CHAPTER 4

FIN555
Introduction to Technical Analysis
2
Technical Indicators

4.1 Moving Average

4.2 Envelopes and Bollinger Bands

 4.1
MOVING AVERAGE
Let’s start our first set of slides

3
 4.1 MOVING AVERAGE Simple using the terms
“moving average or MAs”
4 IN GENERAL

It is evident that trends in prices The three principal types of MAs

for any freely traded entity can be used in technical analysis
very volatile, almost haphazard at
times. One technique for dealing
with this phenomenon is the
moving average (MA). An MA Weighted Exponential
attempts to tone down the MAs (WMAs) MAs (EMAs)
fluctuations of stock prices into a
smoothed trend so that distortions
are reduced to a minimum.
Will always be specifically
referenced.

Major Technical Moving averages should be thought of as

Principle a dynamic level of support and resistance.
 4.1 MOVING AVERAGE
5 SIMPLE MOVING AVERAGE (SMA)

It is the most widely used

In order to get the average to “move”

It is constructed by
totaling a set of data and
dividing the sum by the A new item of data is added and the
number of observations. first subtracted.
The
process
is
The resulting number is repeated The new total is then divided by the
known as the average or number of observations
mean average.
 4.1 MOVING AVERAGE
6 SIMPLE MOVING AVERAGE (SMA)

For example, the

calculation of a 10-week
MA would follow the
method shown in Table
11.1

Major Technical Changes in the price trend are identified by the price
Principle crossing the MA, not by a reversal in the direction of the MA.
 4.1 MOVING AVERAGE
7 MOVING AVERAGE CHARACTERISTICS
An MA is a smoothed version of a trend, and the average itself is an area of
dynamic support and resistance. In a rising market, price reactions are often reversed
1 as they find support in the area of the MA. If the rest of the evidence agrees, it’s not a
bad idea to wait for the price to reach its MA prior to making a purchase.

A carefully chosen MA should reflect the underlying trend; its violation, therefore,
warns that a change in trend may already have taken place. If the MA is flat or has
2 already changed direction, its violation is fairly conclusive proof that the previous trend
has reversed.

If the violation occurs while the MA is still proceeding in the direction of the prevailing
trend, this development should be treated as a preliminary warning that a trend
3 reversal has taken place. Confirmation should await a flattening or a change in
direction in the MA itself, or should be sought from alternative technical sources.
 4.1 MOVING AVERAGE
8 MOVING AVERAGE CHARACTERISTICS

Generally speaking, the longer the time span covered by an MA, the greater is the
4 significance of a crossover signal. For instance, the violation of an 18-month MA is
substantially more important than a crossover of a 30-day MA.

Reversals in the direction of an MA are usually more reliable than a crossover.

In instances in which a change in direction occurs close to a market turning point, a
5 very powerful and reliable signal is given. However, in most instances, an average
reverses well after a new trend has begun and so is only useful as a confirmation.
 4.1 MOVING AVERAGE
9 WHAT IS A VALID CROSSOVER?
A crossover is any
penetration of an MA.
However, close observation Major Technical Principle
of any chart featuring an MA
will usually reveal a number If an MA crossover takes place at the same time
a trendline is violated or a price pattern is
of whipsaw, or false, signals. completed, these signals strongly reinforce each
other and, therefore, need less in the form of a
filter requirement.
However, it is possible to avoid some of
these close calls by using filtering MAs are usually constructed from closing data.
techniques. The type of filter to be used These are more reliable than intrasession prices
depends on the time span in question, and because they reflect positions that investors are
willing to carry overnight or, in the case of
is very much a matter of individual
weekly charts, over the weekend.
experimentation. For example, we may
decide to take action on MA crossovers for
which a 3 percent penetration takes place.
 4.1 MOVING AVERAGE
10 WHAT IS A VALID CROSSOVER?

Major Technical Principle

During a trading range, MA

crossovers have a strong tendency to
be counterproductive. Two examples
are shown in Chart 11.5 for Asian
Paints, an Indian stock. In these
situations, it is usually best to use the
outer ends of the trading range for the
signal rather than the MA.
 4.1 MOVING AVERAGE
11 CHOICE OF TIME SPAN

MAs can be constructed for

any time period, whether a few
days, several weeks, many
months, or even years.
Optimal selection of length is
very important.

The choice of MA depends on

the type of market trend that is
to be identified, i.e., short,
intermediate, or primary.
Because different markets.
 4.1 MOVING AVERAGE
12 CHOICE OF TIME SPAN

Major Technical Principle

Try for consistency, never for

perfection

Perfection just does not exist in

psychologically driven markets.
Generally speaking, long-term time
spans are less influenced by
manipulation and kneejerk random
reactions to unexpected news than
are short-term ones. This is why
long time spans usually give the
best test results; both daily and
weekly averages work best at or
above a 40-period span.
 4.1 MOVING AVERAGE
13 CHOICE OF TIME SPAN

The important thing to

remember is that an MA is one
tool in the technical arsenal,
which is used with other
techniques as part of the art of
identifying trend reversals.
Again, it’s important to
remember that we are looking
for a time span that works
reasonably well over most
securities.
 4.1 MOVING AVERAGE
14 CROSSOVER RULE

A closing price crosses above

the moving average is
interpreted as a buy signal
(bullish signal).

A closing price crosses below

the moving average is
interpreted as a sell signal
(bearish signal).
 4.1 MOVING AVERAGE
15 CROSSOVER RULE (GOLDEN CROSS)
It is a technical chart pattern indicating
the potential for a major rally.

It appears on a chart when a

stock’s short-term moving
average crosses above its
long-term moving average.

It is can be contrasted with a

death cross indicating a
bearish price movement.
 4.1 MOVING AVERAGE
16 CROSSOVER RULE (DEATH CROSS)
It is a technical chart pattern indicating
the potential for a major selloff.

It appears on a chart when a

stock’s short-term moving
average crosses below its
long-term moving average.

It is an indicator has proven to

be a reliable predictor of some
of the most severe bear
markets of the past century:
1929, 1938, 1974, and 2008

It can be contrasted with a

golden cross indicating a bull
price movement.
 4.2
ENVELOPES AND
BOLLINGER BANDS
Let’s start our second set of slides

17
 4.2 ENVELOPES AND BOLLINGER BANDS
18 1. ENVELOPES

It has already been established

that moving averages (mas) can
act as important juncture points in
their role as support and
resistance areas. In this respect,
the longer the time span, the
greater the significance of mas.

This support and resistance

principle can be taken one step
further by constructing
symmetrical lines parallel to a MA
of any variety, called envelopes
(see figure 12.1).
 4.2 ENVELOPES AND BOLLINGER BANDS
19 1. ENVELOPES

There is no hard-and-fast rule

about the exact position at which
the envelope should be
constructed. That can be
discovered only on a trial-and-
error basis with regard to the
volatility of the price being
monitored and the time span of
the MA.

This process can be expanded,

as in figure 12.2, to include four
or more envelopes (i.e., two
above and two below the MA).
 4.2 ENVELOPES AND BOLLINGER BANDS
20 1. ENVELOPES

Major Technical Principle

Envelopes are best calculated using

proportionate as opposed to point or
dollar amounts.

The disadvantage is that there is no

certainty that the envelope will
prove to be the eventual turning
point.
 4.2 ENVELOPES AND BOLLINGER BANDS
21 1. ENVELOPES

Major Technical Principle

This method, like all techniques that

attempt to forecast the duration of a
move, should be used on the basis
that if the index reaches a particular
envelope, there is a good probability
that it will reverse course at that
juncture, provided of course, that
the envelope has had a reasonable
record of acting as a
support/resistance point in the past.
 4.2 ENVELOPES AND BOLLINGER BANDS
22 1. ENVELOPES (OVERBOUGHT)

A situation in technical analysis

where the price of a security has
risen to such a degree - usually on
high volume - that an oscillator
has reached its upper bound.

This is generally interpreted as a

sign that the price of the asset is
becoming overvalued and may
experience a pullback.

Represent a selling opportunity

(selling signal) for investors
 4.2 ENVELOPES AND BOLLINGER BANDS
23 1. ENVELOPES (OVERSOLD)

A situation in technical analysis

where the price of a security has
fallen to such a degree -usually on
high volume -that an oscillator has
reached a lower bound.

This is generally interpreted as a

sign that the price of the asset is
becoming undervalued.

Represent a buying opportunity

(buying signal) for investors.
 4.2 ENVELOPES AND BOLLINGER BANDS
24 1. ENVELOPES (OVERBOUGHT & OVERSOLD)

A sell signal when price reaches

or crosses the upper band
(overbought).

A buy signal when price reaches

or crosses the lower band of an
envelope channel (oversold).
 4.2 ENVELOPES AND BOLLINGER BANDS
25 2. BOLLINGER BANDS (THE CONCEPT)

Bollinger bands (chart 12.4)

operate in a similar way, except
that the envelopes, or bands, are
calculated using standard
deviations.

The first requirement in plotting a

Bollinger band is a time span, as
with a moving average. The longer
the span, the smoother, but less
sensitive, are the fluctuations.
 4.2 ENVELOPES AND BOLLINGER BANDS
26 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)
Rule 1. When the bands narrow, there
is a tendency for sharp price changes to
follow. This, of course, is another way of
saying that when prices trade in a
narrow range and lose volatility,
demand and supply are in a fine state of
balance and its resolution will trigger a
sharp price move. In this context, a
narrowing of the bands is always
relative to the recent past. That’s where
Bollinger bands can help visually by
showing the narrowing process. They
also give us some indication of when a
breakout might materialize because the
bands start to diverge once the price
begins to take off.
 4.2 ENVELOPES AND BOLLINGER BANDS
27 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)
Two examples are shown in Chart 12.7,
where it is also possible to construct
some trendlines marking the breakout
points.

Rule 2. If the price exceeds a band, the

trend is expected to continue. This is
really another way of saying that if the
price moves above the band, upside
momentum is strong enough to support
higher ultimate prices, and vice versa.
This is a common experience at the
start of a bull market and vice versa for
a downward penetration.
 4.2 ENVELOPES AND BOLLINGER BANDS
28 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)

After both breakouts in Chart 12.7, we

see the price immediately move outside
the band. The re-crossover of the
Bollinger band usually indicates short-
term exhaustion, and it quickly pulls
back again. However, this is just a
process of pausing for breath until the
trend is then able to extend again.
 4.2 ENVELOPES AND BOLLINGER BANDS
29 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)

Rule 3. When the price traces out a

reversal formation after it has crossed
outside a band, expect a trend reversal.
In Chart 12.8, featuring the New York
Stock Exchange (NYSE) Composite, we
see a series of three rallies that touch or
exceed the upper band (range A). The
first two show no sign of exhaustion.

However, after the final attempt, the up

trendline is violated. Then the price falls
below the previous minor low to
complete a small top at point F.
 4.2 ENVELOPES AND BOLLINGER BANDS
30 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)

• Bollinger Bands are a technical

analysis tool developed by John
A Bollinger Band is a technical Bollinger.
analysis tool defined by a set of lines • There are three lines that compose
plotted two standard deviations Bollinger Bands: A simple moving
(positively and negatively) away from a average (middle band) and an upper
simple moving average (SMA) of the and lower band.
security's price, but can be adjusted to • The upper and lower bands are
user preferences. typically 2 standard deviations +/- from
a 20- day simple moving average, but
can be modified.
 4.2 ENVELOPES AND BOLLINGER BANDS
31 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)

Investors also use

Bollinger Bands to
help determine buy
and sell signals on a
stock.
 4.2 ENVELOPES AND BOLLINGER BANDS
32 2. BOLLINGER BANDS (RULES FOR INTERPRETATION)

Anytime the stock

price touches the
lower band, the stock
is usually oversold
and therefore is in
buying signal.

Investors view a touch

of the stock price to
the upper band
(overbought) as a sell
signal.
THANKS!
Any questions?