely to get over
enthused about good news and so no and
buy too much after good news itself too
much after bad news
so outlaw trading becomes a kind of
stand-in for the man on the street the
individual investor and with the
assumption that that investor is more
likely to be the overreacting the second
actually moves up the spectrum it looks
at cash positions and mutual funds
equity mutual funds if you look at
equity mutual funds in theory these
these mutual funds tell you that they're
going to invest all the money they get
from you in stocks but in practice they
don't most of them hold some of the
money you send them in cash why did they
do it partly for know partly because
they can't have everything invested all
the time but also because they are they
take market timing positions in other
words if they're bullish about markets
they will try to get you cash into the
market right away if they're bearish
they will actually hold the money as
cash so here's a second or a second
technical trading rule that's a
contrarian draw you look at the mutual
fund cash position if the mutual fund
cash position is high that means mutual
funds shall be are are collectively
bearish right you do the exact opposite
mutual funds of bearers you'd think that
that you basically go out and buy stocks
of mutual funds of bullets you go out
and sell stocks again effectively as
saying mutual funds are my stand-in for
the typical investor they're far more
likely to be overreacting
to be doing the wrong thing I'm gonna do
the exact opposite and here's the third
technical trading rule that's built on
contrarian investing investment if there
are investment advisors out there who
put out newsletters and there are
studies there are actually surveys that
look at the bullish and bearish
proportions
investment advisors so here again here's
what you do you look at the percentage
of investment advisors or bullish if
that number is really high you sell
stocks why because most investors are
bullish and you assume that investors
overreact then they're being bullish for
the wrong reason so you sell when
they're buying and buy when they're
selling but in all three what you're
trying to do is get a standard for the
typical investor and go against the
typical investor contrarian
technical trading rules here's the
second set of trade technical indicators
I want to look at the second title set
of technical indicators try to detect
shifts in demand and supply before they
have it so for instance there are there
are people who look at normalize p/e
ratios what is that basically they look
at the average earnings over time and
look at what multiple of earning stocks
are trading at right now here's the rule
they use if stocks are trading at a much
higher multiple of earnings and the
historic norm that that smoothed out
line that you see in there is there then
they're over price they sell below
they're under priced again you are
trying to detect shifts in demand and
supply using some fundamental indicators
something that you can point to and say
hey that tells me that that something is
going to change so here are measures of
technical indicators right essentially
you could look at the breadth of the
market what is the breadth of the
markets the number of stocks that
advance on any given period a day a week
a month relative to the number of stocks
are declined so the higher the number of
stocks that go up relative the number
the broader the market how is that used
if you have enough movement in the
market that is not accompanied by
breadth in other words markets have the
overall index goes up but it's being
caused by a few stocks jumping in price
rather than a bunch of the vast
proportion of stocks going up that is
less bullish then as price increase it's
accompanied by a broad market similarly
a drop in the market that's caused by
just three or four stocks is less
dangerous than one that's caused by 70
percent of stocks dropping at about the
same time the second is support and
resistance lines Europe talked of this
all the time from charters a stock
that's at 28 50 29 29 25 goes through
the $30 mark which is viewed as a major
resistance line that's mute as a bullish
sign that you've gone through a
resistance line on the other hand if you
have a stock that's dropped in price
from 31 to 27 to twenty five to twenty
three but it stayed above 20 for a long
time but then it drops below 20 the fact
that a drop below that $20 the support
line is viewed as a bearish indicator
again it did there the Assumption here
is when you go through a resistance line
a drop through a support line something
happens in the market and demand supply
line shift so when you go go below the
$20 no support line effectively you see
a whole bunch of selling supposedly
coming into the market causing the stock
to go down even more moving averages
have been a favored device for people
who want to detect shifts in demand and
supply but the argument again is of a
stock moves above a moving average for
over the last 52 weeks 26 weeks and
different Indic different charges use
different indicators that is viewed as a
bullish sign or a bearish sign depending
on whether the stock moves above a
moving average line or below moving
average line and finally shits in volume
are often you also used in conjunction
with price indicators as measures of are
we seeing a shift in demand and supply a
sudden surge in volume is often viewed
as a sign that something is changing
under the surface even if prices are not
changing so the first set of indicators
are contrarian indicators you're looking
for ways to go gates for the typical
investor whether it's a mutual fund an
individual investor or or a newsletter
writer is is thinking the second set of
indicators are indicators that tried
to get ahead of demand and supply ships
in demands of life the third set of
indicators build on something we talked
about a couple of sessions before which
is the force of momentum markets of
momentum and stocks go up they tend to
keep going up and stocks go down they
tend to keep going down and the
evidences we saw is fairly strong at
least over certain time plates one year
period six-month time periods they get
weaker as you go to longer time periods
if you believe there's market momentum
then you're going to be looking for
momentum indicators one of the oldest
and most widely is momentum indicators
is called relative strength sounds fancy
but here's what you do you take the
price now you divide by the price six
months ago so stocks that have gone up
the most will have the highest relative
strength so if you're a believer in
momentum you're going to go with the
stock so that the highest relative
strength and you sell those stocks which
have the most the lowest relative
strength where the price has gone down
relative to the historical price you can
also use trend lines where essentially
you try to fit lines through graphs and
you see how your stock is behaving
relative to a trend line and if you
notice a trend line that's upward
sloping that sign up that's a sign of
momentum so even if the stock is zigzags
if there's a positive trend line it's
viewed as a sign of momentum that's good
news whereas the tendrán trend line is
downward sloping it's bad news so
essentially again you're looking for
measures that will let you detect when
there's momentum in a stock and write
that momentum the hidden weapon or the
secret weapon for many analysts has
become trading volume which in
conjunction with momentum might give you
even more information so if you look at
stocks which have price momentum and
high trading volume it looks like
they're even better momentum picks and
stocks with high price momentum but low
trading volumes so by combining price
and volume you might actually be able to
get much more important technical
indicators and one of the nice things
about the last twenty years is the data
that is available in volume has become
much richer you can do things with
trading volume you could not have done
two decades ago three decades ago
the fourth group of technical indicators
you look for somebody that you believe
is smarter than you are somebody who's a
guru investor somebody can lead the way
somebody who knows more than you do and
you try to do what they're doing here a
couple of examples of smart investor
indicators one is specialists on the New
York Stock Exchange the people on the
floor who supposedly know more than you
are I about demand and supply and the
stuff so in fact as an indicator called
specialist short sales where you can see
which dog specialists are selling short
on and how much so essentially if if you
buy into the notion that experts know
more than you do and specialists are
your experts if they're selling short
you're gonna sell as well so this so
specialist short sales becomes an
indicator as to when you should be
getting out of the market you could also
look at insiders and companies insiders
of course are defined by the SEC did
include not just managers but directors
and and people are all more than 5% of
stock now your argument might be that
those insiders know a great deal more
about the company than you do and you
probably be right so you could track
what they're doing by looking at what
they're buying or selling then you might
try then you might do the same some
they're buying you buy the only problem
is the only data we have an insider
buying and selling comes from the
filings and insiders make with the SEC
but those filings almost by definition
cannot be based on information because
that'd be like illegal insider trading
so the problem with using the the
insider buying and selling that you get
from the SEC filings is you're getting a
subset of insiders who are legal
insiders what you'd really like to get
your hands on is those illegal insider
buying and selling but that of course is
difficult to do though you could track
trading volume maybe you can get ahead
of the game so that's a fourth factor
which brings me to the fifth and final
set of technical indicators and these
make me a little queasy because these
are the indicators that argue that
markets are driven by mystical forces
that cause prices to move
certain ways of a very long time periods
so for instance you have the Elliott
Wave which actually looks at waves and
markets and it it breaks them down into
into various sizes and it tells you
where in a good wave you are it's an
amazingly intricate process I have no
idea what what underlies the process
other than the fact that seems to be
suggesting that history that that
historical wave is a much stronger
factor than any fundamentals you got the
doubt theory which also argues that
markets have these big movements over
time and those movements happen no
matter what the fundamentals are and
from here you also have less less well
known waves and cycles that drive
markets but to the extent that you do
believe that markets are governed by the
by the Stars and by external forces you
might in fact decide to use those
technical indicators so as I said this
is just a small subset of those
technical indicators out there and I
don't begrudge those people who feel
that these technical indicators give
them a leg up and investing if you in
fact decide to go down this route and
use technical indicators here are some
of the suggestions I would have first is
be very clear on the behavioral basis
for why you think a technical indicator
works in other words don't just use a
technical indicator because it looks
good on paper or is delivered returns in
the past step back and ask what is it
I'm assuming about market behavior that
would lead me to believe that this
indicator is gonna let me get ahead of
the game
second when somebody says the technical
indicator works don't take them at their
word verify test it out see if and in
fact work we've talked a few sessions
ago about how to test any kind of market
indicator beat the market scheme
technical indicators paper to the same
test third if you're going to use a
technical indicator to trade you you
almost always have to trade quickly
which means your cost will be higher you
have to make sure that you keep that
balance right that you take it that you
trade quickly enough without letting
your cost get out of control and here's
the follow up most technical trading
rules even once with that work require
that you're holding period be just set
right
I call this the Goldilocks phenomenon
which means view in some some technical
indicators we hold this off for two
weeks you make money but if you hold it
for four and a half you lose money so
you got to be very disciplined about
figuring out what those write them or
time horizons aren't sticking with them
and finally and this was related to the
timely trading you've got the controlled
trading costs because the nature of
technical indicators is you will trade a
lot more than everybody else and we've
talked about trading costs and not just
in terms of brokerage costs but in terms
of price impact in terms of bid-ask
spreads and also in terms of the taxes
tax costs they create for you you got to
make sure the returns you make from your
trading strategy exceed all those costs
so in summary there are lots and lots of
technical indicators out there some of
them actually work but if you find a
technical indicator that works dig
deeper look to see what kind of
behavioral assumption underlies that
indicator and be comfortable with that
are you willing to characterize the
market the way that indicator
characterizes the market but I wish you
the very best with your next technical
indicator in and incorporating it into
your investment strategy thank you for
listening
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