A Presentation On

Moving Averages, ADX and Derivatives

ByKshitij Gupta

©CATALYST

What is Technical Analysis Technical Analysis is the forecasting of

future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.

Three Rules to be Considered While Using Technical Analysis

According to Dow Theory there are three rules ◦Price Discounts Everything◦Price Movements are not totally random◦“What” is more important than “Why”

Price Discounts Everything This theorem is similar to the strong and semi-strong

forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials

Price Movements are not Totally Random

Most technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. 

Jack Schwager states: “One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends).”

“WHAT” is more important than “WHY”

Tony Plummer paraphrases Oscar Wilde by stating, “A technical analyst knows the price of everything, but the value of nothing”.

Technical Analyst mainly focuses on two aspects◦What is the current price?◦What is the history of price movement.

Moving Averages

IntroductionMoving averages smooth the price data to

form a trend following indicator. They do not predict price direction, but rather define the current direction with a lag. Moving averages lag because they are based on past prices. Despite this lag, moving averages help smooth price action and filter out the noise.

There are two types of moving averages◦ Simple Moving Average◦ Exponential Moving Average

Simple Moving Average A simple moving average is formed by computing the

average price of a security over a specific number of periods. Most moving averages are based on closing prices. A 5-day simple moving average is the five day sum of closing prices divided by five. As its name implies, a moving average is an average that moves. Old data is dropped as new data comes available. This causes the average to move along the time scale.

Daily Closing Prices: 11,12,13,14,15,16,17 First day of 5-day SMA: (11 + 12 + 13 + 14 + 15) / 5 = 13 Second day of 5-day SMA: (12 + 13 + 14 + 15 + 16) / 5 =

14 Third day of 5-day SMA: (13 + 14 + 15 + 16 + 17) / 5 = 15

Exponential Moving Average

Exponential moving averages reduce the lag by applying more weight to recent prices. The weighting applied to the most recent price depends on the number of periods in the moving average. There are three steps to calculating an exponential moving average. First, calculate the simple moving average. An exponential moving average (EMA) has to start somewhere so a simple moving average is used as the previous period's EMA in the first calculation. Second, calculate the weighting multiplier. Third, calculate the exponential moving average. The formula below is for a 10-day EMA.

SMA: 10 period sum / 10 Multiplier: (2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%) EMA: {Close - EMA(previous day)} x multiplier + EMA(previousday).

Simple v/s Weighted MA Even though there are clear differences between

simple moving averages and exponential moving averages, one is not necessarily better than the other. Exponential moving averages have less lag and are therefore more sensitive to recent prices - and recent price changes. Exponential moving averages will turn before simple moving averages. Simple moving averages, on the other hand, represent a true average of prices for the entire time period. As such, simple moving averages may be better suited to identify support or resistance levels

The Lag FactorThe longer the moving average, the more the lag.

A 10-day exponential moving average will hug prices quite closely and turn shortly after prices turn. Short moving averages are like speed boats - nimble and quick to change. In contrast, a 100-day moving average contains lots of past data that slows it down. Longer moving averages are like ocean tankers - lethargic and slow to change. It takes a larger and longer price movement for a 100-day moving average to change course.

Average Directional Index(ADX)

Introduction The Average Directional Index (ADX), Minus Directional

Indicator (-DI) and Plus Directional Indicator (+DI) represent a group of directional movement indicators that form a trading system developed by Welles Wilder. Wilder designed ADX with commodities and daily prices in mind, but these indicators can also be applied to stocks. The Average Directional Index (ADX) measures trend strength without regard to trend direction. The other two indicators, Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI), complement ADX by defining trend direction. Used together, chartists can determine both the direction and strength of the trend.

Directional Movement Plus Directional Movement (+DM) and Minus Directional

Movement (-DM) form the backbone of the Average Directional Index (ADX). Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between the highs.

Directional movement is positive (plus) when the current high minus the prior high is greater than the prior low minus the current low. This so-called Plus Directional Movement (+DM) then equals the current high minus the prior high, provided it is positive. A negative value would simply be entered as zero.

Directional movement is negative (minus) when the prior low minus the current low is greater than the current high minus the prior high. This so-called Minus Directional Movement (-DM) equals the prior low minus the current low, provided it is positive. A negative value would simply be entered as zero.

CalculationThe example below is based on a 14-day ADX calculation.

1. Calculate the True Range (TR), Plus Directional Movement (+DM) and Minus Directional Movement (-DM) for each period.

2. Smooth these periodic values using the Wilder's smoothing techniques. 3. Divide the 14-day smoothed Plus Directional Movement (+DM) by the

14-day smoothed True Range to find the 14-day Plus Directional Indicator (+DI14). Multiply by 100 to move the decimal point two places. This +DI14 is the Plus Directional Indicator (green line) that is plotted along with ADX.

4. Divide the 14-day smoothed Minus Directional Movement (-DM) by the 14-day smoothed True Range to find the 14-day Minus Directional Indicator (-DI14). Multiply by 100 to move the decimal point two places. This -DI14 is the Minus Directional Indicator (red line) that is plotted along with ADX.

5. The Directional Movement Index (DX) equals the absolute value of +DI14 less - DI14 divided by the sum of +DI14 and - DI14.

6. After all these steps, it is time to calculate the Average Directional Index (ADX). The first ADX value is simply a 14-day average of DX. Subsequent ADX values are smoothed by multiplying the previous 14-day ADX value by 13, adding the most recent DX value and dividing this total by 14.

Wilder’s SmoothingFirst TR14 = Sum of first 14 periods of

TR1 Second TR14 = First TR14 - (First

TR14/14) + Current TR1 Subsequent Values = Prior TR14 - (Prior

TR14/14) + Current TR1

InterpretationThe Average Directional Index (ADX) is

used to measure the strength or weakness of a trend, not the actual direction. Directional movement is defined by +DI and -DI. In general, the bulls have the edge when +DI is greater than - DI, while the bears have the edge when - DI is greater. Crosses of these directional indicators can be combined with ADX for a complete trading system.

Derivatives

Introduction A derivative is a security with a price that is dependent

upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. 

Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterparty than do standardized derivatives. 

Derivatives are further divided into three parts ◦ Forward Contract◦ Future Contract◦ Option Contract

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. 

A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts are standardized to facilitate trading on a futures exchange and, depending on the underlying asset being traded, detail the quality and quantity of the commodity.

An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a preset price, referred to as the strike price, prior to the expiration date. The two types of contracts are put and call options, which can be purchased to speculate on the direction of stocks or stock indices, or sold to generate income.

Call Option - A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period.

Put option - A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares.

Basic Terminology Strike Price – The price at which the derivative contract is exercised is

known as strike price. Spot Price – The current price at which the security can be bought or sold is

known as spot price. In the money - A call option is said to be in the money when the current

market price of the stock is above the strike price of the call. It is "in the money" because the holder of the call has the right to buy the stock below its current market price.

At the money - At the money is a situation where an option's strike price is identical to the price of the underlying security.

Out the money - Out of the money (OTM) is term used to describe a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset.

Intrinsic Value - The intrinsic value is the difference between the underling's price and the strike price. 

Premium - An option premium is the income received by an investor who sells or "writes" an option contract to another party. An option premium may also refer to the current price of any specific option contract that has yet to expire.

How to Calculate Option Price

Black Scholes Model

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