Moving 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. They also
form the building blocks for many other technical indicators and overlays, such
as Bollinger Bands, MACD and the McClellan Oscillator. The two most popular
types of moving averages are the Simple Moving Average (SMA) and
theExponential Moving Average (EMA). These moving averages can be
used to identify the direction of the trend or define potential support and
resistance levels.

Here's a chart with both an SMA and an EMA on it:

Click the chart for a live version

Simple Moving Average Calculation

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. Below is an example of a 5-day
moving average evolving over three days.

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

The first day of the moving average simply covers the last five days. The second
day of the moving average drops the first data point (11) and adds the new data
point (16). The third day of the moving average continues by dropping the first
data point (12) and adding the new data point (17). In the example above, prices
gradually increase from 11 to 17 over a total of seven days. Notice that the moving
average also rises from 13 to 15 over a three-day calculation period. Also notice
that each moving average value is just below the last price. For example, the
moving average for day one equals 13 and the last price is 15. Prices the prior
four days were lower and this causes the moving average to lag.

Exponential Moving Average Calculation

Exponential moving averages (EMAs) 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. EMAs differ from simple moving
averages in that a given day's EMA calculation depends on the EMA calculations
for all the days prior to that day. You need far more than 10 days of data to
calculate a reasonably accurate 10-day EMA.

There are three steps to calculating an exponential moving average (EMA). First,
calculate the simple moving average for the initial EMA value. 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 for each
day between the initial EMA value and today, using the price, the multiplier, and
the previous period's EMA value. The formula below is for a 10-day EMA.

2. The candlestick techniques we use today originated in the style of technical

charting used by the Japanese for over 100 years before the West developed
the bar and point-and-figure analysis systems. In the 1700s, a Japanese man
named Homma, a trader in the futures market, discovered that, although there
was a link between price and the supply and demand of rice, the markets
were strongly influenced by the emotions of traders. He understood that when
emotions played into the equation, a vast difference between the value and
the price of rice occurred. This difference between the value and the price is
as applicable to stocks today as it was to rice in Japan centuries ago. The
principles established by Homma are the basis for the candlestick chart
analysis, which is used to measure market emotions surrounding a stock.

This charting technique has become very popular among traders. One reason
is that the charts reflect only short-term outlooks, sometimes lasting less than
eight to 10 trading sessions. Candlestick charting is a very complex and
sometimes difficult system to understand. Here we get things started by
looking at what a candlestick pattern is and what it can tell you about a stock.

Candlestick Components

When first looking at a candlestick chart, the student of the more common bar
charts may be confused; however, just like a bar chart, the daily candlestick
line contains the market's open, high, low and close of a specific day. Now this
is where the system takes on a whole new look: the candlestick has a wide
part, which is called the "real body". This real body represents the range
between the open and close of that day's trading. When the real body is filled
in or black, it means the close was lower than the open. If the real body is
empty, it means the opposite: the close was higher than the open.
 Figure 1: A candlestick
Just above and below the real body are the "shadows". Chartists have always
thought of these as the wicks of the candle, and it is the shadows that show
the high and low prices of that day's trading. If the upper shadow on the filled-
in body is short, it indicates that the open that day was closer to the high of the
day. A short upper shadow on a white or unfilled body dictates that the close
was near the high. The relationship between the day's open, high, low and
close determines the look of the daily candlestick. Real bodies can be either
long or short and either black or white. Shadows can also be either long or
short.

3. Developed J. Welles Wilder, the Relative Strength Index (RSI) is a momentum

oscillator that measures the speed and change of price movements. RSI oscillates
between zero and 100. Traditionally, and according to Wilder, RSI is considered
overbought when above 70 and oversold when below 30. Signals can also be
generated by looking for divergences, failure swings and centerline crossovers.
RSI can also be used to identify the general trend.

RSI is an extremely popular momentum indicator that has been featured in a

number of articles, interviews and books over the years. In particular, Constance
Brown's book, Technical Analysis for the Trading Professional, features the
concept of bull market and bear market ranges for RSI. Andrew Cardwell,
Brown's RSI mentor, introduced positive and negative reversals for RSI. In
addition, Cardwell turned the notion of divergence, literally and figuratively, on
its head.

Wilder features RSI in his 1978 book, New Concepts in Technical Trading
Systems. This book also includes the Parabolic SAR, Average True Range and the
 Directional Movement Concept (ADX). Despite being developed before the
computer age, Wilder's indicators have stood the test of time and remain
extremely popular.

Calculation

100
RSI = 100 - --------
1 + RS

RS = Average Gain / Average Loss

4. In finance, intrinsic value refers to the value of a

company, stock, currency or product determined through fundamental analysis without
reference to its market value.[1] It is also frequently called fundamental value. It is
ordinarily calculated by summing the discounted future income generated by the asset to
obtain the present value. It is worthy to note that this term may have different meanings
for different assets.

5. verbought and Oversold Levels

The most basic RSI application is to use it to identify areas that are potentially
overbought or oversold. Movements above 70 are interpreted as indicating
overbought conditions; conversely, movements under 30 reflect oversold conditions.
The level of 50 represents neutral market momentum and corresponds with the
center line in other oscillators such as MACD.
In terms of market analysis and trading signals, RSI moving above the horizontal 30
reference level is viewed as a bullish indicator, while the RSI moving below the
horizontal 70 reference level is seen to be a bearish indicator.
As with other momentum oscillators, overbought and oversold readings for RSI work
best when prices are moving within a sideways range rather than trending up or
down.
Figure 1: The elipse marks RSI movement into overbought conditions above 70 on
the EUR/USD chart.
Price/Oscillator Divergence
Wilder suggests that divergence between an asset's price movement and the RSI
oscillator can signal a potential reversal. The reasoning is that in these instances,
directional momentum does not confirm price.
A bullish divergence forms when the underlying asset makes a lower low and RSI
makes a higher low. RSI diverges from the bearish price action in that it shows
strengthening momentum, indicating a potential upward reversal in price.
A bearish divergence forms when the underlying asset makes a higher high and RSI
forms a lower high. RSI diverges from the bullish price action in that it shows
weakening momentum, indicating a potential downward reversal in price.
As with overbought and oversold levels, divergences are more likely to give false
signals in the context of a strong trend.

6. Technical analysis is the study of market action, primarily through the use of charts, for the
purpose of forecasting future price trends.". In its purest form, technical analysis considers only
the actual price behavior of the market or instrument, based on the premise that price reflects
all relevant factors before an investor becomes aware of them through other channels.

Technical analysis is widely used among traders and financial professionals, and some studies
say its use is more widespread than is "fundamental" analysis in the foreign exchange market.
Academics such as Eugene Fama say the evidence for technical analysis is sparse and is refuted
by the efficient market hypothesis, yet some Federal Reserve and academic studies include
evidence that supports technical analysis. MIT finance professor Andrew Lo argues that "several
academic studies suggest thattechnical analysis may well be an effective means for extracting
useful information from market prices."Burton Malkiel argues, "Technical analysis is anathema
to the academic world."

7. Dow Theory is an analysis that explores the relationship between the Dow Jones
Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). When
one of these averages climbs to an intermediate high, then the other is expected to
follow suit within a reasonable amount of time. If not, then the averages show
"divergence" and the market is liable to reverse course.

HOW IT WORKS (EXAMPLE):

Dow Theory has its origins in the writings of Charles Dow -- founder of the Wall
Street Journal and creator of the Dow Jones Industrial Average. His editorials
pioneered technical analysis. On his death in 1902, William Hamilton continued
Dow's work, writing editorials of his own until 1929. Robert Rhea then collected the
work of both of these men and used it as a basis to publish The Dow Theory in 1932.

This book expounds upon many key principles of technical analysis, such as defining
the nature of the primary, secondary and minor trends. Dow Theory divergence is
fully explained in the idea that "the two averages must confirm."

In Dow's time, the two averages were the Industrials and the Rails. The logic behind
the theory is simple: Industrial companies manufactured the goods and the rails
shipped them. When one average recorded a new secondary or intermediate high,
the other average was required to do the same in order for the signal to be
considered valid.

8. 1. Investment Policy 2. Investment Analysis 3. Valuation of

Securities 4. Portfolio Constructio.

Investment Process: Step # 1. Investment Policy:
The first stage determines and involves personal financial affairs and
objectives before making investments. It may also be called preparation of
the investment policy stage.

The investor has to see that he should be able to create an emergency

fund, an element of liquidity and quick convertibility of securities into cash.
This stage may, therefore; be considered appropriate for identifying
investment assets and considering the various features of investments.

Investment Process: Step # 2. Investment Analysis:

When a individual has arranged a logical order of the types of investments
that he requires on his portfolio, the next step is to analyse the securities
available for investment. He must make a comparative analysis of the type
of industry, kind of security and fixed vs. variable securities. The primary
concerns at this stage would be to form beliefs regarding future behaviour
or prices and stocks, the expected returns and associated risk.

Investment Process: Step # 3. Valuation of Securities:

The third step is perhaps the most important consideration of the valuation
of investments. Investment value, in general, is taken to be the present
worth to the owners of future benefits from investments. The investor has to
bear in mind the value of these investments.

ADVERTISEMENTS:

An appropriate set of weights have to be applied with the use of forecasted

benefits to estimate the value of the investment assets. Comparison of the
value with the current market price of the asset allows a determination of
the relative attractiveness of the asset. Each asset must be valued on its
individual merit. Finally, the portfolio should be constructed.

Investment Process: Step # 4. Portfolio Construction:

Under features of an investment programme, portfolio construction requires
a knowledge of the different aspects of securities. These are briefly
recapitulated here, consisting of safety and growth of principal, liquidity of
assets after taking into account the stage involving investment timing,
selection of investment, allocation of savings to different investments and
feedback of portfolio as given in Table 1

9. Riskmitigation is defined as taking steps to reduce

adverse effects. There are four types of risk mitigation
strategies that hold unique to Business Continuity and
Disaster Recovery. Its important to develop a strategy
that closely relates to and matches your companys
profile.
Risk Acceptance: Risk acceptance does not reduce any effects however it is still considered a
strategy. This strategy is a common option when the cost of other risk management options
such as avoidance or limitation may outweigh the cost of the risk itself. A company
that doesnt want to spend a lot of money on avoiding risks that do not have a high possibility
of occurring will use the risk acceptance strategy.
Risk Avoidance: Risk avoidance is the opposite of risk acceptance. It is the action that avoids
any exposure to the risk whatsoever. Risk avoidance is usually the most expensive of all
risk mitigation options.
Risk Limitation: Risk limitation is the most common risk management strategy used by
businesses. This strategy limits a companys exposure by taking some action. It is a strategy
employing a bit of risk acceptance along with a bit of risk avoidance or an average of both. An
example of risk limitation would be a company accepting that a disk drive may fail and
avoiding a long period of failure by having backups.
Risk Transference: Risk transference is the involvement of handing risk off to a willing third
party. For example, numerous companies outsource certain operations such as customer
service, payroll services, etc. This can be beneficial for a company if a transferred risk is not a
core competency of that company. It can also be used so a company
10. In the article on portfolio theory, we saw that the motivation behind the establishment of a portfolio is that risk
(the bad) can be reduced without a consequential reduction in return (the good). This was mathematically evident
when the portfolios' expected return was equal to the weighted average of the expected returns on the individual
investments, while the portfolio risk was normally less than the weighted average of the risk of the individual
investments.
The portfolio's total risk (as measured by the standard deviation of returns) consists of unsystematic and
systematic risk. We saw the dramatic risk reduction effect of diversification (see Example 1). If an investor invests
in just 15 companies in different sectors (a well-diversified portfolio), it is possible to virtually eliminate
unsystematic risk. The only risk affecting a well-diversified portfolio is therefore systematic. As a result, an
investor who holds a well-diversified portfolio will only require a return for systematic risk. In this article, we
explain how to measure an investment's systematic risk.
Learning Objectives
By the end of this article you should be able to:
calculate beta from basic data using two different formulae
calculate the required return using the CAPM formula
understand the meaning of beta
prepare an alpha table and understand the nature of the alpha value
explain the problems with CAPM
briefly explain the arbitrage pricing model (APM)
calculate the portfolio risk of a multi-asset portfolio when there is no correlation between the return of the
investments.

Risk reduction effect of diversification example image

The measurement of systematic risk
You may recall from the previous article on portfolio theory that the formula of the variance of a large portfolio
(where we invest equal amounts in each investment) is:

The first term is the average variance of the individual investments (unsystematic risk). As N becomes very large,
the first term tends towards zero. Thus, unsystematic risk can be diversified away.
The second term is the covariance term and it measures systematic risk. As N becomes large, the second term
will approach the average covariance. The risk contributed by the covariance (the systematic risk) cannot be
diversified away.

Systematic risk reflects market-wide factors such as the country's rate of economic growth, corporate tax rates,
interest rates etc. Since these market-wide factors generally cause returns to move in the same direction they
cannot cancel out.

Therefore, systematic risk remains present in all portfolios. Some investments will be more sensitive to market
factors than others and will therefore have a higher systematic risk.

Remember that investors who hold well-diversified portfolios will find that the risk affecting the portfolio is wholly
systematic. Unsystematic risk has been diversified away. These investors may want to measure the systematic
risk of each individual investment within their portfolio, or of a potential new investment to be added to the
portfolio. A single investment is affected by both systematic and unsystematic risk but if an investor owns a well-
diversified portfolio then only the systematic risk of that investment would be relevant. If a single investment
becomes part of a well-diversified portfolio the unsystematic risk can be ignored.
The systematic risk of an investment is measured by the covariance of an investment's return with the returns of
the market. Once the systematic risk of an investment is calculated, it is then divided by the market risk, to
calculate a relative measure of systematic risk. This relative measure of risk is called the beta' and is usually
represented by the symbol b. If an investment has twice as much systematic risk as the market, it would have a
beta of two. There are two different formulae for beta. The first is:

You must commit both formulae to memory, as they are not given on the exam formulae sheet. The formula that
you need to use in the exam will be determined by the information given in the question. If you are given the
covariance, use the first formula or if you are given the correlation coefficient, use the second formula.
Example 2
You are considering investing in Y plc. The covariance between the company's returns and the return on the
market is 30%. The standard deviation of the returns on the market is 5%.
Calculate the beta value:
be =
30% = 1.2
52%
Example 3
You are considering investing in Z plc. The correlation coefficient between the company's returns and the return
on the market is 0.7. The standard deviation of the returns for the company and the market are 8% and 5%
respectively.
Calculate the beta value:
be =
0.7 x 8% = 1.12
5%

Investors make investment decisions about the future. Therefore, it is necessary to calculate the future beta.
Obviously, the future cannot be foreseen. As a result, it is difficult to obtain an estimate of the likely future co-
movements of the returns on a share and the market. However, in the real world the most popular method is to
observe the historical relationships between the returns and then assume that this covariance will continue into
the future. You will not be required to calculate the beta value using this approach in the exam.
The CAPM Formula
The capital asset pricing model (CAPM) provides the required return based on the perceived level of systematic
risk of an investment:
The calculation of the required return
The required return on a share will depend on the systematic risk of the share. What is the required return on the
following shares if the return on the market is 11% and the risk free rate is 6%?
The shares in B plc have a beta value of 0.5
Answer: 6% + (11% - 6%) 0.5 = 8.5%

The shares in C plc have a beta value of 1.0

Answer: 6% + (11% - 6%) 1.0 = 11%

The shares in D plc have a beta value of 2.0

Answer: 6% + (11% - 6%) 2.0 = 16%.

Obviously, with hindsight there was no need to calculate the required return for C plc as it has a beta of one and
therefore the same level of risk as the market and will require the same level of return as the market, ie the RM of
11%. The systematic risk-return relationship is graphically demonstrated by the security market line. See
Example 4.

11. Unsystematic risk, also known as "specific risk," "diversifiable risk" or

"residual risk," is the type of uncertainty that comes with the company or
industry you invest in. Unsystematic risk can be reduced through
diversification. For example, news that is specific to a small number of stocks,
such as a sudden strike by the employees of a company you have shares in,
is considered to be unsystematic risk. Systematic risk, also known as
"market risk" or "un-diversifiable risk", is the uncertainty inherent to the entire
market or entire market segment. Also referred to as volatility, systematic risk
consists of the day-to-day fluctuations in a stock's price. Volatility is a measure
of risk because it refers to the behavior, or "temperament," of your investment
rather than the reason for this behavior. Because market movement is the
reason why people can make money from stocks, volatility is essential for
returns, and the more unstable the investment the more chance there is that it
will experience a dramatic change in either direction.

Interest rates, recession and wars all represent sources of systematic risk
because they affect the entire market and cannot be avoided through
diversification. Systematic risk can be mitigated only by being hedged.

Systematic risk underlies all other investment risks. If there is inflation, you
can invest in securities in inflation-resistant economic sectors. If interest rates
are high, you can sell your utility stocks and move into newly issued bonds.
However, if the entire economy underperforms, then the best you can do is
attempt to find investments that will weather the storm better than the broader
market. Popular examples are defensive industry stocks, for example,
or bearish options strategies.

Beta is a measure of the volatility, or systematic risk, of a security or a

portfolio in comparison to the market as a whole. In other words, beta gives a
sense of a stock's market risk compared to the greater market. Beta is also
used to compare a stock's market risk to that of other stocks. Investment
analysts use the Greek letter '' to represent beta. Beta is used in the capital
asset pricing model (CAPM), as we described in the previous section.

Beta is calculated using regression analysis, and you can think of beta as the
tendency of a security's returns to respond to swings in the market. A beta of 1
indicates that the security's price will move with the market. A beta of less than
1 means that the security will be less volatile than the market. A beta of
greater than 1 indicates that the security's price will be more volatile than the
market. For example, if a stock's beta is 1.2, it's theoretically 20% more
volatile than the market.

Many utility stocks have a beta of less than 1. Conversely, most high-
tech Nasdaq-based stocks have a beta greater than 1, offering the possibility
of a higher rate of return, but also posing more risk.

Beta helps us to understand the concepts of passive and active risk. The
graph below shows a time series of returns (each data point labeled "+") for a
particular portfolio R(p) versus the market return R(m). The returns are cash-
adjusted, so the point at which the x and y axes intersect is the cash-
equivalent return. Drawing a line of best fit through the data points allows us to
quantify the passive, or beta, risk and the active risk, which we refer to
as alpha.

The gradient of the line is its beta. For example, a gradient of 1.0 indicates
that for every unit increase of market return, the portfolio return also increases
by one unit. A manager employing a passive management strategy can
attempt to increase the portfolio return by taking on more market risk (i.e., a
beta greater than 1) or alternatively decrease portfolio risk (and return) by
reducing the portfolio beta below 1. Essentially, beta expresses the
fundamental tradeoff between minimizing risk and maximizing return. Let's
give an illustration. Say a company has a beta of 2. This means it is two times
as volatile as the overall market. Let's say we expect the market to provide a
return of 10% on an investment. We would expect the company to return 20%.
On the other hand, if the market were to decline and provide a return of -6%,
investors in that company could expect a return of -12% (a loss of 12%). If a
stock had a beta of 0.5, we would expect it to be half as volatile as the market:
a market return of 10% would mean a 5% gain for the company. (For further
reading, see Beta: Know The Risk.)

Investors expecting the market to be bullish may choose funds exhibiting high
betas, which increase investors' chances of beating the market. If an investor
expects the market to be bearish in the near future, the funds that have betas
less than 1 are a good choice because they would be expected to decline less
in value than the index. For example, if a fund had a beta of 0.5 and the S&P
500 declined 6%, the fund would be expected to decline only 3%. (Learn more
about volatility in Understanding Volatility Measurements and Build Diversity
Through Beta.)

Here is a basic guide to various betas:

Negative beta - A beta less than 0 - which would indicate an inverse

relation to the market - is possible but highly unlikely. Some investors
used to believe that gold and gold stocks should have negative betas
because they tended to do better when the stock market declined, but
this hasn't proved to be true over the long term.
Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of
which way the market moves, the value of cash remains unchanged
(given no inflation).
Beta between 0 and 1 - Companies with volatilities lower than the
market have a beta of less than 1 (but more than 0). Many utilities fall in
this range.
Beta of 1 - A beta of 1 represents the volatility of the given index used
to represent the overall market against which other stocks and their
betas are measured. The S&P 500 is such an index. If a stock has a
beta of 1, it will move the same amount and direction as the index. So,
an index fund that mirrors the S&P 500 will have a beta close to 1.
Beta greater than 1 - This denotes a volatility that is greater than the
broad-based index. Many technology companies on the Nasdaq have a
beta higher than 1.
Beta greater than 100 - This is impossible as it essentially denotes a
volatility that is 100 times greater than the market. If a stock had a beta
of 100, it would be expected to go to 0 on any decline in the stock
market. If you ever see a beta of over 100 on a research site, it is
usually either the result of a statistical error or a sign that the given
stock has experienced large swings due to low liquidity, such as
an over-the-counter stock. For the most part, stocks of well-known
companies rarely have a beta higher than 4.
Why You Should Understand Beta
Are you prepared to take a loss on your investments? Many people are not
and therefore opt for investments with low volatility. Other people are willing to
take on additional risk because with it comes the possibility of increased
reward. It is very important that investors not only have a good understanding
of their risk tolerance, but also know which investments match their risk
preferences.

By using beta to measure volatility, you can better choose those securities
that meet your criteria for risk. Investors who are very risk-averse should put
their money into investments with low betas such as utility stocks
and Treasury bills. Those investors who are willing to take on more risk may
want to invest in stocks with higher betas.

Many brokerage firms calculate the betas of securities they trade, and then
publish their calculations in a beta book. These books offer estimates of the
beta for almost any publicly-traded company. The problem is that most of us
don't have access to these brokerage books, and the calculation for beta can
often be confusing, even for experienced investors.

However, there are other resources. One of the better-known websites as of

2012 that publishes beta isYahoo! Finance (enter a company's name, then
click on Key Statistics and look under Stock Price History). The beta
calculated on Yahoo! compares the activity of the stock over the last five years
and compares it to the S&P 500. A beta of "0.00" simply means that the stock
either is a new issue or doesn't yet have a beta calculated for it.

Warnings about Beta

The most important caveat for using beta to make investment decisions is that
beta is a historical measure of a stock's volatility. Past beta figures or historical
volatility do not necessarily predict future beta or future volatility. In other
words, if a stock's beta is 2 right now, there is no guarantee that in a year the
beta will be the same. One study by Gene Fama and Ken French called "The
Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of
Finance) on the reliability of past beta concluded that for individual stocks past
beta is not a good predictor of future beta. An interesting finding in this study
is that betas seem to revert back to the mean. This means that higher betas
tend to fall back toward 1 and lower betas tend to rise toward 1.

The second caveat for using beta is that it is a measure of systematic risk,
which is the risk that the market as a whole faces. The market index to which
a stock is being compared is affected by market-wide risks. So, since it is
found by comparing the volatility of a stock to the index, beta only takes into
account the effects of market-wide risks on the stock. The other risks
companies face are firm-specific risks, which are not grasped fully in the beta
measure. So, while beta will give investors a good idea about how changes in
the market affect the stock, it does not look at all the risks faced by the
company alone.

The following is a chart of IBM's stock for the trading period of June 2004 to
June 2005. The red line is the IBM percent change over the period and the
green line is the percent change of the S&P 500. This chart helps to illustrate
how IBM moved in relation to the market, as represented by the S&P 500
during the one-year period.

12.