TOC
1. Technical Analysis
Technical analysis studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future.
Assumptions:
- Price moves in trends
- Market participants tend to provide a consistent reaction to similar market stimuli over time
1.1 Dow Theory
The goal was to identify the primary trend and catch the big moves.
The market has three movements
- Primary trend: last less than 1 year to several years
- Secondary or intermediate trends: last from 10 days to 3 months
- Minor trends: last from hours to a month
The trend is confirmed by volume: When prices move on low volumes, there could be many different explanations.
Three Phases:
- Accumulation phase:
- Investors “in the know” are actively buying (sell) stock against the general opinion
- Prices does not change much
- Public participation phase:
- Market catches on to these astute investors
- A rapid price change occurs
- Speculation phase:
- The astute investors begin to distribute their holdings to the market
- Price does not change much
1.2 Elliott Wave Theory
All developments result from human socio-economic processes: Collective investor psychology moves from optimism to pessimism and back
Every action is followed by a reaction: price movement up or down must be followed by a contrary movement
Trends show the main direction of prices while corrections move against the trend: Creating specific Elliott wave patterns
Elliott wave theory:
- Five waves move in the direction of the main trend, followed by three waves in a correction (totaling a 5-3 move)
- This 5-3 move then becomes two subdivisions of the next higher wave move
- The underlying 5-3 pattern remains constant, though the time span of each wave may vary
2. Theoretical Foundation
2.1 Irrationality
Classical Theory
Campbell (2000): “Asset pricing is concerned with the sources of risk and the economic forces that determine the rewards for bearing risk.”
Cocharnce (2000): “The central task of financial economics is to figure out what are the real risks that drive asset prices and expected returns.”
Hirshleifer (2001): “The central task of asset pricing is to examine how expected returns are related to risk and to investor misvaluation.”
Irrationality
- Irrational traders cause deviations from fundamental value (FV)
- Hormone.
2.2 Limits to Arbitrage
Limits to arbitrage
- The actions of the arbitrageurs are limited
- Strategies designed to correct the mispricing can be both risky and costly
- “No free lunch” can also be true in a inefficient market
Considerations of Arbitrager:
- Arbitragers may prefer to trade in the same direction as the noise traders, thereby exacerbating the mispricing, rather than against them
- Firm managers can issue new stocks to eliminate the opportunity: transaction cost, risk of misprice
Risk and Costs
- Fundamental risk
- Substitute securities are rarely perfect
- Noise trader risk
- Mispricing being exploited by arbitrageur worsens in the short run
- Separation of brains and capital: force arbitrageurs to liquidate theiry positions early
- Implementation costs
Example: Index Inclusion
Strategy: Short the included security and to buy a substitute security
Cost and Risk:
- Fundamental risk: no such substitute security
- Noise trader risk: shoted stock may go up
- Implementation cost: No (long and short are free)
Example: Internet Carve-outs
In march 2000, in an IPO, 3 com sold 5% of its wholly owned subsidiary palm INC, retaining ownership of the remaining 95%. In 9 months, spin off the remainder of palm, give each shareholder 1.5 shares of Palm. The shareholder of 3com indirectly owned 1.5 shares of Palm.
Thus, NA: price(3 com) = 1.5*price(Palm)
Actually, price(3 com) = 81; price(Palm) = 95
Arbitrage strategy: buy one share of 3com and short 1.5 share of Palm
Cost and Risk:
- Fundamental risk: no
- Noise trader risk: no
- Implementation cost: yes ⇒ no enough stocks to trade
3. Psychological Biases
3.1 Overconfidence
Example: 82% of the sampled college students thought they were above average.
Consequence: high risk portfolio ⇒ reason: higher risk stocks and under-diversify
Source 1: Illusion of the knowledge:
- No-use information
- Example: Roll a fair six-sides die
Source 2: Illusion of control:
- Making an active choice induces control
- Example: choosing lottery number
3.2 Fear of Regret
Regret: The emotional reaction people experience after realizing they’ve made an error in judgement
Example: You have been holding the same stock for months, a friend suggests a new stock
Example 1: Disposition Effect
Investors are affected by the price at which they purchased the stock:
- Selling winner stock: validates your good decision, enjoy price
- Selling loser stock: realize your decision was bad, pain of regret
Investors to be predisposed to selling winners too early and riding losers too long (Schlarbaum et.al. JB, 1984)
Example 2: Allais Paradox
Investor violate the independent axiom,
Compare A1 and A2:
- A1: 10% prob 1M + nothing
- A2: 90% prob 1.5M + nothing
- A1 < A2
Compare B1 and B2
- B1: 100% prob 1M
- B2: 90% prob 1.5 M + nothing
- B1 > B2
By the structure of compound lotteries,
- A1 = 0.1 prob of B1 + nothing
- A2 = 0.1 prob of B2 + nothing
So if A1<A2, then B1<B2, a paradox
Explanation: The notion of regret, the expected regret is high because of the nontrivial probability 0.1 in B2.
Phenomena
Framing
Framing: individuals’ choices are substantially influenced by the context in which they are presented.
In the negative framework, participants were more interested in risky program.
Mental Accounting
Investor place each investment into a separate mental account
Matching costs to benefits
Sunk-cost effect
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