Technical Analysis

There are two basic types of stock market analysis. These are fundamental analysis and technical analysis. Fundamental analysis uses corporate earnings, assets, liabilities, cash flow, etc. as a basis for projecting future performance of a security. Technical analysis uses price movements as its primary basis for performance predictions. Technical analysis is based on the theory that the fundamental analysis of individual securities is already built into its price movements and can, therefore, be virtually ignored.

Stock Charts

MI’s three basic stock charting options are accessed by Clicking the Charts button on the Reports & Charts page. The three basic stock charts are described in the following paragraphs. A variety of technical indicators may be overlaid on each of the three basic charts. These are accessed by clicking on command buttons at the bottom of the chart display.

The Single Issue option plots price and volume movements of a selected security or market index. Try this chart by Selecting Stock Charts/Single Issue. Once a chart has been displayed, you may click the New button at the bottom left of the chart to select another security to be displayed. Other buttons display technical indicators that are described below.

The Relative Performance option plots a comparative analysis of the price movements of one security against another security or a market index. Prices of the two selected securities are plotted using the same relative scale. The price bars and axis labels are color coded to the security names. Try this chart by Selecting Stock Charts/Relative Performance. Be sure to select 2 different stocks from the menu.

The Correlation chart performs a least squares linear regression analysis on the price movements of one security versus those of another security or index. Correlation is the statistical means of determining whether the prices of one security move in direct relation to the prices of a market index or another security. After entering the year ending date, select the two securities to be used in the correlation analysis.

Correlation analysis operates by plotting a scatter-gram of the closing prices of the first security (measured on the y-axis) against the corresponding closing prices of the other security or index (measured on the x-axis). Once the points have been plotted, the straight line that best fits the points is computed and plotted. The line is computed using a least squares linear regression. The program displays the formula for the plotted line, the standard deviation (the standard error between plotted prices and the line), and the correlation coefficient.

Correlation coefficients range from zero to plus or minus one and provide an indication of how good the price relationship is between the two securities. Values near plus or minus one indicate that there is a strong relationship between the price movements of the two securities. Values closer to zero (-0.75 to +0.75) indicate poor correlation. If the coefficient is negative, it means that an inverse price relationship exists (a price increase in one produces a corresponding price decrease in the other).

After plotting the scatter-gram, a price chart of the first selected security is plotted. The solid green band denotes the predicted prices for the security within plus or minus one standard deviation.

The Correlation chart is most useful when there is a high degree of interdependence between two securities (i.e., correlation coefficient is greater than 0.9 or less than -0.9). Under these circumstances, a sudden deviation of the price outside the solid area may indicate a change of market sentiment towards the stock. Such changes in sentiment are often the result of an unexpected change in earnings, a buy or sell recommendation from a major broker, takeover rumors, etc. Rather than a signal to buy or sell, it is a signal to research any recent news on the company.

Technical Indicators

Technical indicators may be overlaid on any of the three basic stock charts by clicking the button that corresponds to the indicator to be plotted. These indicators and their interpretation are described in the following paragraphs.

The MA button plots a simple moving average. Click the MA button and enter a moving average period in the displayed dialog then click OK. The period entered is the number of data points over which the average is computed. Simple moving averages are commonly interpreted to give a Buy signal when the price is above the moving average line and a Sell signal when the price is below the moving average line. While this method is useful in a trending market, it yields poor results (frequent buy and sell signals) in a horizontal market.

The Exp MA button plots an exponential moving average. Click the Exp MA button and enter a moving average factor in the displayed dialog then click OK. The moving average factor is the weight applied to each new point when it is added to the previous value. That is, a factor of 10 means that each new point is given a weight of one tenth of the previous average when computing the new average. The formula for this is:

EI = EI-1 + (PriceI-EI-1)/Factor

Exponential moving average lines are interpreted in the same manor as simple moving average lines.

The Fit button uses a best fit algorithm to fit a polynomial curve to the closing prices. Click the Fit button and enter a polynomial order from 1 to 9 then click the OK button. The polynomial order refers to the number of elements in the polynomial equation used to determine the best fit line. A polynomial order of 1 is a straight line. Curvature and complexity of the line increases as the polynomial order is increased. The formulation of a fourth order polynomial is:

Y = A + BX + CX2 + DX3 + EX4

The best fit line can generally be regarded as a price trend. A buy is thought to be signaled when the line is moving up and prices are below the line. Conversely, a sell is signaled when the line is trending downward and prices are above the line.

The OBV button plots On-Balance Volume. On-Balance Volume is a technical indicator that shows the strength of price movements by incorporating volume information. When the stock closes higher than the previous period’s close, the volume is added. Conversely, when the stock closes lower, the volume is subtracted. The cumulative value is plotted as a single line that is overlaid on the price chart. Click the OBV button to display the On-Balance Volume line.

The main advantage of this indicator is in determining the level of market support for a price advance or decline. For example: if the price of an issue is increasing over a period and the on-balance volume is relatively flat over the same period, it indicates that the price advance has poor support and may not be sustained.

The MACD button plots the indicator known as Moving Average Convergence Divergence. MACD is computed as the rate at which two exponential moving average lines move relative to one another. Click the MACD button and enter exponential moving average weights for the fast and slow line. Hint: The fast weight must be less than the slow weight.

MACD is plotted on the bottom chart having a simple plus, zero, minus scale shown on the right of the chart To help you understand MACD, you may also want to plot the Exponential Moving Average lines that correspond to the weights of your fast and slow MACD lines. Comparing the MACD plot to the corresponding Exponential Moving Averages, you will see that MACD is positive when the slope of the fast moving average is greater than the slope of the slow moving average. MACD is zero when the two moving average lines are exactly parallel.

MACD is interpreted as giving a buy signal when it crosses the zero line moving from negative to positive. A sell signal is given when the MACD falls from positive to negative.

The RSI button plots Wilder’s Relative Strength Index. Click the RSI button and enter the RSI period. The RSI period is the number of points (i.e., days or weeks) over which each RSI value is computed. The formulation is:

RSI = 100 – 100/(1+U/D)

Where U is the average of the days closing higher during the period and D is the average of the days closing lower over the period. A 14 day interval is the default period on 6 month charts.

RSI is generally interpreted as showing an overbought condition (sell signal) when the value is above the 70% line. An oversold condition (buy signal) exists when the value is below the 30% level.

The %KD button plots the Stochastic Oscillator (%K) and the Smoothed Stochastic Oscillator (%D). The stochastic oscillator is formulated as:

%K = 100 * (Closing Price – Lowest Low)/(Highest High – Lowest Low)

where the highest high and lowest low are determined over the period you enter. The smoothed stochastic oscillator (%D) is the exponential moving average of %K. The factor used in the moving average is the number of %K periods.

Click the %KD button to plot the stochastic oscillator. The stochastic oscillator (%K) is plotted in cyan and the smoothed oscillator is plotted in blue. The generally accepted interpretation of %KD states that an overbought condition exists when the %K crosses %D and both are above 70% and pointing downward. Conversely, an oversold condition exists (buy signal) when %K crosses %D and both are trending up but below 30%.

A simpler interpretation of %KD, and one that we prefer, is to buy when %K is higher then %D and sell when %K is lower than %D.

The Clear button clears any previously plotted oscillators or volume data from the lower chart and displays a clean grid for plotting MACD, RSI and %KD. The Vol button re- plots the volume bar chart.