Beyond the Fundamentals; Technical Analysis FIN 40500: International Finance

Fundamental analysis focuses on economic/financial theory and various economic indicators to explain market movements Trade Balance Approach Monetary Approach Interest Rate Approach Price Level Approach

 Chart Analysis  Quantitative Methods Technical analysis is not concerned with the causes of market movements. Instead, technical analysis focuses on the movements themselves. Is there information in past price movements that can be used to predict future movements? The forecasting equation for a technical analysis would be something like this

$/Euro: Weekly data over 3 years Chart analysis begins with a time series plot of an asset’s price

Charts can be hourly, daily, weekly, etc. Higher frequency data will be more detailed, but noisier

A chartist looks for patterns in the to identify resistance (upper bounds) and support levels (lower bounds) Old Support level New Support level

A “breakout” indicates a new pattern forming Connect two consecutive highs to get the upper channel A parallel line through a recent low becomes the lower support

Bullish channels tend to have upward breakouts

Find the trend by connecting at least two highs Two lows complete the triangle “Breakout” occurs at the apex, usually with increasing volume

Ascending triangles usually have upward breakouts

Two lows identify the “lead in” trend The “Run”: A breakout from the lead in trend The “Bump”: Increase in trend by more than 50%

Two lows identify the “lead in” trend The left shoulder is the first high above the current trend The head is the first advance past the left shoulder The right shoulder is the first high following the reversal The neckline connects the two shoulders and indicates lower support

What pattern do you see? “Bump” “Run”

Fibonacci, one of the greatest mathematicians of all time discovered a sequence of numbers which are now used across many disciplines 1 Month One Pair (Y) Now One Pair (M) 2 Months Two Pair (M, Y) 3 Months Three Pairs (M, M, Y) Y = Young, M = Mature Suppose that you begin with a pair of rabbits:  Rabbits take one month to mature. Once mature, they can breed offspring  Offspring come in pairs (one male and one female). A pair of offspring are born each month  The rabbits never die

Can you find the Pattern? Each number in the Fibonacci sequence is the sum of the previous two 1+ 1 = = = 5 …. 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, …… These numbers seem to appear a lot in nature…

One White Calla LilyEuphorbia Two Trillium Three Five ButtercupsBloodroot Eight Black-eyed Susan Thirteen (By far the most common)

Ordinary field daisies have 34 petals – a fact to be remembered when playing “she loves me, she loves me not”! (with 34 petals, you will always finish with “she loves me not!”) Take a pineapple…hmmm…look at the various spirals formed

Every human has 2 hands with 5 fingers on each. Each finger is made of 3 segments connected by 2 joints…don’t these numbers sound familiar? Each section of your index finger, from the tip to the base of the wrist, is larger than the preceding - fitting the Fibonacci numbers 2, 3, 5 and 8. By this scale, your fingernail is 1 unit in length. Similar ratios are seen between your hand and forearm…coincidence?

Suppose that we divide each number into the following number 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, ……… 1/1 = 18/5 = 1.6 2/1 = 113/8 = /2 = 1.521/13 = /3 = /21 = The ratios converge to Now, suppose that we divide each number into the previous number 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, ……… 1/1 = 15/8 =.625 1/2 =.5 8/13=.615 2/3 =.66713/21 =.619 3/5 =.621/34 =.617 The ratios converge to.618 AND

Suppose that we begin with a 1X1 square Put another 1X1 square next to it Now, put a 2X2 underneath Now, add a 3X3 square

Connect the corners of the squares and you get the golden spiral…look familiar??

Math is everywhere!!

Anyways, back to technical analysis. Many of the technical methods are based on PHI (.618) and powers of =.618* =.618*.618*.618 First, draw a trend line Draw arcs that intersect the trend at 61.8%, 50%, and 38.2% of the high (these will indicate future supports)

Draw an initial trend line between two extreme points At the second extreme point, draw a vertical line Draw rays that intersect at 61.8%, 50%, and 38.2%

Once a reversal occurs, it tends to find support at Fibonacci levels!

Large price swings tend to occur on “Fibonacci times”! (times could be in days, months, years, etc)

Elliott Waves Elliot wave theory relies on cycles within cycles  Grand Super cycle  Super cycle  Cycle Each cycle consists of 5 moves with the trend (1,3,5 are impulse, 2,4 are corrective) and 3 that are against the trend. A “5-3” wave

Impulse Correction Beginning of the next wave Elliott Waves consist of 5 moves with the trend (1,3,5 are impulse, 2,4 are corrective) and 3 that are against the trend. A “5-3” wave cycle

Impulse (1) Correction (2) The 5-3 wave cycles actually oscillate around a larger “super-cycle” The super-cycle is also a 5-3 wave.

Note that the grand super cycle has two movements, the super cycle has 8 movements, the cycle has 34……Fibonacci numbers!! Finally, the super-cycle oscillates around a “grand super-cycle ”

RSI (Relative Strength Indicator) If “Up Points” = 0, RSI = 0 If “Down Points” = 0, RSI = 100 RSI < 30 (Oversold) RSI > 70 (Overbought)

RSI (Relative Strength Indicator) Chart Interval: 15 minutes Period Length: 20 (300 minutes) Total “up” points = 7 Total “down” points = 11

Fast Stochastic Period High: FS = 100 Period Low: FS = 0 Signal < 30 (Oversold) Signal > 70 (Overbought)

MayJuneJulyAug.Sept.Oct.Nov.Dec MAMayJuneJulyAug.Sept.Oct.Nov.Dec A moving average takes out the volatility by averaging several observations. For example, a MA(3) would average the current observation with the previous 2 observations. Data

Moving Average Convergence/Divergence (MACD) The MACD indicator calculates the difference between moving averages of two different lengths (usually, 12 periods and 26 periods) The signal is typically a 9 period moving average of the difference A divergence means that “something is happening” Positive to Negative = Sell Signal Negative to Positive = Buy Signal

MACD Suppose that the longer run moving average has a length equal to the number of observations – the series average MA Time MA(N) MA(10) - To + : Buy point + To - : Sell point - To + : Buy point

Punch line Technical methods are useful for short run prediction Don’t lose sight of the fundamentals!!!