BLOCK 5

Portfolio Theory and Behavioral Finance

• This course covers portfolio theory and behavioral finance.
• The focus of chapter 6 is technical analysis and hedging strategies.

Technical Analysis and Hedging Strategies

• Technical analysis is a security analysis method utilizing price and volume data, often displayed graphically, for decision-making.
• It applies to securities in any freely traded market globally.
• Behavioral finance studies how psychology influences investor behavior, highlighting that investors aren't always rational and are affected by biases.
• This field motivates practitioners to use technical analysis to understand and explain irrationalities in financial markets.
• Prices are results of supply and demand interactions in real time.
• Technical analysis helps analyze this battle between buyers and sellers.
• It's used to analyze various financial instruments: equities, bonds, commodities futures, currency futures, and cryptocurrencies.

Technical Analysis: Underlying Logic

• Supply and demand determine prices.
• Changes in supply and demand affect price levels and volumes.
• Past price actions help anticipate future prices using charts and other tools.
• Defining the time period for analysis is a crucial step in applying technical analysis successfully.

Technical Analysis: Underlying Logic - Consequences

• Basic technical analysis of financial instruments doesn't require detailed knowledge of the instrument itself.
• Technical analysis can be applied to short-term or long-term price movements (e.g., annual closing prices).
• It's suitable for short-term trading and tactical asset allocation decisions.
• Long-term chart analysis adds value to strategic asset allocation and long-term investment decisions.

Principles and Assumptions:

The market discounts everything

• The price of a financial instrument reflects all known factors.
• A stock's price reflects everything impacting the organization (balance sheet, income statement, cash flow, and management).
• Broader economic factors and market psychology are also reflected in pricing.

Principles and Assumptions: Prices Move in Trends and Countertrends

• Prices have directional movements (upward, downward, sideways, or combinations).
• Recognizing a trend suggests that future price movements will follow it.
• Trends typically continue unless they reverse.
• "The trend is your friend" is a common technical analysis adage.

Principles and Assumptions: Price Action Creates Certain Patterns

• The repetition of price movements is due to market psychology.
• News is important, but its value depends on initial market psychology.
• Charted price movements reveal patterns that technicians recognize.

Technical Analysis: Aspects of Behavioral Finance

• Technical analysis studies collective investor psychology and sentiment, connecting with behavioral finance.
• Prices in freely traded markets are set by human-driven buy/sell activity at market equilibrium.
• Technicians monitor subtle clues in the supply/demand battle to understand overall market health.

Technical Analysis: Aspects of Behavioral Finance

• Technicians recognize that humans are often irrational and emotional, behaving similarly in similar circumstances.
• Price charts reflect this irrational behavior (e.g., volatile price action, large sell-offs or parabolic advances).

Technical Analysis: Aspects of Behavioral Finance

• Chart patterns reveal repeated human trading behavior, offering predictive value.
• Trading driven by fear (market sell-offs) or greed (bubbles) is especially significant.
• These patterns show collective investor knowledge and sentiment.

Technical Analysis: Technical Analysis vs. Fundamental Analysis

• Technicians focus solely on market analysis and financial instrument trading.
• Technicians derive their analysis from price and volume data, assuming all factors reflected in those price signals.
• Fundamental Analysis is a wider field, encompassing financial and economic, and societal trends.
• Fundamental analysts determine intrinsic value by studying a company and the external factors.
• Fundamental analysts wait for the release of financial statements to analyze which can introduce a delay.

Technical Analysis: Technical Analysis vs. Fundamental Analysis

• Technicians analyze security price movements before fundamental developments, often before their reporting.
• Technicians use more concrete price and volume data to work with.
• Financial statements analyzed by fundamental analysts are based on estimates and assumptions, rather than objective data.
• Statement changes in accounting and even fraud can cause restatements.

Technical Analysis: Technical Analysis vs. Fundamental Analysis

• Price and volume data used in technical analysis is objective.
• Fundamental and technical analysis become subjective due to judgment input.
• Predefined rules and conditions in technical analysis can make it more objective.
• Technicians project security trading levels, while fundamental analysts predict "should" trading levels based on intrinsic values.

Technical Analysis: Combine with Fundamental Analysis

• Fundamental analysis identifies undervalued securities; technical analysis determines optimal entry/exit points.
• Combining both works well when a security is fundamentally cheap but buying too early can be costly.
• Technical analysis can identify attractive risk/reward entry points to match the fundamental view.

Technical Analysis: Disadvantages and Drawbacks

• Technicians are limited to studying market movements without external predictive techniques (e.g., interviewing).
• Markets can change unexpectedly. Investor psychology driving trends is typically gradual.
• Time lag can exist between market activity and analysis conclusions.
• Technicians may be late in identifying market moves, similar to the potential delays related to fundamental analysis.

Technical Analysis: Disadvantages and Drawbacks

• Technical analysis requires sufficient market liquidity for its application (deep/liquid markets).
• Technical analysis is less effective in illiquid markets due to the impact of single large trades.
• Success rates depend on the specific price actions within the market.
• Technicians' role is to interpret, not force, technical evidence; each market is different.

Technical Analysis: Disadvantages and Drawbacks

• Retail investors might over-rely on technical analysis and momentum trading compared to institutional investors.
• Micro-cap stocks pose a liquidity hurdle to institutional users.
• Strong trend periods in emerging and frontier markets are often inefficient and exploited easily.

Types of Technical Analysis Charts

• Line charts display price trends over time.
• Bar charts include highs, lows, open, and closing prices for time periods.
• Candlestick charts show opening/closing, high/low prices for a period.

Types of Technical Analysis Charts - Scaling

• Charts can use linear (arithmetic) or logarithmic scales.
• Logarithmic scales use percentage change and are better for longer time frames.
• Linear scales use equal vertical distances and are suitable for shorter time frames.

Types of Technical Analysis Charts - Volume

• Volume is a crucial chart characteristic measuring buyer/seller strength.
• High volume during an uptrend suggests strong investor conviction.
• Divergence between price and volume indicates potential weakness or change.

Types of Technical Analysis Charts - Relative Strength Analysis

• Relative strength analysis compares asset performance to benchmarks (e.g., index).
• The ratio of one asset's price to another's reveals outperformance/underperformance.
• A flat line represents neutral performance, while upward/downward movements reflect better/worse performance versus the benchmark.

Types of Technical Analysis Charts - Trend, Support, and Resistance

• Trends represent long-term price movements. Consolidation shows stability.
• Trend analysis observes that participants act in groups and trends persist.
• Uptrends show increasing demand (investor belief in rising intrinsic value).
• Retracements are price reversals.
• The length of time below trendlines suggests more powerful break-downs.

Types of Technical Analysis Charts - Resistance: Change in Polarity

• Support levels demonstrate price appreciation prospects even during downturns.
• Breaching a support level turns it into resistance. Resistance levels once broken become support levels.

Types of Technical Analysis Charts - Common Chart Patterns

• Chart patterns are graphical representations of market psychology.
• They're categorized as reversal or continuation patterns. Reversal patterns indicate a trend change; continuation patterns suggest trend continuity.
• Not every chart is easily interpretable; avoid forcing interpretations.

Technical Analysis and Hedging Strategies - Chart Patterns

• Understanding chart patterns assists in analyzing the market.
• Head and shoulders patterns (head-and-shoulders and inverse head-and-shoulders) are reversal patterns. Double/Triple tops/bottoms are also used in reversal analysis.
• Triangles/rectangles/flags/pennants are continuation patterns.

Technical Indicators: Technical Indicators

• Technical indicators are measures based on price, sentiment, or funds flow for predicting price changes.
• Mathematically calculated, they often reflect supply and demand.
• Moving averages are common smoothing techniques.

Technical Indicators: Price-Based Indicators - Moving Averages

• Bullish/bearish crossovers involve short-term and longer-term moving averages crossing.
• Crossovers between the 50-day and 200-day moving averages are significant. Golden crosses (bullish) and death crosses (bearish).

Technical Indicators: Price-Based Indicators - Bollinger Bands

• Bollinger Bands utilize moving averages plus/minus standard deviations.
• They establish a reasonable trading range.
• Significant breakdowns below a band might represent downtrends and risk aversion.

Technical Indicators: Momentum Oscillators

• Momentum oscillators track rates of price changes, emphasizing unusual movements.
• Oscillators often oscillate between 0-100 or centered on a number like 0 or 100. This characteristic makes recognizing extreme highs/lows easier.
• Momentum oscillators use standard trend identification tools to analyze price trends.

Technical Indicators: Momentum Oscillators - Rate of Change Oscillator (ROC)

• ROC represents the rate of change in price.
• It helps quantify changes.
• Analyzing ROC alongside price data can identify potential weaknesses or strengths.
• Divergence/convergence suggest potential trend changes.
• RSI is a commonly used momentum oscillator.

Technical Indicators: Momentum Oscillators - Relative Strength Index (RSI)

• RSI tracks price changes to assess market sentiment.
• High/low values on the RSI can offer trend confirmation or warning.
• Divergence means the price and oscillator signals differ; this signals potential reversal.

Technical Indicators: Momentum Oscillators - Moving Average Convergence Divergence (MACD)

• MACD calculates the difference between short-term and long-term moving averages.
• The signal line smooths the MACD, helping detect trend changes.
• MACD's movements outside normal ranges can mean trend reversals or significant market action.

Technical Indicators: Sentiment Indicators

• Sentiment indicators measure investor behavior toward increasing bullishness or bearishness.
• Put/call ratios compare call and put option volume to estimate market sentiment.
• The VIX (volatility index) measures near-term market uncertainty based on option prices.
• Margin debt reflects investor borrowing to finance investments, indicating sentiment.
• Investor polls gauge sentiment and investor perspective.

Technical Analysis & Hedging Strategies - Introduction to Hedging Strategies

• Hedging strategies attempt to reduce risk by offsetting potential losses.
• Forward hedge: using Bond's currency and home currency.
• Proxy hedge: using a highly correlated currency.
• Cross hedge: using different currencies with limited correlation.
• Mean-variance hedges minimize return volatility, all Cross Hedges are but not all Cross Hedges are MVs.

Technical Analysis & Hedging Strategies - Example: Hedging with Futures

• Hedging a long position involves shorting appropriate index futures.
• Calculation involves current index level, portfolio value, beta, and contract multiplier.

Technical Analysis & Hedging Strategies - Intermarket Analysis

• Intermarket analysis combines different security types to find trends and inflection points in trends.
• It analyzes relationships between sectors and industries.
• Relative strength analysis is used for this purpose (one security's price relative to another's).

Technical Analysis & Hedging Strategies - Portfolio Management

• Analyzing global benchmarks (like MSCI and FTSE) is a top-down approach in global equity markets.
• Analyzing major index performance can reveal investment themes and opportunities for long-term investors.
• Identifying consolidation periods helps capitalize on major market trends.

Technical Analysis & Hedging Strategies - Trading Rules

• Breakouts should occur above the 200-day exponential moving average.
• Identifying existing uptrends in stocks before breakouts is important.
• Breakouts following consolidations usually precede continued trend continuation.
• Trend direction offers a relatively low-risk investment approach.

Technical Analysis & Hedging Strategies - Trading Rules - Continued

• Prior to a breakout, prices should exhibit low volatility.
• Following low volatility, high volatility is likely, reinforcing trend.
• Well-defined chart patterns (lasting 3-24 months) tend to generate strong follow-up trends.
• Confirmation of breakout should come from a weekly closing price above chart boundaries.

Technical Analysis & Hedging Strategies - Trading Rules Example

• Understanding examples of successful trading rules demonstrates effective application.
• Analyzing breakout examples, like the silver price from the inverse head and shoulders pattern, clarifies real-world implications.

Technical Analysis & Hedging Strategies - Trading Rules: Additional Notes

• Technical analysis is a supporting tool rather than a stand-alone method. It contributes to investment decisions, research, strategy development, and generating trade/investment ideas.
• Technical analysis aids portfolio management by improving security timing decisions.
• It helps determine potential risks and validate price levels, leading to more informed decision-making.
• A portfolio manager would use technical analysis to help weigh decisions.