Data Analysis for Decision Making

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A useful tool in the hands of investors will be one that identifies share price movements. The tool should also help to make a good guess of the coming prices in the future. We know that technical analysis has developed rules based on simple statistical analysis of price data and price patterns. An investor can make decisions based on relevant data price analysis. A handy set of tools are provided below.

Arithmetic Moving Averages

Under this method of data analysis, a for a time period of ‘n days’ share prices is used as a sample. The moving averages are frequently plotted with prices to make buy and sell decisions. The Arithmetic Moving Average is nothing but the simple average of the last ‘n’ period prices.

Here ‘n’ = number of days starting from a given chosen point of time of a sample period. The number of days chosen as a sample can be linked with the investors holding period. For example, an investor with a long holding period may use a 250 day moving average curve. An investor with a short holding period may use a 25 day moving average curve.

The process is like this. Let us say that we are configuring an Arithmetic Average on the 2nd day from a given chosen point of time:

·         AMA = (Price on day 2 + price on day 1) / 2

Let us say that we are configuring an Arithmetic Average on the 3rd day from a given chosen point of time:

·         AMA = (price on day 3 + price on day 2 + price on day 1) / 3

With the AMA approach, the price curve and the moving average curve have to be used together to draw the most likely prices of the future based on the price trend. It depends on whether the price curve cuts the moving average curve from above or below.

·         If the price curve cuts the moving average curve from below, then it is a buy signal as prices are expected to go up.

·         If the price cuts the moving average curve from above, then is a signal to sell the stock.

·         An investor can use a ‘filter’ to allow for a certain percentage of price movements above or below the moving average price line. For example, an investor may allow a further 15% ‘filter’ once the price curve cuts the moving average curve either from above or below.

Rate of Change

This measures the acceleration and deceleration of share prices. These charts are used in conjunction with the price charts, when an investors needs to draw inferences. It is important to know that any change in the trend of the prices would immediately show on the chart because it could signify acceleration or a deceleration of prices. This can also be interpreted as a change in trend of the share prices for a specific period of time. These charts are available in abundance nowadays as many software programs provide the information.

Filter Rules

These represent mechanized trading rule provided by today’s computerized trading systems. For this rule to apply, a certain percentage is used, say ‘z’ percent. Whenever the price rises above ‘z’ percent from the most recent peak, an uptrend is indicated and vice versa.

It is not to say that these are golden rules that apply to every situation. A single rule may work at one time but may fail miserably in the next time span. In fact, there is no one that can predict with certainty about stock market prices. Market knowledge and sentiments always seem to play a major role in the demand and hence the price of the stocks. It would be wise for an investor to invest his time into using various methods of security analysis together before he decides to buy or sell a share.

 

 

 

Support and Resistance Levels

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Almost every investor will be familiar with the terms support and resistance levels. It is important to know how these levels come about and what is their exact implication and impact. We all know that a curve has its ups and downs like a roller coaster.  

A resistance level is said to be obtained whenever the index price goes down from a peak. The peak becomes the resistance level. Whenever the price approaches the resistance level, there is a selling pressure. This is because of the effect that the peak level has – the investors who failed to sell at a high level would be keen to sell or liquidate their shares.

A support level is said to be reached whenever the price or index rebounds after reaching a trough. At the support level there is a buying pressure. This occurs because those investors who failed to buy at the lowest price would like to purchase the shares before the price increases further.

A breach of these levels would indicate a distinct departure from the ongoing trends. This situation would indicate an attempt to set newer levels. An investor will therefore need to keep track of the support and resistance levels of the share and in addition the investor will need to watch out for factors that cause a shift in these levels due to the changing market sentiment.
 

The illustration illustrates the prices of Share ‘X’ during December 20xx. From the reading on the chart it can be seen that the support level hovers at around $90 $95. The resistance level hovers at around $130 - $135. An investor can do well once the concepts and interpretation of the levels of support and resistance have been made. This study allows an investor to infer the movement of the price of the share before its actual occurrence.

Monetary Policy of the Central Bank of a Country

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The primary function of a Central Bank of a country is to formulate Monetary Policies for a country. The Central Bank also has the responsibility of administering the monetary policy. Monetary policies are made to affect and regulate the level of aggregate demand of a country. The objectives of Monetary Policies are to regulate the growth of the country and to achieve stability of price levels. For this purpose, the Central Bank uses certain instruments.

Money supply will have its effects on output and prices. A situation of excess money supply would imply that there is more money in the economy without simultaneous production of goods and services. This will lead to an inflationary situation. A deficit of money supply will mean that the demand for goods and services will reduce. This will in turn curtail the production of goods and services.

The main instrument of monetary policy of the Central Bank is the control and regulation of money supply within the economy. The traditional measures of the Central Bank are Quantitative Credit Control Measures. The instruments include open market operations (sale and purchase of Government Bonds, treasury bills, securities and so on), changes in Bank Rate (discount rate at which the Central Bank discounts the Commercial Bank’s bill of exchange) and changes in statutory reserve ratios (proportion of a Commercial banks time and demand deposits which they are required to deposit in the Central Bank). All these measures directly and indirectly influence the credit creation capacity of commercial banks. In this manner, the Central Bank of a country seeks to influence the level of money stock within an economy.

The Central Bank can also use selective credit control measures to regulate the flow of funds within an economy. These methods of moral persuasion are meant to control the flow of credit to particular sectors only, while at the same time maintaining the total amount of credit available within an economy. Selective control measures are meant to change the composition of credit from an undesirable to a desirable pattern. Typical examples of selective control measures include loans at lower rates available to defense sector to build the defense capacity of a country and the entrepreneurs to build the rural infrastructure.

Pricing Patterns of Securities

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There is always a need for an investor to lookout for a standard pattern which can provide a clue about how the market or security is likely to behave in the near future. With the proper tools in hand, an investor can be empowered to make profitable decisions. There are many price charting patterns that can be made. What is needed is to use the price patterns and make useful interpretations. Some useful price patterns are Channel, Wedge, Head and Shoulders pattern and the gap pattern.

CHANNEL:  A channel is formed by a series of uniformly changing tops and bottoms. These are seen to be identical and constant over time. The important factor is the slope of the channel. A channel that slopes downwards signifies declining prices. A channel that slopes upward signifies rising prices over the course of time. A change in market sentiments is indicated whenever the price breaches the boundary channels.

 

WEDGE:  A successively reducing difference between the tops and bottoms will form a wedge. Therefore the tops and bottoms are seen to be changing in the same direction but at different rates. The slopes therefore take the form of a funnel. As usual, whenever there is a breach in the boundaries, there is an indication of changing market sentiments.

HEAD AND SHOULDERS: An important price pattern, the head and shoulders pattern is like a human form with a large head (hump) in the middle and shoulders at the sides have been formed by buying pressures. At the peak of each of the humps, there is a selling pressure that results in a subsequent decline in prices. An inverted head and shoulder pattern can be expected to be formed in a falling market.

In a head and shoulder price pattern, if and when the price goes below the neckline, then a further drop in the prices is expected. In an inverted head and shoulder pattern, if and when the price cuts the neckline after the second inverted shoulder has formed, it is indicative for of a rise in the price of the stock. There is no definite explanation for the movements for the prices once the neckline has been breached.

 

GAP: The gap gives the difference between the opening price of the trading day and the closing price of the earlier trading day. A wider gap indicates that there is a stronger signal for the continuation of the observed trends. In a rising market, a wider gap indicates the investor’s willingness to pay a higher price to buy the script. In a falling market, a wider gap indicates that there is an extreme selling pressure from the investors and prices may be expected to fall further.

An investor can make use of these handy tools in their research, to help in decision making for buying and selling stocks. Further study can be made by an interested reader by reading books and journals that are specialized in the topic of stock market pricing patterns.

 

Capital Asset Pricing Model

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Beta  of a security shows how the price of a security responds to market forces. The Capital Asset Pricing Model uses a beta to form a link between risk and return. CPAM provides a platform where investors are able to assess the effects of their investment in a security. The investors are able to calculate the impact that the investment has on the risk and return of their security portfolio.
CPAM reflects a positive mathematical relationship between risk and return of a security. The relationship is expresses in mathematical terms as given below:

The required return on investment = The returns, expected in a risk free investment (example: U.S treasury bills) +The securities beta risk * (The average return on all securities given by the stock indices - Risk free returns on risk free investment).

Therefore, the higher the beta of the security the higher will be the required return for a given security. Whenever a new security has been added into a portfolio, it impacts the overall performance of the investor's portfolio. Using the mathematical relationship given by the CAPM, the investor can ascertain whether the returns of the new security are matching up to the required returns for the security
 

The Dow Theory - A Technical Theory

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Made in the late nineteenth Century by Charles Dow, the Dow theory enunciates the principles of stock behavior.  Charles Dow was also the founder of the Dow Jones and Co. To understand the behavior of the market as a whole, Charles Dow constructed two indices which are now known as Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA).The main observations of Charles Dow are as follows;

a) Most stocks respond in the same direction as the market moves. When the market goes up, the stock also goes up. When the market comes down the stock also comes down.

b) Averages as reflected by the indices would show three kinds of trends; the primary, the secondary and the minor trends. Charles Dow's theory was mainly concerned with the primary trends.

c) The theory proposed that the primary uptrend would have three moves.

d) The first uptrend will be caused by the initial investment made by well read and knowledgeable investors.

e) The second uptrend will  be caused by good performance results of the company.

f) The third uptrend will be caused by the goodwill earned by the company due to the spread of the word of the good financial performance.

g) After the third stage has started ending, the well read investors who had invested initially will realize high returns as expected may not be able to be sustained and they may start selling the shares. This will result in the first downtrend.

h) When the non-sustainability becomes confirmed, the second move for selling would be initiated.

g) The final third move results from distress selling of the share.
 
h) This trend goes on until there is a confirmed reversal in the financials of the firm and earnings behavior of the share.

i) Optimism about earning starts a bullish trend and continues until when the averages cross the one acheived earlier.

j) An ensuing downtrend will again signal a bearish trend and both the averages drop below the previous low achieved.

k) After this secondary reaction, a basic uptrend can be expected.


 

Beta of a Security

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The responsiveness of the price of a security with the market forces is called as beta of a security. The more responsive the price of a security to the changes in the market, the higher is its beta. The beta for the market is the average return for a large sample of stocks, such as Nifty 50 and S&P 500 Stock index. The beta for the overall market is equal to 1.The beta for individual securities is calculated by relating the returns on a security with that of the market. Betas can be less than 1 or more than 1. Normally the beta for a security is positive and lies between the values of 1 to 1.5.

Beta Coefficients of selected stocks

COMPANY                                          BETA

Black & Decker                                       1.75

Disney                                                     1.30

IBM                                                        1.1

Merrill Lynch                                           1.5

Newmont Mining                                      0.5

Beta is useful to investors. Beta helps to measure the impact that market movements have on the expected return  from a share of stock.
Let us consider an example.

a) Let us assume that the market is expected to provide a 7% rate of return for the next year. A stock having a beta of 2 would be expected to increase in return of 14%  (7% * 2) during the same period.

b) If the market return is expected to be -7%, then a stock having a beta of 2% will experience a negative return of -14%  (-7% * 2). The stock experiences decreasing returns and this is where risk prevails.

c) Stocks having Beta less than one will be less responsive to changing returns in a market and therefore are less risky. These stocks will not change too much in value due to market fluctuations.

Betas for a large number of stocks are provided by many large brokerage firms like Merrill Lynch. They are also provided for by services such as Value line. The parameters used in calculating beta include
R= The estimated return on the stock when the market value is zero
S= Measure of the stocks sensitivity to the market value and
M= The return on the market index.
Where:
The estimated return on the stock = R + (S*M)

Returns on a Share and Bonus Issues

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The fundamental value of a share can be estimated based on the future dividend stream and the average rate of return of the security in the market. The expected future dividend stream is calculated by knowing the present dividend and its average growth rate. The expected return on a security is made on the basis of the riskiness of investment which is given by the modern portfolio theory. Alternatively, the expected return on a share can be made over a long period by computing the historical return on a comparable share which is in the same risk situation.
Bonus issues are made by companies with profitable operations. For these companies, the retained earnings or reserves can become very large. The management decides to issue bonus shares by transferring some amount from the retained earnings or reserves into share capital. This is done by a book entry. The effect that this has is an increase the share capital and a decrease in the reserves in the balance sheet of a firm. When bonus issue is made, it has the effect of keeping the market price per share low on account of the enlarged share capital base. Bonus issues do not really change the fortunes of the business or the shareholders. This is because the company has decided to allot shares with a chosen rate say 1:2; or 1 bonus share for every two share held by the shareholder. However, the same effect could have been reached by the company declared a 50% dividend per share without making any bonus issue.

Need for regulation of the Insurance Sector

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The Insurance Sector of an economy handles a vast amount of public funds. The contract of insurance is based on the principle of good faith. Insurance policyholders believe that the insurance policies that are sold in the market are viable and true. The policyholder also expects that a policy-claim is settled in a fair and efficient manner.
The Insurance sector has customers from all segments of the society. Regulation becomes necessary to protect the public interest. Towards this end, the management of Insurance Company should be responsible and responsive, safe and sound.
The proper and healthy performance of the insurance sector of an economy becomes necessary to protect public interests of a nation. Therefore, the Insurance Regulatory Authority lays down the performance conduct standards for the Insurance Company. The authority lays these standards through regulations and directives. Insurance regulations exist all over the world and are now considered to be important towards achieving financial stability and encouraging savings of a country and in the international arena.
The first international regulatory authority to take care of the development and health of the insurance sector came from the United States of America. The USA formed a National Association of Insurance Commissioners (NAIC). The NAIC was formed by the coming together of different State Regulators.
The next major international development was the formation of the International Association of Insurance Supervisors (IAIS). This association,which grew from the NAIC has its headquarters in Basle in Switzerland.
Therefore, Country wise and International Insurance regulations have evolved. These regulations control the registration of Insurance companies, ensure that management is fit and proper; price Insurance product after thorough research has been made, ensure that claims are settled effectively and ensures that the Insurance Company maintains the solvency margin requirements.

 

Derivatives

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Derivatives are financial instruments whose value is derived from the value of underlying assets. These are contracts between two parties. The underlying assets from which the value of the derivative is derived includes assets including commodities that are tangible including agricultural produce. The other assets include currencies and gold and other precious metals. The assets considered for valuation of derivatives can also be intangible. Intangible assets include inflation index and equity price index.
It follows logically that the value of derivatives depends on the value of the underlying asset. Another important aspect is that, in trading derivatives the trading of the underlying assets are not involved. Transactions are settled by taking the value of derivatives traded themselves. Effectively, there is no particular limit on the quantity that can be traded with the underlying assets.
There are many varieties of derivatives available in the market nowadays. The noteworthy ones to mention are futures, options, swaps, warrants, captions, swaptions and so on.

FUTURES: These are standardized contracts between sellers or 'shorts' or 'writers' and buyers or 'longs'. Future contracts require that the sellers deliver and buyers receive the stipulated assets in specified quantities at contracted prices in the future. The period of the contract could be between 3 months and 21 months. Stock index futures are traded on share price indices. Interest rate futures are traded on the basis of interest rates or price indices of treasury bills, industrial debentures, commercial paper, certificates of deposit and mortgage loans. Currency futures are written on the basis of currency rates.
The only paper that is exchanged is the note of contract. Futures based on equity index and currency is usually settled in cash.
Futures are organized by the futures exchanges which have their own clearing system. The buyers and sellers do not have to worry about each other's creditworthiness because the futures exchanges guarantee the performance of the parties in the contract.

OPTIONS: Options are contracts between sellers or writers and buyers. Under this contract, the buyers are enabled to buy stated quantities of assets at some future date at today' contracted price which is also known as the strike price or exercise price. The sellers are obligated by this contract to deliver these assets. The buyers pay a onetime non-refundable premium to the sellers for the right that they enjoy under this contract.
The situation under which the buyer's have the right to the delivery of the underlying asset is known as 'call options'. When buyers have the right to receive payment by handing over assets is known as a 'put' option.
In an option transaction, the potential loss of the seller is unlimited. The potential loss of the buyer is limited to the extent of premium paid.

Options of recent origin include stock index options and interest rate options on treasury notes and bonds and option on foreign currency exchange. The latest innovation in derivatives is the futures option. This is a combination of futures and options.
Options on swaps are known as 'swaptions'. Under this contract, the holders of swaptions have a right, but not an obligation to enter into swap contracts on or before the exercise date. It is interest amount that are counted in swaptions. A premium is paid by the buyer for obtaining a swaption.