Behavioral finance and

technical analysis

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Behavioral Finance
Limit of arbitrage
Psychology

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Investors do not always process information correctly

Investors often make Inconsistent or systematically
suboptimal decisions

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Limit of Arbitrage vs Market Efficiency

EMH

Prices reflect value

Mispricing will be corrected by arbitrageurs

Limit of Arbitrage

Strategies may not be arbitrage

Problems entering positions?

Correct => no free lunch

No free lunch =>correct prices

Implementing costs

Commission
Bid-ask spread
Price impact
Short sale costs

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Fees
Volume constraints
Legal constraints

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Evidence Supporting Limits to

Arbitrage
Index inclusions
Twin shares

Stock price jumps permanently

Royal Dutch (60%) and Shell (40%)

3.5% average
Only risk is noise traders

Explanation?
We should have P(RD)=1.5*P(S)

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Evidence Supporting Limits to

Arbitrage ...
Internet carve-outs

3COm sells 5% of Palm in IPO, and will spin off the

remainder in 9 months
1 share of 3Com will own 1.5 shares of Palm

3Com should be at least $142

But P(3Com)=$81

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P(Palm) =$95

Which implies 3Com excluding Palm = -$60.

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Evidence Supporting Limits to Arbitrage ...

Why?

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Very few shares of Palm available to short

Arbitrage was limited
Mispricing persisted
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Psychology
Herding
Beliefs

Overconfidence &Optimism/Wishful thinking

Unrealistic view of personal abilities/prospects

Eg. 90% of drivers claim above average driving skill
99% of freshman claim superior intelligence

Representativeness

Law of small numbers

Belief perseverance

Search for contradictory evidence

Treatment of contradictory evidence

Anchoring

Initial arbitrary value and make adjustments

Availability biases

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Gamblers fallacy

Recent or salient events

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Excessive Trading
Barber/Odean (JF, 2000) have a huge database from 1991 to 1996 of individual
trading

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Average returns of individuals is below all sorts of benchmarks such as: portfolio they
had in the beginning of the year, market portfolio, CAPM benchmark, 3 factor model
benchmark.
This in net returns (!) after transaction costs. No strong underperformance in gross
returns.
The more you trade the worse you do (gross is higher than S&P500 the net is lower).

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Excessive Trading
Annual portfolio turnover

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Pride and Regret

People avoid actions that create regret and seek
actions that cause pride
Disposition effect

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this cause investors to be predisposed to selling winners

too early and riding losers too long

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Considering the Past

House money effect

Risk aversion and (or snake-bite) effect
Trying to break even effect

Endowment effect

Coval and Shumway studied the activities of proprietary traders at CBOT in 1998 (426 traders), and found that
they are more likely to increase their level of risk in the afternoon when they suffer losses in the morning.

Status quo

Memory and decision

Give more weight to recent memory

Example:

Investor buys a share in biotechnology and a share in pharmaceutical, both worth $100. Throughout the
following year, bio stock slowly declines to $75, while the pharmaceutical stock stays at 100 and drops to
$80 at the end of the year
Similarly, 100 -> 125 gradually vs 100 -> 120 at the end

Cognitive dissonance

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Investors seek to reduce psychological pain by adjusting their beliefs about the success of past investment choices
People want to believe that their investment decisions are good. In the face evidence of the contrary, the brains
defense mechanisms filter the contradictory information and alter the recollection of the decision.
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Technical Analysis
An attempt to exploit recurring and predictable patterns in stock prices
Technicians beliefs:

Shifts in market fundamentals can be discerned before their impact is fully

reflected in prices
Market fundamentals can be perturbed by irrational factors

These presumptions are in contradiction with the weak form of the

EMH
Basic terms:

Volatility

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Fluctuations

52-week high / low

Price / trading range
Open / closing price

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The Dow Theory

Originated by Charles Dow

Dow Theory presumes market moves in persistent bull and bear trends

Founder of the Dow Jones Company and editor of Wall Street Journal
Often used for market as a whole, but used for individual securities also

Types of movements defined by Dow theorists

Primary trends (bull or bear market)

Secondary trends (corrections)
Market collapses or upward surges lasting a few weeks or months
Tertiary moves (little daily fluctuations)
Meaningless random wiggles but should be studied to determine if relate to a primary trend

Most Dow theorists do not think a

new primary trend has been
confirmed until pattern of ascending
or descending tops occur in both
industrial and transportation
averages.

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Head and Shoulders Formation

A series of reversals

Supposed to signal that a securitys price has reached a ceiling and

is expected to decline in the future

Left shoulderheavy
buying increases price
to a peak before lull in
trading pushes price
downward.

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Confirmation
(breakout)the
price falls
below the
neckline which
is a sell signal.

Heada spurt of
buying activity
increases price to new
high. Then a lull in
trading decreases
prices to below top of
left shoulder.

Right shouldera
moderate rally
increases price but not
to a new level equal to
the top of the head.

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Charts
Maps price performance
Sheds light on supply and
demand
investment roadmap
Price / volume
relationship important

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Chart Types
Line Charts

Most basic of all charts

Just a line that connects the closing prices
over a time frame
No trading range

Bar Chart

Vertical line represents highs/lows of the

day
Horizontal line represents closing price
Red = down
Blue/Black = up

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Chart Types
Candlestick Charts

Vertical line represents the trading

range
Wide bar represents open and close
White bar Up and closes above
opening price
Red Bar down
Black bar up, but closes below the
opening price

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Chart Basics Time Scale

Time Scale

Dates along bottom of chart (varies from seconds to decades)

Common Types: intraday, daily, weekly, monthly
Subtle differences between different time scales

Daily Chart
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Weekly Chart
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Volume
Amount of shares that trade
hands between seller and
buyers
Price movements more
significant when volume is
above average
Price and Volume

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Trends are your Friends

Trend: general direction of stock
Uptrend: higher highs, higher lows

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Sometimes, trends difficult to see

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Trendlines
Simply put, a line drawn on a
chart to represent the overall
trend

Upward trendline, connecting the

lows, represents support

Two parallel trend lines that act as areas of

support and resistance (more later)

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Any break through the channel is a break of

the trend, otherwise the price should stay in
range

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Support and Resistance Levels

Support level

Price at which Buyers > Sellers

Floor (trough) below which stock price is not expected to drop

Resistance level

Price at which Buyers < Sellers

Ceiling (peak) above which stock price is not expected to go

Demand of security is expected to increase

Supply of security is expected to increase

Congestion Areas

Price fluctuates

Price rises through $50 resistance level

old resistance level becomes new
support level.

Price fluctuates in first

congestion area for a while.

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AMZN Example of Supports

AMZN retraces from a

monstrous rally to $60

AMZN stops tanking at

$60. NOT A
COINCIDENCE.

$510. I should have bought GOOG

GOOG Support Psychology

$$$$$!!

GOOG skyrockets from

AWESOME earnings, but
should I buy it????

OK. Im not gonna

miss out again.
BUY @ $452
CAUTION: Supports
can breakdown.

TM Resistance Psychology

Finally! $138. I better

sell this time.

Should I sell?? Na, Ill

take my chances.

I should have sold

when TM was $138!!

TGT Resistance Breakout

BREAKOUT!

RESISTANCE BECOMES
SUPPORT

Moving Average Analysis

Moving averages are used to provide a smooth reference
point for

Individual securities
Market indices
Commodity prices
Interest rates
Foreign exchange rates

Common choices: 50, 100, 150, 200-day moving average

Changes each day

Most recent day is added and oldest day is dropped

Following calculation is performed
50 DMAt = (1/50)(Valuet + Valuet-1 + Valuet-49)

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Moving Average Analysis

Moving average analysts recommend buying/selling stock if
stock price and its moving average cross path

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Moving Averages (DMA or WMA)

Most popular are 50-day and 200-day
Shows the average price of the last # days and plots it on a line
Often acts as areas of support and/or resistance

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WIRE Support @ 10 WMA

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CPA Support at 20 & 50 DMA

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CPA Support at 20 & 50 DMA

20 DMA and 50 DMA becomes points of

support for this stock
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So
Charts are fundamental to technical analysis
Important to understand what is shown on a chart
and the information it conveys
Other technical analysis methods

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Elliot wave
Bollinger band
And many more

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Technical Indicators
Sentiment indicators

Odd-Lot trading
Confidence Index
Put/Call ratio
Mutual fund cash position

Flow of funds indicators

Short interest total number of shares of stock currently sold short in the market
Some technicians interpret high levels of short interest as bullish, some as bearish
Credit balances in brokerage accounts

Market structure indicators

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Moving averages
Breadth

The most common measure the spread between the number of stocks that advance
and decline in price

Relative strength

The ratio of the price of the security to a price index for the industry
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Folklore
Examples

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Buy on good news, sell on bad

Buy on rumor, sell on news
Buy a stock just after a split to earn abnormal returns
Firms wholes earning decreased relative to the market
price fell in years preceding
Low priced stocks, low P/E stocks outperform high
prices, high P/E stocks

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