Technical Analysis: Understanding Moving Averages

Technical Analysis: Understanding Moving Averages
by Gautam Upadhyaya 25/07/2017

Moving averages

Moving average is a widely used technical indicator of stock prices that helps to smooth out the volatility in the price action by filtering out the noise from random price fluctuations. A moving average is a trend-follow lagging indicator as it is calculated taking past data into consideration.  As its name suggests, a moving average is an average that moves as old values are dropped out as new values become available. Moving averages can be employed to identify the current trend in a script.

Types of moving averages

There are 3 types of moving averages

a) Simple moving average (SMA)

It is obtained by computing the simple average of price data over a defined period of time. In general, we compute the simple moving average based on the closing price of the security as it is considered to have more significance as compared to the rest of price points (Namely open/high/low price for the day). Thus, a 5-day SMA is calculated by adding the closing price of 5 days and dividing this sum by the total number of days (in this case, five).

For example, the 5 days SMA of ITC is calculated as follows:

While calculating the Moving Average after the close of the trading session on July 7, 2017, we can compute the SMA value by taking the closing price of the last 5 trading session, including July 7, 2017, and dividing the same by 5. At close of the next trading session on July 10, 2017, SMA is calculated by excluding the Closing Price of July 3, 2017 by adding the new data point. (Closing Price of July 10, 2017).

As illustrated in the example below, prices gradually decreases from 342.5 to 328.85 over a period of eight days in the same timeframe the 5 Period SMA decreases from 336.44 to 332.79, indicating a lag associated with the Moving Averages. Hence, larger the time period, larger is the lag.

Date

Close Price

5 Period SMA

03-Jul-17

342.5

 

04-Jul-17

337.25

 

05-Jul-17

331.05

 

06-Jul-17

337.10

 

07-Jul-17

334.30

336.44

10-Jul-17

333.30

334.60

11-Jul-17

330.40

333.23

12-Jul-17

328.85

332.89

7TH July SMA = 336.44= (342.50+337.25+331.05+337.10+334.30)
                                                                          5 

10th July SMA =334.6=        (337.25+331.05+337.10+334.30+333.30)
                                                                          5         
11th July SMA= 333.23=   (331.05+337.10+334.30+333.30+330.40)
                                                                          5
12th July WMA= 332.89=    (337.10+334.30+333.30+330.40+328.85)
                                                                          5

b) Weighted moving average (WMA)
Weighted moving average moves a step ahead from simple moving average. Here, we assign a weight to each value, with a bigger weight assigned to the most recent data points as they are more relevant than historical data points. The sum of weights should add up to 1 (or 100%). As new data points are added, the new weights will align accordingly. In contrast, in simple moving average, each value is assigned the same weight. Ideally, traders calculate WMA on the basis of closing price.

The weighted moving average is calculated by multiplying the given price by its assigned weight and then dividing the sum by total number of days. The weights assigned are subjective in nature, and it is based on the discretion of the trader. Because of its calculation methodology, WMA will follow prices more closely than a corresponding SMA. The WMA reduces the lag effect to an extent.

 


Date

Close Price

Weights

WMA

03-Jul-17

342.5

0.07

 

04-Jul-17

337.25

0.13

 

05-Jul-17

331.05

0.20

 

06-Jul-17

337.10

0.27

 

07-Jul-17

334.30

0.33

335.34

10-Jul-17

333.30

 

334.29

11-Jul-17

330.40

 

332.89

12-Jul-17

328.85

 

331.43

 

7TH July WMA = 335.34= (342.50*0.07+337.25*0.13+331.05*0.20+337.10*0.27+334.3*0.33)
                                                 5

10th July WMA =334.29=        (337.25*0.07+331.05*0.13+337.10*0.20+334.3*0.27+333.3*0.33)
                                                 5
11th July WMA= 332.89=   (331.05*0.07+337.10*0.13+334.30*0.20+333.3*0.27+330.4*0.33)
                                                 5
12th July WMA= 331.43=    (337.1*0.07+334.30*0.13+333.30*0.20+330.4*0.27+328.85*0.33)
                                                 5

C) Exponential moving average (EMA)
Exponential moving average differs from the simple and weighted moving average as an EMA is calculated by taking all the historical data points since the inception of the stock. Ideally, to calculate 100% accurate EMA, we should make use of all the closing prices right from the time of the listing of stock.

Calculation of the EMA is a 3 step process

Step 1: Since it is not practical to calculate historical data right from the inception of the stock, we use the SMA value as the initial EMA value. So, a simple moving average is used as the previous period's EMA in the first calculation.
Step 2: We calculate the weighting multiplier by dividing 2 by the sum of total periods and 1.
Step 3:  We subtract the EMA of the previous day from the current closing price, and multiply this number by the multiplier. We then add this product with its previous period EMA to find out the final EMA value.

Therefore, the current EMA value will change depending on how much past data we use in our EMA calculation. The more data points we use, the more accurate our EMA will be. The goal is to maximize accuracy while minimizing calculation time.

Initial EMA value = 5-period SMA

Weighting Multiplier= (2 / (Time periods + 1)) = (2 / (5 + 1) ) = 0.3333 (33.33%)

EMA= {Close – EMA of previous day} x multiplier + EMA (previous day).

A 5-period EMA applies a 33.33% weighting to the most recent prices. A 10-period EMA has a weighting multiplier of 18.18%. The shorter the time period, larger the weighting multiplier will be. We notice that as the time period doubles, the weighting multiplier drops ~50%.

Date

Close Price

5 Period SMA

Weighting factor

5 Period EMA

03-Jul-17

342.5

     

04-Jul-17

337.25

     

05-Jul-17

331.05

     

06-Jul-17

337.10

     

07-Jul-17

334.30

336.44

 

336.44

10-Jul-17

333.30

334.60

0.3333

335.39

11-Jul-17

330.40

333.23

0.3333

333.73

12-Jul-17

328.85

332.79

0.3333

332.10

7TH July EMA = 5 Period SMA= 336.44
10THJuly EMA = 335.39= (333.30-336.44) x0.33 + 336.44
11THJuly EMA = 333.73= (330.40-335.39) x0.33 + 335.39
12THJuly EMA =332.10= (328.85 -333.72) x0.33 +333.72

Comparison of the 3 moving averages
As we see by comparing the computation methodology of the 3 moving averages, different values are generated. EMA is most commonly used by traders.

Moving Averages

SMA

WMA

EMA

Advantages

1)Smoothened Average
2)Less prone to whipsaw
3)Best average to consider for support & resistance

1)Reduction in price lag, so can be implemented for short term trading 

1)Reduction in price lag, hence can be used for short term trading
2)No omission in price data points

Disadvantages

1)Has  maximum price lag
2) Assigns same weight to all price data.
3)Omission of previous data points leading to all price data not made use of

1) Omission of previous data points leading to all price data not made use of
2) Chance of whipsaw

1)Chance of  whipsaw

Moving Average Value comparison – The following table represents a comparison between the different values of the 3 types of Moving Averages over the same period of time

Date

Close Price

 5 Period SMA

Next Article

Short Put Options Trading Strategy

Short Put Options Trading Strategy
by Nilesh Jain 02/08/2017

What is short put option strategy?

A short put is the opposite of buy put option. With this option trading strategy, you are obliged to buy the underlying security at a fixed price in the future. This option trading strategy has a low profit potential if the stock trades above the strike price and exposed to high risk if stock goes down. It is also helpful when you expect implied volatility to fall, that will decrease the price of the option you sold.

When to initiate a short put?

A short put is best used when you expect the underlying asset to rise moderately. It would still benefit if the underlying asset remains at the same level, because the time decay factor will always be in your favour as the time value of put will reduce over a period of time as you reach near to expiry. This is a good option trading strategy to use because it gives you upfront credit, which will help to somewhat offset the margin.

Strategy Short Put Option
Market Outlook Bullish or Neutral
Breakeven at expiry Strike price - Premium received
Risk Unlimited
Reward Limited to premium received
Margin required Yes

Let’s try to understand with an Example:

Current Nifty Price 8300
Strike price 8200
Premium received (per share) 80
BEP (strike Price - Premium paid) 8120
Lot size 75

Suppose Nifty is trading at Rs. 8300. A put option contract with a strike price of 8200 is trading at Rs. 80. If you expect that the price of Nifty will surge in the coming weeks, so you will sell 8200 strike and receive upfront profit of Rs. 6,000 (75*80). This transaction will result in net credit because you will receive the money in your broking account for writing the put option. This will be the maximum amount that you will gain if the option expires worthless. If the market moves against you, then you should have a stop loss based on your risk appetite to avoid unlimited loss.

So, as expected, if Nifty Increases to 8400 or higher by expiration, the options will be out of the money at expiration and therefore expire worthless. You will not have any further liability and amount of Rs. 6000 (75*80) will be your maximum profit. If Nifty goes against your expectation and falls to 7800 then the loss would be amount to Rs. 24000 (75*320). Following is the payoff schedule assuming different scenarios of expiry. For the ease of understanding, we did not take into account commission charges and Margin.

Short Put Options Trading Strategy

Analysis of Short Put Option Trading Strategy

A short put options trading strategy can help in generating regular income in a rising or sideways market but it does carry significant risk and it is not suitable for beginner traders. It’s also not a good strategy to use if you expect underlying assets to rise quickly in a short period of time; instead one should try long call trade strategy.

 

Next Article

Short Call Ladder Options Strategy

Short Call Ladder Options Strategy
by Nilesh Jain 05/08/2017

A Short Call Ladder is the extension of Bear Call spread; the only difference is of an additional higher strike bought. The purpose of buying the additional strike is to get unlimited reward if the underlying asset moves up.

When to initiate a Short Call Ladder?

A Short Call Ladder spread should be initiated when you are expecting big movement in the underlying assets, favoring upside movement. Profit potential will be unlimited when the stock breaks highest strike price. Also, another opportunity is when the implied volatility of the underlying assets falls unexpectedly and you expect volatility to go up then you can apply Short Call Ladder strategy.

How to construct a Short Call Ladder

A Short Call Ladder can be created by selling 1 ITM call, buying 1 ATM call and buying 1 OTM call of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader. A trader can also initiate the Short Call Ladder strategy in the following way - Sell 1 ATM Call, Buy 1 OTM Call and Buy 1 Far OTM Call.

Strategy Sell 1 ITM Call, Buy 1 ATM Call and Buy 1 OTM Call
Market Outlook Significant moment (higher side)
Upper Breakeven Higher Long call strike price + Strike difference between short call and lower long call - Net premium received
Lower Breakeven Strike price of Short call + Net Premium Received
Risk Limited (expiry between upper and lower breakeven).
Reward Limited to premium received if stock falls below lower breakeven.

Unlimited if stock surges above higher breakeven.

Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs)

9100

Sell 1 ITM call of strike price (Rs)

9000

Premium received (Rs)

180

Buy 1 ATM call of strike price (Rs)

9100

Premium paid (Rs)

105

Buy 1 OTM call of strike price (Rs)

9200

Premium paid (Rs)

45

Upper breakeven

9270

Lower breakeven

9030

Lot Size

75

Net Premium Received (Rs)

30

Suppose Nifty is trading at 9100. An investor Mr. A is expecting a significant movement in the Nifty with slightly more bullish view, so he enters a Short Call Ladder by selling 9000 call strike price at Rs 180, buying 9100 strike price at Rs 105 and buying 9200 call for Rs 45. The net premium received to initiate this trade is Rs 30. Maximum loss from the above example would be Rs 5250 (70*75). It would only occur when the underlying assets expires in the range of strikes bought. Maximum profit would be unlimited if it breaks higher breakeven point. However, profit would be limited up to Rs 2250(30*75) if it drops below the lower breakeven point.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff chart:

The Payoff Schedule:

On Expiry NIFTY closes at

Payoff from 1 ITM Call sold (9000) (Rs)

Payoff from 1 ATM Calls Bought (9100) (Rs)

Payoff from 1 OTM Call Bought (9200) (Rs)

Net Payoff (Rs)

8600

180

-105

-45

30

8700

180

-105

-45

30

8800

180

-105

-45

30

8900

180

-105

-45

30

9000

180

-105

-45

30

9030

150

-105

-45

0

9100

80

-105

-45

-70

9200

-20

-5

-45

-70

9270

-90

65

25

0

9300

-120

95

55

30

9400

-220

195

155

130

9500

-320

295

255

230

9600

-420

395

355

330

9700

-520

495

455

430

9800

-620

595

555

530

Impact of Options Greeks:

Delta: At the initiation of the trade, Delta of short call condor will be negative and it will turn positive when the underlying asset moves higher.

Vega: Short Call Ladder has a positive Vega. Therefore, one should initiate Short Call Ladder spread when the volatility is low and expects it to rise.

Theta: A Short Call Ladder has negative Theta position and therefore it will lose value due to time decay as the expiration approaches.

Gamma: This strategy will have a long Gamma position, which indicates any significant upside movement, will lead to unlimited profit.

How to manage Risk?

A Short Call Ladder is exposed to limited loss; hence it is advisable to carry overnight positions. However, one can keep stop Loss in order to restrict losses.

Analysis of Short Call Ladder Options strategy:

A Short Call Ladder spread is best to use when you are confident that an underlying security will move significantly. Another scenario wherein this strategy can give profit is when there is a surge in implied volatility. It is a limited risk and an unlimited reward strategy if movement comes on the higher side.

 

Next Article

Reverse Cash and Carry arbitrage

Reverse Cash and Carry arbitrage
by Nilesh Jain 05/08/2017

Reverse Cash and Carry arbitrage is a combination of short position in underlying asset (cash) and long position in underlying future. It is initiated when future is trading at a discount as compared to cash market price. In other words, the cash market price is trading higher as compared to future. The arbitrageur/ trader can take position by selling his delivery of stocks in cash and simultaneously buying futures of same underlying assets of equal quantity. A trader must have delivery in that particular stock when there is such an opportunity available in the market.

Reverse cash and carry arbitrage occurs when market is in "Backwardation", which means future contracts are trading at a discount to the spot price.

Let’s try to understand with the help example of CEATLTD as on 26th APRIL 2017:

As we can see in the above illustration from 5paisa terminal there was a price difference between cash market price and May futures price of Rs 60.

Cash market price (as on 26th April 2017) (S)

Rs 1570

May Futures (Expiry on 29th May 2017) (F)

Rs 1510

Contract size

700

Rate of Interest

9% (p.a.)

Time to expiry (n)

29 days

Amount received from selling Delivery of CEAT

Rs 10,99,000 (1570*700)

Margin required to sell futures

Rs 1,37,595

Free cash available

Rs 9,61,405

Fair value is measured by the formula

S= F/(1+R)^n

Lending rate

0.72%

Basis

Spot price-Future price

Free cash available to lend will be Rs 10,99,000 - Rs 1,37,595 = Rs 9,61,405

Gain from amount lend is Rs 6,874.71 (9,61,405*(0.09^(29/365)))

S= 1510/(1+0.09)^(29/365)

Fair Value of spot price (S)= 1500

Current spot price= 1570

Hence, we can see that there is an arbitrage opportunity.

Risk free Arbitrage=Rs 70 (1570-1500)

To take advantage from this mispricing, trader/arbitrageur will buy futures at Rs 1510 and sell CEATLTD in cash market at Rs 1570. This would result in gross arbitrage profit of Rs 42,000 (60*700). And income received from lended amount would be Rs 6874.71, so Net arbitrage profit would be Rs 48,874.71.

Scenario analysis:

Case 1: CEATLTD rises to 1620, at expiry

Loss on underlying (cash) = (1620-1570)*700= (Rs 35,000)

Profit on futures = (1620-1510)*700= Rs 77,000

Gross Gain on Arbitrage= Rs 42,000

Inflow from lending: Rs 6874.71

Net gain from arbitrage: Rs 48,874.71

Case 2: CEATLTD falls to 1450, at expiry

Profit on underlying (cash) = (1570-1450)*700= Rs 84,000

Loss on Futures= (1510-1450)*700= (Rs 42,000)

Gross Gain on Arbitrage= Rs 42,000

Inflow from lending: Rs 6874.71

Net gain from arbitrage: Rs 48,874.71

To round up, in any reverse cash and carry arbitrage, the moment you trigger this arbitrage, your profit is fixed depending upon the arbitrage opportunity. This is also called risk free arbitrage because your profit is secured irrespective of underlying price movement.

Whenever future price of an underlying asset are higher than the current spot price, a cash and carry arbitrage opportunity arises.

Next Article

Bear Call Option Trading Strategy

Bear Call Option Trading Strategy
by Nilesh Jain 05/08/2017

What is a Bear Call Spread Option strategy?

A Bear Call Spread is a bearish option strategy. It is also called as a Credit Call Spread because it creates net upfront credit at the time of initiation. It involves two call options with different strike prices but same expiration date. A bear call spread is initiated with anticipation of decline in the underlying assets, similar to bear put spread.

When to initiate a Bear Call Spread Option strategy?

A Bear Call Spread Option strategy is used when the option trader expects that the underlying assets will fall moderately or hold steady in the near term. It consists of two call options – short and buy call. Short call’s main purpose is to generate income, whereas higher buy call is bought to limit the upside risk.

How to construct the Bear Call Spread?

Bear Call Spread can be implemented by selling ATM call option and simultaneously buying OTM call option of the same underlying assets with same expiry. Strike price can be customized as per the convenience of the trader.

Probability of making money

A Bear Call Spread has a higher probability of making money. The probability of making money is 67% because Bear Call Spread will be profitable even if the underlying assets holds steady or falls. While, Bear Put Spread has probability of only 33% because it will be profitable only when the underlying assets fall.

Strategy

Sell 1 ATM call and Buy 1 OTM call

Market Outlook

Neutral to Bearish

Motive

Earn income with limited risk

Breakeven at expiry

Strike Price of short Call + Net Premium received

Risk

Difference between two strikes - premium received

Reward

Limited to premium received

Margin required

Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs)

9300

Sell 1 ATM call of strike price (Rs)

9300

Premium received (Rs)

105

Buy 1 OTM call of strike price (Rs)

9400

Premium paid (Rs)

55

Break Even point (BEP)

9350

Lot Size

75

Net Premium Received (Rs)

50

Suppose Nifty is trading at Rs 9300. If Mr. A believes that price will fall below 9300 or holds steady on or before the expiry, so he enters Bear Call Spread by selling 9300 call strike price at Rs 105 and simultaneously buying 9400 call strike price at Rs 55. The net premium received to initiate this trade is Rs 50. Maximum profit from the above example would be Rs 3750 (50*75). It would only occur when the underlying assets expires at or below 9300. In this case both long and short call options expire worthless and you can keep the net upfront credit received. Maximum loss would also be limited if it breaches breakeven point on upside. However, loss would also be limited up to Rs 3750(50*75).

For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry Nifty closes at

Net Payoff from Call Sold 9300 (Rs)

Net Payoff from Call Bought 9400 (Rs)

Net Payoff (Rs)

8900

105

-55

50

9000

105

-55

50

9100

105

-55

50

9200

105

-55

50

9300

105

-55

50

9350

55

-55

0

9400

5

-55

-50

9500

-95

45

-50

9600

-195

145

-50

9700

-295

245

-50

9800

-395

345

-50

Bear Call Spread’s Payoff Chart:

Impact of Options Greeks:

Delta: The net Delta of Bear Call Spread would be negative, which indicates any upside movement would result in to loss. The ATM strike sold has higher Delta as compared to OTM strike bought.

Vega: Bear Call Spread has a negative Vega. Therefore, one should initiate this strategy when the volatility is high and is expected to fall.

Theta: The net Theta of Bear Call Spread will be positive. Time decay will benefit this strategy.

Gamma: This strategy will have a short Gamma position, so any upside movement in the underline asset will have a negative impact on the strategy.

How to manage Risk?

A Bear Call is exposed to limited risk; hence carrying overnight position is advisable.

Analysis of Bear Call Options strategy:

A Bear Call Spread strategy is limited-risk, limited-reward strategy. This strategy is best to use when an investor has neutral to bearish view on the underlying assets. The key benefit of this strategy is the probability of making money is higher.

 

Next Article

IPO Note - HUDCO

IPO Note - HUDCO
IPO
by Nutan Gupta 05/08/2017

Issue Opens - May 8, 2017

Issue Closes - May 11, 2017

Price Band - Rs. 56-60

Face Value - Rs. 10

Issue Type - 100% book building

% Shareholding

Pre IPO

Post IPO

Promoter

100.0

89.8

Public

0.0

10.2

Source: DRHP

HUDCO is a wholly-owned government entity with more than 4 decades of experience in providing loans for housing and urban infrastructure in India. It has an outstanding loan portfolio of Rs.36,386 cr (as on 9MFY17), which can be divided into– Housing Finance (30.86%) and Urban Infrastructure Finance (69.14%).

The offer consists of Offer for sale (OFS) of up to 204.1 mn equity shares for disinvestment by the government and employee reservation is up to 3.9 mn shares. There is a discount of Rs. 2 per share for eligible employees and retail investors.

Key Investment Rationale

HUDCO currently focuses on the low income group or the economically weaker sections for housing finance and social housing. The company’s housing finance loan book has grown at a CAGR of 21.9% over FY14-16. This segment has better NIMs and lower gross NPAs @ 3.08% (8.46% for urban infrastructure). There is an increasing demand for housing loans from Tier II/III cities. Deployment of funds towards housing loans by banks and HFCs has increased over the years.

The HUDCO Board decided to stop sanctioning new Housing Finance loans to private sector entities in FY14 in order to reduce NPAs from the private sector. As on December 31, 2016, its gross NPAs for loans made to the private sector (excluding loans given to individuals) were 5.98% compared to 0.75% for loans to state governments. Furthermore, the management decided to stop sanctions of new Urban Infrastructure Finance loans to the private sector. Since 2014, state governments and their agencies represent 99.94% of the total sanctions. As a result, net NPAs have decreased from 2.52% in FY14 to 1.51% in 9MFY17.

The issue is attractively priced at 1.4x9MFY17 P/Adj.BV (upper band price).

Risks Involved

HUDCO’s loan growth may be restricted by a slowdown in real estate and increasing competitive intensity. Also, the company faces general business risks of providing organized finance to LIG and EWS and competitive pricing of HFCs as compared to banks.