Investment Analysis and

Portfolio Management

Technical Analysis
 Technical Analysis
Trading rules from past price
movements
Identifies stocks and the timing for
investments and divestments
Price pattern is not used blindly and
exclusively; other indicators like
cycles, volume and trend-following
indicators are used

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 Why does it work?
‘Stocks don’t sell for what they are
worth, but for what people think they
are worth’
Prices are determined by psychology –
people’s attitudes toward the emerging
fundamentals
TA assumes that these attitudes are
reflected in price action
History repeats, may not be exactly;
similarity of people’s attitudes shows up
in identifiable price patterns
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 Limitations
Empirical studies in the areas of serial
correlation of prices and profitability of
trading strategies have turned out
against TA
Multiple interpretation of same patterns
A great deal of subjectivity in decision
making
Efficacy of a particular trading rule may
be short lasting due to its exploitation
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 Charting Techniques
To look for patterns in past price
data, one of the following methods
may be used to chart the prices
– Bar Charts
– Japanese Candlestick Charts
– Point and Figure Charts

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 Drawing Bar Charts
 Each bar is High High
composed of 4 Close Open
elements:
– Open
– High
– Low
– Close Open Close
 Note that the Low Low
candlestick body is Standard Japanese Standard Japanese
empty (white) on Bar Chart Candlestick Bar Chart Candlestick
up days, and filled
(some color) on
down days
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 Bar Charts
 This is a bar (open, high, low, close or
OHLC) chart of AMAT from early July to
mid October 2001.

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 Japanese Candlesticks
 This is a Japanese Candlestick (open, high,
low, close) chart of AMAT from early July to
mid October 2001

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 Point & Figure Charts
 Point & Figure charts are
independent of time.
 An X represents an up
move.
 An O represents a down
move.
 The Box Size is the
number of points needed
to make an X or O.
 The Reversal is the price X
change needed to X
recognize a change in X X O
direction. X X O
 Typically, P&F charts use
X O O
X O O
a 1-point box and a 3- X
point reversal.
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 Point & Figure Charts
 This is a Point & Figure chart of AMAT from
early July to mid October 2001.

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A Few Basic TA Tools

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 Trends
Trend is a time measurement in which
a price moves in an irregular but
persistent direction
Secular Trend: 12 -25 years
Primary Trend: 9 months – 2 years
Intermediate Trend: 6 weeks – 9 mo.s
Short-term Trend: 2 – 6 weeks
Intraday Trend: minutes and hours

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 Trends continued
Longer-term dominates near-term action
Need to understand which type of trend
is being reversed
A rising trend consists of a series of
rallies and reactions – each high is
higher than its predecessor as is each
low
When the series of rising peaks and
troughs is interrupted, a trend reversal is
signaled – should have support of other
technical indicators
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 Support and Resistance
 Support and resistance
lines indicate likely ends
of trends.
 Resistance results from Breakout

the inability to surpass

prior highs.
 Support results from
the inability to break
below to prior lows.
 What was support Support Resistance
becomes resistance,
and vice-versa.
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 Trendlines
 Fundamental building
block of pattern
identification
 When the price breaks
free of the trendline, a
trend change signals
 There are three basic
kinds of trends:
– An Up trend where prices
are generally increasing.
– A Down trend where prices
are generally decreasing.
– A Trading Range. 15
 Moving Averages
A moving average is simply the
average price (usually the closing
price) over the last N periods.
They are used to smooth out
fluctuations of less than N periods.
Movement of MA lines suggest possible
change in trends
When short-term MA line and long-
term MA line intersects and are
supported by other indicators like
volume, they are interpreted as strong
change signals 16
 Head and Shoulders

 This formation is H&S Top

characterized by two
Head

small peaks on Left Shoulder Right Shoulder

either side of a
larger peak. Neckline

 This is a reversal H&S Bottom

pattern, meaning Neckline

that it signifies a Left Shoulder

Right Shoulder
change in the trend.
Head

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Head and Shoulders Example

Sell Signal

Minimum Target Price

Based on measurement rule

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 Importance of Volume
Volume is an independent variable from
price and normally goes with the trend
When volume trends are moving in a
direction opposite to that of price, that is
abnormal and either warns of an
impending trend reversal or emphasizes
the significance of any breakout
Ratio of up/down volume is used as an
indicator of short-term market
momentum (>1.5 = Bullish and <0.75 =
Bearish)
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 Other Indicators
Breadth of market: number of scripts
that increased each day versus the
number that declined
Short Interest: Uncovered short sale
outstanding divided by average daily
trading volume
Margin Debt from Brokers: Balances
and changes therein indicate the
attitude of informed investors
Put/Call Ratio: number of puts traded
divided by the number of call 20
A Few TA Methods

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 Dow Theory
This theory was first stated by Charles
Dow in a series of columns in the WSJ
between 1900 and 1902.
Dow (and later Hamilton and Rhea)
believed that market trends forecast
trends in the economy.
A change in the trend of the DJIA
must be confirmed by a trend change
in the DJTA in order to generate a
valid signal 22
 Moving Average
Convergence/Divergence
 MACD was developed by Gerald Appel as a
way to keep track of a moving average
crossover system.
 Appel defined MACD as the difference
between a 12-day and 26-day moving
average. A 9-day moving average of this
difference is used to generate signals.
 When this signal line goes from negative
to positive, a buy signal is generated.
 When the signal line goes from positive to
negative, a sell signal is generated.
 MACD is best used in choppy (trendless)
markets, and is subject to whipsaws (in
and out rapidly with little or no profit). 23
MACD Example Chart

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 Bollinger Bands
Bollinger bands were created by John
Bollinger (former FNN technical analyst,
and regular guest on CNBC).
Bollinger Bands are based on a moving
average of the closing price.
They are two standard deviations above
and below the moving average.
A buy signal is given when the stock price
closes below the lower band, and a sell
signal is given when the stock price
closes above the upper band.
When the bands contract, that is a signal
that a big move is coming, but it is
impossible to say if it will be up or down. 25
Bollinger Bands Example
Chart
Sell signal

Buy signals

Sometimes, the buy

signals just keep coming and
you can go broke!

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Survey article on Indian TA
practitioners
Number of Respondents 25
Most use TA along with FA and do not
think volume data is superior to price
Do not use time series analysis
Used the same tools for individual
stocks as for the market as a whole
None of the TA methods beat ‘Buy
and Hold’ strategy!
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 Leland O’Brien Case
Market existed for products capping the
downside risk while retaining the
upward potential of portfolio
In 1981, there were no S&P 500 index
futures and put option market was thin
Synthetic put option requires short sale
of portfolio and frequent rebalancing
due to price change and this precluded
rapid business growth as the clients
found it to be costly 28
Leland O’Brien Case Continued…
In 1984, with the advent of S&P 500
Index Futures, the hedging strategy
shifted a little wherein the client is to
park a small portion of their portfolio
in cash with LOR which the firm used
to transact futures at a considerably
reduced transaction cost and provide
hedge against the market movement
as against the client’s specific
portfolio

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Leland O’Brien Case Continued…
Since the ‘portfolio insurance’ system
was not patentable, other players
entered in the fray
In order to compete, LOR in 1985
licensed their system to other financial
services firms and this increased the
assets under management manifolds
Standard Portfolio Insurance contract
was for a fixed period of 3 years at a
cost of 3-4% of client portfolio plus a
declining scale of annual fees based on
asset size 30
Leland O’Brien Case Continued…
Variations in product included different
periods of contracts including perpetual
insurance, lower protection level in
order to reduce costs, change in
protection level with the market
movement, protection from sudden
jump in the index up to a limit
For the insurance protection to work
– Price changes must be small
– Futures and Stock market must be active
and orderly
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 Case Questions
Potential Customers:
– Those funds which have outflow
commitments and are extremely averse to
fund value falling below a particular level
– Those who are running after alphas would
like to limit the risks of their portfolio
within reasonable distance of the
benchmark while they pursue the alphas

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Portfolio Insurance
– Short on S&P 500 Index Futures and long
on Treasury Bills
– Matches the Put option delta at each level of
stock price
– Rebalancing is done at pre-specified levels
of stock price change and is cash neutral for
small changes
– Protection is provided for very small change
in stock price as for larger change, synthetic
put fails to match the non-linearity of actual
put option value
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To make the portfolio ‘jump’ proof
– Not sufficient to make the portfolio delta-
neutral, it has to be made gamma-neutral
too
– Gammas are small for options far in and
out-of-money and large for at the money
options
– Since the gammas of stocks, futures and
T-bills are all zeros, replicating portfolio
gamma can be made zero only by adding
options
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Transaction Cost
– Higher the transaction cost, the more
costly it is to rebalance and the optimal
frequency of rebalancing will decline
– Rebalancing is particularly costly for at-
the-money options which have large
gammas
– An option’s gamma represents the change
in the number of shares in replicating
portfolio for a small change in stock price
• Transaction cost associated with each rebalancing =
gamma x stock price x .4%
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Benefit of Index Futures
– No need to disturb the original portfolio
and hence the client can be spared of
the task of actually creating the put
– Transaction cost was much lower

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