Portfolio Theory and Behavioral Finance (w.IN.23HS.V) Chapter 6 PDF

Portfolio Theory and Behavioral Finance (w.IN.23HS.V) Chapter 6: Technical Analysis and Hedging Strategies Building Competence. Crossing Borders. Dr.-Ing. Martin Schnauss, CFA, FRM / Dr. Jan-Alexander Posth, Dr. Marcus Wunsch [email protected], p...

Portfolio Theory and Behavioral Finance (w.IN.23HS.V) Chapter 6: Technical Analysis and Hedging Strategies Building Competence. Crossing Borders. Dr.-Ing. Martin Schnauss, CFA, FRM / Dr. Jan-Alexander Posth, Dr. Marcus Wunsch [email protected], [email protected] / Vers. 1.1.3 Technical Analysis and Hedging Strategies TECHNICAL ANALYSIS: PRINCIPLES, ASSUMPTIONS, AND LINKS TO INVESTMENT ANALYSIS -2- Technical Analysis Not every chart will have obvious or clear implications, so the analyst must avoid the temptation to force a conclusion from every chart, which may lead to a wrong interpretation. -3- Technical Analysis - Bloomberg -4- Technical Analysis Learning Goals  Know the principles and assumptions of technical analysis  Describe potential links between technical analysis and behavioral finance  Compare principles of technical analysis and fundamental analysis.  Describe and interpret different types of technical analysis charts  Explain uses of trend, support, and resistance lines -5- Technical Analysis Learning Goals  Explain common chart patterns;  Explain common technical indicators;  Describe principles of intermarket analysis  Explain technical analysis applications to portfolio management.  Name the concepts of the main hedging strategies. -6- Technical Analysis Introduction  Technical analysis is a form of security analysis that uses price and volume data, often graphically displayed, in decision making.  Technical analysis can be applied to securities in any freely traded market around the globe. A freely traded market is one in which willing buyers trade with willing sellers without external intervention or impediment -7- Technical Analysis Introduction  Behavioral finance, which is the study of the influence of psychology on the behavior of investors, focuses on the fact that investors are not always rational, have limits to their self- control, and are influenced by their own biases.  This relatively new field of finance is motivating more practitioners to consider technical analysis as a tool for understanding and explaining irrationalities in financial markets. -8- Technical Analysis Introduction  Prices are the result of the interaction of supply and demand in real time.  Technical analysis allows us to see a battle between buyers and sellers.  Technical analysis is used on a wide range of financial instruments, including equities, bonds, commodity futures, currency futures, and cryptocurrencies -9- Technical Analysis Underlying Logic  Supply and demand determine prices.  Changes in supply and demand—both in price level and volume—cause changes in prices.  Past price action can be used to anticipate and project potential future prices with charts and other technical tools.  One of the most important steps in successfully applying technical analysis is to define the time period being analyzed. - 10 - Technical Analysis Underlying Logic - Consequences  Basic technical analysis of any financial instrument does not require detailed knowledge of that instrument.  Technical analysis can also be applied over any time frame— from short-term price movements to long-term movements of annual closing prices.  Technical analysis is ideal for short-term trading decisions or tactical asset allocation decisions  Long-term chart analysis can add value regarding strategic asset allocation or long-term investment decisions. - 11 - Principles and Assumptions: The market discounts everything  Price already reflects all known factors impacting a financial instrument.  At any point in time, a stock’s price is a reflection of everything that affects the organization, including fundamental factors, such as the balance sheet, the income statement, the cash flow, and the management team.  It considers broader economic factors and market psychology to be reflected in pricing. - 12 - Principles and Assumptions: Prices move in trends and countertrends.  Prices follow trends, which move directionally—upward, downward, sideways, or in a combination of these directions.  Once a trend is recognized, the expectation is that any future movement in the price of the asset will follow that trend rather than go against it.  A trend in motion is more likely to continue than to reverse. An important corollary is that a trend in motion will continue until it reverses.  “The trend is your friend.” - 13 - Principles and Assumptions: Price action creates certain patterns  The repetition of price movements, according to technical analysts, is due to market psychology.  News is always important, but the value of any news depends upon the initial market psychology.  Because the behavior of investors repeats itself, price movements can be charted, allowing technicians to recognize patterns. - 14 - Technical Analysis: Aspects of Behavioral Finance:  Technical analysis can be thought of as the study of collective investor psychology or sentiment and thus has a direct connection with behavioral finance.  Prices in any freely traded market are set by human beings or their automated proxies (such as computerized trading programs), and a price is set at the equilibrium between supply and demand at any given instant.  The role of a good technician is to monitor and evaluate the subtle clues in this battle between supply and demand—much like a doctor looking at a patient for subtle clues to that patient’s overall health. - 15 - Technical Analysis: Aspects of Behavioral Finance:  Technicians believe that humans are often irrational and emotional and that they tend to behave similarly in similar circumstances.  Patterns reflect this irrational human behavior  It can be seen on price charts in the form of volatile price action, such as major sell-offs or strong buying resulting in parabolic advances. Apple Inc. - 16 - Technical Analysis: Aspects of Behavioral Finance:  The reason chart patterns have predictive value is that they are graphic representations of human trading activity and human behavior is frequently repeated, especially trading activity that is driven:  by fear (in market sell-offs) or  greed (as evidenced in bubbles—that is, rallies that extend well beyond valuation levels derived from fundamental data). Tesla Inc. - 17 - Technical Analysis: Aspects of Behavioral Finance:  Technical analysis reflects the collective knowledge and sentiment of the many different participants responsible for the buying and selling activity in a particular security  In a freely traded market, only those market participants who actually buy or sell a security have an impact on its price  The greater the volume of a participant’s trades, the more impact that market participant will tend to have on price.  Without trading, there will be no meaningful price fluctuations. - 18 - Technical Analysis: Technical Analysis vs. Fundamental Analysis  Technicians focus solely on analyzing markets and the trading of financial instruments:  Technicians analyze market prices. A technician’s analysis is derived solely from price and volume data  assumes that all of the factors considered by a fundamental analyst are reflected in the price of a financial instrument through buying and selling activity  Fundamental analysis is a much wider field, encompassing financial and economic analysis as well as analysis of societal and political trends  studies a company, incorporating data that are external to the market, and then uses this analysis to predict security price movements. - 19 - Technical Analysis: Technical Analysis vs. Fundamental Analysis  By studying market technical data—price and volume trends— the technician is seeking to understand investor sentiment.  The technician benefits from the wide range of knowledge of market participants and their collective conclusion about a security.  Fundamental analyst must wait for the release of financial statements to conduct financial statement analysis, so a time lag occurs between the market’s activities and the analyst’s conclusions:  Technicians may therefore be ahead of fundamental analysts in their positioning - 20 - Technical Analysis: Technical Analysis vs. Fundamental Analysis Surprise Potential – Covid 2. Wave: Quellen: Unternehmensangaben WarburgResearch 23.10.2020 Investors with a fundamental view may sell a financial instrument for different reasons, including pessimistic investor sentiment, margin calls, and a need for capital. Technicians do not care why market participants are buying or selling, just that they are doing so: These actions move prices, forming trends the technician can profit from. - 21 - Technical Analysis: Technical Analysis vs. Fundamental Analysis  Technicians believe that security price movements occur before fundamental developments unfold—and certainly before they are reported.  A key distinction between technical analysis and fundamental analysis is that the technician has more concrete data, primarily price and volume data, to work with.  The financial statements analyzed by fundamental analysts do not contain objective data but rather are the result of numerous estimates and assumptions that have been combined to produce the various line items. - 22 - Technical Analysis: Technical Analysis vs. Fundamental Analysis  Financial statements are subject to restatement because of such issues as changes in accounting assumptions and even fraud: Wirecard - 23 - Technical Analysis: Technical Analysis vs. Fundamental Analysis  The price and volume data used in technical analysis are objective.  When the data are analyzed fundamentally and technically, both types of analysis become subjective because judgment is exercised when a technician analyzes a price chart and when a fundamental analyst analyzes an income statement.  However, by assigning predefined rules and conditions to their techniques, technical analysts can become more objective. - 24 - Technical Analysis: Technical Analysis vs. Fundamental Analysis  Technicians seek to project the level at which a financial instrument will trade, whereas fundamental analysts seek to predict where it should trade.  Fundamental analysis can be considered the more theoretical approach because it seeks to determine the underlying long-term (or intrinsic) value of a security.  Technical analysis can be considered the more practical approach because a technician studies the markets and financial instruments as they exist - 25 - Technical Analysis: Combine with Fundamental Analysis  An investor may use fundamental analysis to identify an undervalued stock and then use technical analysis to find specific entry and exit points for that position.  Using fundamental and technical analysis together works well, for example, when a security is deemed fundamentally cheap but purchasing the security too early could prove costly.  Technical analysis could help identify an attractive risk/reward entry point and moment in time to express the core fundamental view - 26 - Technical Analysis: Disadvantages and drawbacks  Technicians are limited to studying market movements and do not use other predictive analytical methods, such as interviewing the customers of a subject company to determine future demand for a company’s products.  Markets can also change without warning. Trends are driven by collective investor psychology and generally change gradually, so that the trained technician can spot subtle shifts.  Additionally, it can take some time for a new trend to become evident.  Thus, technicians may make wrong calls and have to change their opinions.  Technicians are generally better at identifying market moves when the moves are already underway. Therefore they might be late.  This shortcoming mirrors a key shortcoming of fundamental analysis in that securities often overshoot fundamental fair values in an uptrend and undershoot fundamental fair values in a downtrend. - 27 - Technical Analysis: Disadvantages and drawbacks  In general, technical analysis is a trading tool that requires liquidity, so it is best and most easily applied to liquid and deep markets.  The use of technical analysis is limited in illiquid markets where even modestly sized trades can have an inordinate impact on prices.  The success rate of technical analysis will depend on the nature of the price action in any asset class.  Each market has its own character, and the role of the technician is to interpret—but not force—the technical evidence - 28 - Technical Analysis: Disadvantages and drawbacks  As a result, retail investors may depend upon technical analysis and momentum trading somewhat more than institutional investors.  Institutional investors also must have enough float/liquidity in a given stock to participate in scale, so are limited in their interest in micro-cap stocks with minimal liquidity.  Strong trend periods are the result of inefficiencies, and inefficiencies can be more easily exploited in emerging and frontier markets. - 29 - Technical Analysis and Hedging Strategies Types of Technical Analysis Charts - 30 - Types of Technical Analysis Charts Line Chart Line charts are familiar to all types of analysts and are a simple graphic display of price trends over time. Simplest kind of chart, an analyst can quickly glean information from this representation of price data Line charts are typically drawn with closing prices as the data points. The vertical axis (y-axis) reflects price level, and the horizontal axis (x-axis) represents time. - 31 - Types of Technical Analysis Charts Bar Chart A bar chart, has four bits of data in each entry: the high and low prices encountered during the time interval plus the opening and closing prices. Such charts can be constructed for any time period, but they are customarily constructed from daily data. How a chart is interpreted will not depend on its periodicity. A short bar indicates little price movement during the day; that is, the high, low, and close are near the opening price. - 32 - Types of Technical Analysis Charts Candlestick Chart Candlestick chart provides four prices per data point: the opening and closing prices and the high and low prices during the period. A vertical line represents the range through which the security price traveled during the time period. The line is known as the wick or shadow. The body of the candle is white (or clear) if the opening price was lower than the closing price, and the body of the candle is dark if the opening price was higher than the closing price. Long-legged candlesticks usually Charting indicate the price finding support after meeting sellers during the day - 33 - Types of Technical Analysis Charts Candlestick Chart vs. Bar Charts USD/SGD – Candlestick-Chart USD/SGD – Bar-Chart The doji in mid-May 2018 marked a short-term trend reversal from Begriff: Ein Doji ist eine Kerze (Bar), bei the 1.33 level but also strengthened that level, which later became a dem Eröffnung- und Schlusskurs auf dem support level during June 2018. gleichen Kursniveau liegen. Spikes on the upside and on the downside will form support and resistance levels. The advantage of the candlestick chart over the bar chart is that price fluctuations are much more visible on the candlestick chart, which allows for better analysis. - 34 - Types of Technical Analysis Charts Scaling  For any chart—line, bar, or candlestick—the vertical axis can be constructed with either a linear scale (also known as an arithmetic scale) or a logarithmic scale, depending on how the analyst wants to view the data.  logarithmic scale:  Equal percentage change  working on longer time frames  linear scale:  equal vertical distances (equal unit change)  for shorter-term price charts - 35 - Types of Technical Analysis Charts Scaling Linear Scale Logarithmic Scale Dow Jones Industrial Average 1920–2018 How you construct your scale will impact the trendlines you draw on your price chart. - 36 - Types of Technical Analysis Charts Volume  Volume is an important characteristic that is included at the bottom of many charts.  Volume is used to assess the strength or conviction of buyers and sellers in determining a security’s price.  If volume increases during a time frame in which price is also increasing, that combination is considered positive and the two indicators are said to “confirm” each other. (More investors are buying the financial instrument, and they are doing so at higher and higher prices.)  If volume and price diverge—for example, if a stock’s price rises while its volume declines—the implication is that fewer and fewer market participants are willing to buy that stock at the new price - 37 - Types of Technical Analysis Charts Volume Weekly Candlestick Price Chart and Volume Bar Chart: Sunac China Holdings, August 2016–May 2019 (Hong Kong dollars) If volume and price diverge—for example, if a stock’s price rises while its volume declines—the implication is that fewer and fewer market participants are willing to buy that stock at the new price. - 38 - Types of Technical Analysis Charts Relative Strength Analysis  Relative strength analysis is widely used to compare the performance of a particular asset, such as a common stock, with that of some benchmark  The intent is to show outperformance or underperformance of the individual issue relative to some other index or asset. 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵  A flat line shows neutral performance. A move from 1.00 to 1.50 on the chart indicates a 50% outperformance - 39 - Types of Technical Analysis Charts Relative Strength Analysis Relative Strength Analysis of Two Retail Giants: AMZN vs. the S&P 500 Amazon was a strong performer starting in 2015, but its relative performance wasn’t as strong prior to that year - 40 - Types of Technical Analysis Charts Trend, Support, and Resistance  A trend is a long-term pattern of movement in a particular direction. When a security is not trending, it is considered to be in a consolidation.  Trend analysis is based on the observations that market participants tend to act in herds and that trends tend to stay in place for some time.  In an uptrend, the forces of demand are greater than the forces of supply - investors believe the intrinsic value of the security is increasing.  A retracement is a reversal in the movement of the security’s price  The longer the security price stays below the trendline, the more meaningful the breakdown is considered to be - 41 - Types of Technical Analysis Charts Trend, Support, and Resistance  In a downtrend, supply overwhelms demand. Over time, sellers are willing to accept lower and lower prices to exit long positions or enter new short positions.  The downtrend is assumed to continue until contrary technical evidence appears.  A security may trade in a fairly narrow range, moving sideways on the price chart without much upward or downward movement. This pattern indicates a relative balance between supply and demand. - 42 - Types of Technical Analysis Charts Trend, Support, and Resistance Trend and consolidation: Each consolidation period is eventually followed by a trend period and vice versa. - 43 - Types of Technical Analysis Charts Resistance: Change in polarity principle Support indicates that at some price level, investors consider a security to be an attractive investment (even in the wake of a sharp decline) once a support level is breached, it becomes a resistance level. The same holds true for resistance levels; once breached, they become support levels. - 44 - Types of Technical Analysis Charts Common Chart Patterns Chart patterns are graphical depictions of the collective psychology of the market at a given time Can be divided into two categories: reversal patterns and continuation patterns. reversal pattern signals the end of a trend continuation patterns signal the continuation of trend. Not every chart will lend itself to easy interpretation: the analyst should not force an interpretation on any chart - 45 - Technical Analysis and Hedging Strategies Chart Patterns - 46 - Chart Patterns Reversal: Head and Shoulders Pattern Left shoulder: While the security is in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. (may represent the highest volume of the entire pattern) Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. (Volume typically will wane a bit into the head high) Right shoulder: This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. (volume be lowest on the second shoulder) - 47 - Chart Patterns Reversal: Head and Shoulders Pattern After the price breaks the neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. Price may exceed the chart pattern 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 = 𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵 − (𝑯𝑯𝑯𝑯𝑯𝑯𝑯𝑯 − 𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵𝑵) objective or fall short. Neckline: The neckline forms by connecting the beginning of the left shoulder and the end of the right shoulder. Volume: a) Volume during the advance of the left shoulder should be higher than during the advance of the head. b) The decrease in volume into the new high of the head then serves as an initial warning sign. c) The next warning sign comes when volume increases on the decline from the peak of the head. - 48 - Chart Patterns Reversal: Head and Shoulders Pattern 𝟔𝟔𝟔𝟔 = 𝟏𝟏𝟏𝟏𝟏𝟏 − (𝟏𝟏𝟏𝟏𝟏𝟏 − 𝟏𝟏𝟏𝟏𝟏𝟏) With a low-priced stock, such as one with a price of $0.50, there is a possibility of projecting price levels below 0. Because negative values for an asset are not possible, measuring price objectives using a percentage decline might be more reasonable. - 49 - Chart Patterns Reversal: Head and Shoulders Pattern Non perfectly formed head and shoulders patterns are possible: The head, however, should rise to a higher price level than either shoulder, whereas the shoulders should be roughly symmetrical. necklines may not always form exactly horizontal lines - 50 - Chart Patterns Reversal: Inverse Head and Shoulders Pattern Volume is important to watch Volume should generally diminish into the final reverse shoulder before ideally exploding higher on the subsequent neckline break. - 51 - Chart Patterns Double & Triple Tops and Bottoms A double top is formed when an uptrend reverses twice at roughly the same high price level. Typically, volume is lower on the second high than on the first high, signaling a diminishing of demand. The longer the time between the two tops and the deeper the sell-off after the first top, the more significant the pattern is considered to be. A double bottom is considered to be a more significant pattern than a single bottom because traders have stepped in on two occasions to halt declines. The most significant pattern is the triple top, but still …. the greater the time interval over which this pattern occurs, the greater the significance of the pattern. - 52 - Chart Patterns Trend and Consolidation - 53 - Chart Patterns Continuation Pattern From a supply and demand standpoint, a continuation pattern often indicates a change in ownership from one group of investors to another. The negative impact on price is quickly offset by other investors buying, so the forces of supply and demand go back and forth in terms of their impact on price. This type of pattern is often called “a healthy correction” Continuation patterns can take various forms: triangles, rectangles or flags - 54 -  Chart Patterns Continuation Pattern: Triangle Pattern +/-10 In a triangle, a trendline connects the highs and another trendline connects the lows. As the distance between the highs and lows narrows, the trendlines meet, forming a triangle. The pattern ends with an ongoing move in the same direction as the trend that preceded it, either up or down. The possible price target is derived by calculating the difference in price from the two trendlines at the start of the triangle. Typically, price breaks out of a triangle pattern between halfway and three-quarters of the way through the pattern. - 55 - Chart Patterns Continuation Pattern: Ascending Triangle Pattern Ascending Triangle: Bitcoin/US Dollar Daily Price Chart, September 2015– June 2016 (US$) The breakout pushes through the horizontal boundary is usually a bullish signal suggesting that buyers have overcome the selling pressure around the horizontal boundary - 56 - Chart Patterns Continuation Pattern: Descending Triangle Pattern Descending Triangle: Following breakdowns or breakouts, the price can pull back to the chart pattern boundary in an attempt to retest it. The previous support became the new resistance—that is, there was a change in polarity. - 57 - Chart Patterns Continuation Pattern: Rectangle Pattern Eeasier to identify on price charts than other classical chart patterns. Two horizontal boundaries and a clearly visible consolidation period on a price chart allows to detect the pause in trend periods. - 58 - Chart Patterns Continuation Pattern: Rectangle Pattern Société Générale SA Daily Price Chart This breakdown was followed by a pullback, a retesting of the previous support. A short pullback found resistance at the pattern boundary, and the downtrend resumed. The price objective was exceeded during the downtrend. The price objective is calculated by taking the width of the rectangle in percentage terms and projecting it lower from the breakdown level. The difference between the 38.5 and 35 levels translates into a 9% drop. Extending the price objective by 9% from the breakdown level of 35 gives us 31.85. - 59 - Chart Patterns Continuation Pattern: Flags and Pennants The key difference between a triangle and pennant is that a pennant is a short-term formation whereas a triangle is a long-term formation. Typically, the trendlines slope in a direction opposite to the trend up to that time The price is expected to change by at least the same amount as the price change from the start of the trend to the formation of the flag or pennant. - 60 - Technical Analysis and Hedging Strategies Technical Indicators - 61 - Technical Analysis: Technical Indicators A technical indicator is any measure based on price, market sentiment, or funds flow that can be used to predict changes in price. These mathematically calculated indicators often have a supply and demand underpinning. The moving average is the simplest of these techniques and has been used by statisticians to smooth data since the early 1900s. Kinds of Indicators: Price Based Indicators Momentum Oscillators Sentiment Indicators - 62 - Technical Indicators Price-Based Indicators: Moving Average Bullish / Bearish crossover: Conversely, when a short-term moving average crosses a longer-term moving average from unterneeath/above A widely followed moving-average crossover signal is the one that takes place between the 50-day moving average and the 200-day moving average. Crossover signal names then: golden cross (bullish crossover) or a death cross (bearish crossover). - 63 - Technical Indicators Price-Based Indicators: Bollinger Bands Bollinger Bands consist of a moving average (middle band), a higher line (upper band) representing the moving average plus a set number of standard deviations from the average price. Help define a statistically reasonable range that the market is expected to trade within. The long-term investor would sell on a significant (say, 5% or 10%) breakdown below the lower band in an attempt to limit downside risk. - 64 - Technical Indicators Price-Based Indicators: Bollinger Bands A breakout from a consolidation period at a time of historical low volatility suggests that the trend period that follows will have the strength to resume toward much higher levels - 65 - Technical Indicators Momentum Oscillators Difficulty of discerning changes in market movements that are out of the ordinary. One Solution: Momentum oscillators  They are constructed from the rate of change in price data, but they are calculated so that they either oscillate between a low and a high (typically 0 and 100) or oscillate around a number (such as 0 or 100).  Because of this construction, extreme highs and lows are recognizable.  Momentum oscillators be analyzed by using the same tools technicians use to analyze price, such as the concepts of trend, support, and resistance. - 66 - Technical Indicators Momentum Oscillators Technicians also look for convergence or divergence between oscillators and price:  For example, when price reaches a new high, this sign is considered bullish, but if the momentum oscillator being used does not also reach a new high at the same time, the result is divergence  Divergence is considered to be an early warning of weakness Oscillators alert a trader to overbought or oversold conditions  In oversold conditions, market sentiment is considered unsustainably bearish Oscillators can be used to determine the strength of a trend When oscillators reach historically high or low levels, they may be signaling a pending trend reversal. - 67 - Technical Indicators Momentum Oscillators: Rate of Change Oscillator (ROC) Rate of Change Oscillator (ROC) Based on Microsoft - 68 - Technical Indicators Momentum Oscillators: Rate of Change Oscillator (ROC) Rate of Change Oscillator (ROC) Based on Microsoft When investors bid up the price of a security too rapidly, the indication is that sentiment may be unduly bullish and the market may be overbought. A good strategy would be to take profits as the ROC approaches the 110 level and initiate new long positions as it falls back to the 100 level. (trendless period (consolidation): oscillator moves in a wide range between 80 and 110). - 69 - Technical Indicators Momentum Oscillators: Relative Strength Index (RSI) Rate of Change Oscillator (ROC) Based on Microsoft - 70 - Technical Indicators Momentum Oscillators: Relative Strength Index (RSI) Rate of Change Oscillator (ROC) Based on Microsoft Just because we have seen the first positive divergence (RSI lows labeled 1 and 2) doesn’t mean that a trend reversal is taking place. We need to see confirmation of the change in trend in the form of a breach of a trendline or a long-term average - 71 - Technical Indicators: Momentum Oscillators: Moving- Average Convergence/Divergence Oscillator (MACD) The MACD is the difference between short-term and long-term moving averages of the security’s price (generally over periods of 12 and 26 days). The signal line is the exponentially smoothed average of the MACD line, generally over 9 days. Analysts look for times when the MACD is outside its normal range for a given security - 72 - Technical Indicators Sentiment Indicators Sentiment indicators attempt to gauge investor activity for signs of increasing bullishness or bearishness. Statistical Indexes: put/call ratio: The volume of call options traded is greater than the volume of put options over time, so the put/call ratio is normally below 1.0 Volatility Index: CBOE Volatility Index (VIX) is a measure of near-term market volatility calculated by the Chicago Board Options Exchange. Margin debt is also often used as an intermediate- to long-term indication of sentiment. Investor Polls - 73 - Technical Indicators Sentiment Indicators a) b) a) The VIX rises when market participants become fearful of an impending market decline b) When the market is rising and indexes reach new highs, investors are motivated to buy more equities in the hope of participating in the market rally. A margin account permits an investor to borrow part of the investment cost from the brokerage firm. - 74 - Technical Analysis and Hedging Strategies Introduction to Hedging Strategies - 75 - Technical Analysis & Hedging Strategies Main Hedging Strategies Forward Hedge - Hedging using the Bond’s Currency and the Home Currency Proxy Hedge - Hedging using a currency that is highly correlated with the Bond’s Currency and the Home Currency. Cross Hedge - Hedging using the two different currencies (one usually being the Bond’s Currency) not highly correlated with the Home Currency. This is used in the case were the PM believes the different currency will depreciate less than the Bond’s Currency and usually represents less volatility. Mean-Variance Hedge is a Cross Hedge aimed at minimizing volatility in returns. All MVHs are Cross Hedges but not all Cross Hedges are MVHs. - 76 - Technical Analysis & Hedging Strategies Example: Hedging with Futures (see Chapter 3) To hedge a long position in an equity index, one needs to short positions in an appropriate index future (i. e. to short a certain amount on future contracts). Example for the calculation of the required amount of future contracts: We assume: The current index level: 3.285 Portfolio value: 9 Mio EUR Beta of the portfolio according to the index: 1 What are the Contract multiplier: 10 EUR per index point relevant markets Number of required contract for a perfect hedge: and risks to −1 9.000.000 10 3.285 = −273.94 ≈ −274 hedge? The “-” indicates one has to short the contracts. - 77 - Technical Analysis & Hedging Strategies Intermarket Analysis Intermarket analysis is a field within technical analysis that combines analyses of major categories of securities—namely, equities, bonds, currencies, and commodities—to identify market trends and possible inflections in a trend. Intermarket analysis also looks at industry subsectors and their relationship to sectors and industries. It measures the relative performance of major equity benchmarks around the globe In intermarket analysis, technicians often look for inflection points in one market as a sign or clue to start looking for a change in trend in a related market. To identify these intermarket relationships, a commonly used tool is relative strength analysis, which charts the price of one security divided by the price of another or the ratio of the values of two assets. - 78 - Technical Analysis & Hedging Strategies Intermarket Analysis Relative Strength of 10-Year T-Bonds vs. S&P 500, Palladium vs. Commodity Prices, 2009–2019 1999–2018 - 79 - Technical Analysis & Hedging Strategies Portfolio Management RSI chart for the Emerging Markets Index vs. the All Country World Index (1997–2019) Analysts, traders, or investors whose focus is global equity markets often start their top-down approach by analyzing global benchmarks, such as MSCI and FTSE. The relative performance of major indexes will reveal important investment themes for investors with a long-term focus The aim is to identify consolidation periods and then participate in major trends - 80 - Technical Analysis & Hedging Strategies Portfolio Management RSI chart for the Emerging Markets Index vs. the All Country World Index (1997–2019) Analysts, traders, or investors whose focus is global equity markets often start their top-down approach by analyzing global benchmarks, such as MSCI and FTSE. The relative performance of major indexes will reveal important investment themes for investors with a long-term focus The aim is to identify consolidation periods and then participate in major trends - 81 - Technical Analysis & Hedging Strategies Portfolio Management S&P 500 Index vs. GSCI (Equities vs. Commodities) 2007–2019 Goldman Sachs Commodities Index = GSCI Following the initial trend change in the last quarter of 2008, equities outperformed commodities until 2010. The ratio moved sideways between 2010 and 2012. In the first half of 2012, the S&P 500 to GSCI ratio cleared the horizontal resistance, suggesting a new phase of outperformance. - 82 - Technical Analysis & Hedging Strategies Trading Rules: The breakout should take place above the 200-day exponential moving average (long-only strategy).  It is important to identify stocks that are already in a steady uptrend or are entering into an uptrend.  Breakouts from consolidation periods in or preceding an uptrend are usually followed by a continuation of the existing trend.  Investing in the overall direction of the trend is the path of least resistance. - 83 - Technical Analysis & Hedging Strategies Trading Rules: Price should be in a low-volatility condition prior to the breakout.  Low-volatility conditions are usually followed by high volatility, and vice versa.  Stocks that break out from low-volatility conditions are likely to experience high volatility, and high volatility in the direction of the existing trend will usually help the trend to pick up momentum. The breakout should take place from a well-defined classical chart pattern between 3 and 24 months in duration.  The longer the consolidation, the stronger the breakout and the subsequent trend period will be. - 84 - Technical Analysis & Hedging Strategies Trading Rules: Breakout confirmation should be a weekly close above the chart pattern boundary  In an attempt to avoid premature breakout decisions, we will wait for a decisive weekly close above the chart pattern boundary. - 85 - Technical Analysis & Hedging Strategies Trading Rules: Example Silver (per Ounce) Price, April 2014–August 2016 (US$) Silver prices formed an inverse head and shoulders chart pattern from the second half of 2015 to the first quarter of 2016. A breakout from the inverse head and shoulders chart pattern took place in April 2016, when price cleared the horizontal resistance at the 16 level. Following the breakout, price pulled back to the chart pattern boundary and resumed the uptrend. - 86 - Technical Analysis & Hedging Strategies How to use in Portfolio Management Can serve a supporting role in investment descisions. Can conduct research and find investment opportunities by applying different strategies. Analyses opportunity set and provides trade and investment ideas for Portfolio Management. The key value-added input would be in the form of timing of the purchase or sale of that security. It provides the rationale as well as potential price targets for the expected move and the price level at which the analysis would be invalidated. A portfolio manager should well and carefully use technical analysis in weighting decisions. - 87 -