How the CFA L1 Tests Technical Analysis
This is an outline and introductory post that serves as an anchor for a mini-series of five posts covering technical analysis (a lengthy reading at the end of Quantitative Methods in the CFA curriculum).
How does the CFA L1 Exam test Technical Analysis?
The lion share of the technical analysis material introduced is conceptual. Most of the LOS command words ask you to “explain” and “describe” the methods and underlying assumptions behind technical analysis.
In terms of directly testable material, for the CFA L1 exam you should know what technical analysis is, the key assumptions it operates on, how it differs from fundamental analysis and then how to read the different types of charts and interpret the underlying market patterns they show, be able to talk about the key technical indicators, and calculate the size of a move based on the pattern.
What is Technical Analysis?
Technical analysis is a method of analyzing securities that uses past information, particularly price and volume, to forecast future prices. Proponents of technical analysis believe that the chart of a securities price over time conveys a real-time snapshot of supply and demand and hence encapsulates the necessary information to predict future prices. Put differently, since price and volume are the representation of the collective action of buyers and sellers it tells you everything you need to know about the market.
Thus technical analysis does not believe that the efficient market hypothesis holds.
Fundamental analysis on the other hand attempts to determine an asset’s intrinsic value, often by discounting its future cash flows (remember NPV?) using information from a firm’s financial statements. Thus technical analysis can be more flexible with respect to assets that do not pay a dividend.
Key Assumptions of Technical Analysis
- Market trends reflect rational and irrational human behavior
- Historical market patterns tend to repeat over time (and can thus be predicted)
- Securities are traded in a free market with perfect information where market prices adjust in a timely manner to reflect that information
- Price and volume are a reflection of supply and demand between buyers and sellers
- Investors tend to follow the market trend
Limitations of Technical Analysis
On the downside:
- It is of limited use in markets with outside intervention (e.g. central bank’s interfering in currency markets)
- It ignores other potentially valuable methods
- It can also suffer if market behavior changes suddenly.
Comparing Technical Analysis vs. Fundamental Analysis
For the L1 exam be prepared for a compare/contrast style question between the two. Pay specific attention to the different assumptions underlying technical and fundamental analysis.
We also dive into this subject in this post comparing the two.
Tools for Technical Analysis
Technical analysis uses two primary tools—charts and technical indicators.
Generally a technical chart will have time on the horizontal axis and price on the Y-axis. They will either be on a linear scale or logarithmic (% change). There are four main types of charts:
- Line charts
- Bar Charts
- Candlestick charts
- Point-and-figure charts
Be able to interpret whether the trend they are showing is bullish or bearish (and why). This generally depends on both price momentum as well as volume indicators. See more within our full post on technical charts.
Key Chart Components (What you Need to Know to Read a Chart)
At its core technical analysis is the interpretation of market trends. In fact, it does not work as well in a market with no discernable trend.
The simplest and most important trend in technical analysis is price. From a technical perspective a downtrend reflects an increase in selling pressure whereas an uptrend shows an increase in buying pressure.
Defining a trend.
- A market is trending up if we see successively higher high prices that retrace to higher lows.
- A market is trending down if we see successively lower low prices and retracement to lower highs
We can identify these trends using a trendline. A trendline in an up market is drawn by connecting the low prices of each period. In a downtrend the trendline is drawn connecting the decreasing high prices.
The longer a trend persists the more significant it is thought to be. Note that trends can appear differently depending on the time period on the X-axis.
A breakout occurs when the price goes above or beyond that trendline by a significant amount.
Breakouts are important because they reflect a push “through” the support or resistance level and can reflect a reversal of the previous trend.
- A support level is where we would expect an increase in buying demand to support a price
- A resistance level is where we would see increased selling to prevent further price increases.
Outside of trend lines, both support and resistance can appear at “psychologically important” prices like round numbers.
Polarity is the technical concept that once a support or resistance line has been breached it flips and the opposite trend becomes dominant. So, if prices fall below a support line, that support level is now a new resistance line and vice versa.
These patterns look like this:
Interpreting Chart Patterns
We’ve shown several key types of charts, but the art or science of technical analysis is in interpreting the patterns shown on the charts to try to predict future prices.
There are some cornerstone patterns that you should be familiar with which either (1) indicate a reversal of a trend or (2) confirm the continuation of that trend. Expect 1-2 questions on the CFA Level1 exam that ask about these patterns and be able to identify the size of an expected move off of a pattern.
Key Patterns include
- Reversal Patterns
- Head and Shoulders Pattern
- Double and Triple Top Patterns
- Continuation Patterns
For a full dive into each pattern see our post on chart patterns.
Key Technical Indicators
A technical indicator looks to predict the future price levels, or simply the general price direction, by examining a security’s supply and demand. We can divide these into four categories:
- Price-based indicators
- Momentum oscillators
- Sentiment indicators
- Flow-of-funds indicators
This post covers all four of these in exhaustive detail.
Elliot Wave Theory
The CFA curriculum material ends with a stand-alone explanation of a long-term technical explanation for market movements--the Elliot Wave Theory. For a full explanation see this post.
Summarizing Technical Analysis for CFA Level One
While everything is fair game, technical analysis constitutes a small part of the CFA Level 1 Curriculum. Most of this material is qualitative. The LOS command words will ask you "explain" and "describe" charts, patterns, or the assumptions behind the practice of technical analysis. So know how to read charts, know the key technical indicators and what they might suggest, and then move on to the next set of material.
Our mini-series on this material consists of:
- This post (defining technical analysis and outlining its key testable material)
- Comparing fundamental analysis vs. technical analysis
- The 4 major charts of technical analysis
- Interpreting chart patterns
- A summary of all the key technical indicators
- A post on the Elliot Wave Theory