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Moving Averages: Basic Logic and Calculation

Petr Houstecky — Thu, 29 Jul 2010 18:27:23 +0000

Moving average: probably the most widely used technical indicator

Moving averages are among the most widely used technical indicators. I would even say moving average is the most widely used technical indicator, though no one can really know and count this. Moving averages enjoy this privilege thanks to their simplicity, both in calculation (or setup in a charting program) and interpretation. In this article we will explore both.

The basic logic and goal of moving averages

The main reason why people use moving averages is that the market’s price action often gives us too much information – more than we want or are able to process at a moment. For example, when the market is trending upwards and price is growing, the growth is far from a straight line. There are many smaller and bigger dips and congestions. How can you tell whether the market is merely temporarily correcting and will continue to rise soon, or the trend is reversing and a bigger decline is likely?

According to its simplest and most common interpretation, we consider an uptrend still valid if price stays above the moving average. Once price has crossed below the moving average, it is a sign that the trend has reversed to a downtrend.

Moving average doesn’t predict the future

You never know for sure what will actually happen next, but at least a moving average can simplify the information you are getting from the market and help you with fast and clear decision making. Like all other tools in technical analysis, moving average does not predict the future, but it simplifies and quantifies the information about the past.

Simple moving average calculation and moving average period

How to calculate moving averages? The most common type of moving averages, the simple moving average, is calculated just as its name suggests. It is the arithmetic average of the last N bars. N is the so called period of the moving average. The smaller N is, the faster the moving average reacts to changes in price development and the more volatile it appears. For very high N – very long moving average period – the moving average reflects changes in price trends only very slowly and it is lagging behind the price. Both long and short moving averages have benefits and weaknesses.

Most common types of moving averages

There are several different types of moving averages. Among the most popular are:

Simple moving average (the one discussed above);
Exponential moving average;
Least-square moving average;
Weighted moving average;
Adaptive moving average.

All types of moving averages follow the same logic: averaging and smoothing prices. There are only little nuances and variations in the exact calculation of particular types. Calculations of individual types of moving averages are beyond the scope of this article. If you want to study moving averages in depth, you will find additional types and various adjusted versions of these common types of moving averages.

In the Money vs. At the Money Options: An Example

Petr Houstecky — Thu, 08 Jul 2010 08:40:59 +0000

In the money vs. at the money options

In the money options are options which have positive intrinsic value. This means that at the moment of expiration (when no time value is left), the option still represents some value if you exercise it. At the money options are options with strike price equal or very close to the current (the word current is very important) market price of the underlying asset.

If you only partly know what we are talking about now, the examples that follow will hopefully help clarify it. You may also want to read other articles explaining basic principles of options, which are summarized here: Options Basic Terms & Concepts Summary.

An example of in the money and at the money options

Let’s say the shares of Caterpillar (CAT) stock are trading at 70 dollars. This is the market price of the underlying stock, which is very important for telling whether an option is in the money or at the money.

You have the following options on Caterpillar expiring shortly:

A call option with strike price of 60 dollars,
A put option with strike price of 60 dollars,
A call option with strike price of 70 dollars,
A put option with strike price of 70 dollars,
A call option with strike price of 80 dollars,
A put option with strike price of 80 dollars.

Which of these options are in the money and which of them are at the money?

At the money options

At the money options are options which have the strike price approximately equal to the current market price of the underlying stock. In our portfolio of 6 options, there are 2 at the money options:

The call with the 70 dollar strike price and
The put with the 70 dollar strike price.

The intrinsic value of both these options is approximately zero, as you would not get any advantage (= not make any money) by exercising them given the current market price of Caterpillar.

In the money options

In the money options have positive intrinsic value. If you exercise in the money options, you are able to buy (if it’s a call) or sell (if it’s a put) the underlying stock (Caterpillar) for better price compared to what you would get in the stock market without using the option. What means better?

When you are buying a stock, lower price is better. Therefore, call options (rights to buy) with strike price lower than the current market price of the underlying stock have positive intrinsic value and they are in the money.

When you are selling a stock, you prefer higher price. Therefore, put options with strike price higher than the current market price of the underlying are better to own. They have positive intrinsic value and they are in the money.

In our Caterpillar example, we have 2 in the money options:

The call option with the 60 dollar strike price (if you exercise it, you can buy Caterpillar stock for less than 70);
The put option with the 80 dollar strike (you can sell Caterpillar stock for more than 70).

What about the remaining two options?

We have not talked about the remaining 2 options:

The 80 dollar strike call and
The 60 dollar strike put.

With the market price of the underlying stock equal to 70, these options are out of the money and their intrinsic value is zero (it can’t be negative because of the optionality – you can choose not to exercise).

Every option is either in the money, at the money, or out of the money. There is no fourth category. Here you can read more about the in the money vs. at the money vs. out of the money differences.

Absorbed (Stock Market)

Petr Houstecky — Sun, 04 Jul 2010 11:06:36 +0000

Absorbed market

The expression absorbed describes a situation in the stock market, when there are corresponding orders on both sides of the market in a particular stock – it means that at the current price there are both people willing to buy and people willing to sell. As a result, in an absorbed market further transactions can be made without the stock’s price changing.

Point of absorption

At some moment the market in the particular stock can reach the point of absorption, which is the situation where no corresponding orders are left on one side and the market price of the stock must move for the outstanding orders on the other side to be filled.

Breadth Ratio

Petr Houstecky — Wed, 30 Jun 2010 07:56:28 +0000

Breadth ratio definition

Breadth Ratio is a measure of breadth of a stock market. Similarly to the Advance/Decline line or index, it compares the number of rising stocks to the number of falling stocks in a particular period. But unlike the A/D line, the breadth ratio divides the number of rising stocks by the number of falling stocks.

Breadth ratio can be measured for any time period, but most frequently for a day, week, or month.

Breadth ratio range of values

As the numbers of advancing and declining stocks can’t be negative, the breadth ratio can reach only positive values. The closer the breadth ratio is to zero, the greater share of individual stocks in the market is declining. Conversely, the higher the breadth ratio, the greater the percentage of advancing stocks. The maximum value the breadth ratio can reach is infinite in case when all stocks in the market are rising during the period measured.

Intrinsic Value of Options and Stocks

Petr Houstecky — Tue, 29 Jun 2010 09:52:01 +0000

The concept of intrinsic value in finance

Intrinsic value is a term frequently used for options and stocks, but it can be applied to any asset. As a financial term, intrinsic value of a security or asset describes the value that is contained in the asset itself. Intrinsic value is often referred to as fundamental value or fair value.

In general, intrinsic value of an asset is calculated by adding up all future income that is expected to be gained from the asset. All future cash flows must be discounted to the present value.

Intrinsic value is a different term from market value. Market value (or market price) is how much people are willing to pay for an asset and it is derived by the interaction of supply and demand (it does not necessarily equal the value contained in the asset).

Intrinsic value of companies and stocks

Intrinsic value (or fundamental value or fair value) of a company is usually calculated by summing up all future cash flows to its owners (typically dividends). All cash flows must be discounted to the present value using the required rate of return.

Intrinsic value of a stock is calculated by dividing intrinsic value of the company by the number of shares.

For complex assets like companies (or their shares of stock) different people may have different opinions regarding how much the intrinsic value is. There may be multiple different methods of calculating intrinsic value of an asset, all leading to different results. The tricky part of intrinsic value calculation is estimating the parameters. After all, who knows what the dividend will be in 5 years?

Intrinsic value of an option

For options, intrinsic value is the value by which an option is in the money. In other words, it is the value you would gain if you exercise the option immediately (for American options). Intrinsic value is one of the two components of an option’s total market value or market price (the second component is time value).

Intrinsic value is determined as the difference between an option’s strike price and the market price of the underlying security. For call options, intrinsic value is calculated by subtracting the call option’s strike price from the market price of the underlying asset. For put options, you subtract the underlying asset’s market price from the put option’s strike price. Intrinsic value of an option can’t be negative – for out of the money options it is zero.

For more detailed explanation and examples of intrinsic value calculation see BeaBu articles on intrinsic value of call options and put options.

Other meanings of intrinsic value outside finance

The meaning of intrinsic value in numismatics:

The value of the metal (e.g. gold or silver) in a coin, irrespective of the coin‘s market price or value for collectors (the logic is the same as option’s intrinsic value as opposed to option’s market price).

The meaning of intrinsic value in ethics (extract from Wikipedia article Intrinsic value (ethics)):

Intrinsic value is an ethical and philosophic property. It is the ethical or philosophic value that an object has “in itself” or “for its own sake”, as an intrinsic property. An object with intrinsic value may be regarded as an end or end-in-itself.

It is contrasted with instrumental value (or extrinsic value), the value of which depends on how much it generates intrinsic value. For an eudaemonist, happiness has intrinsic value, while having a family may not have intrinsic value, yet be instrumental, since it generates happiness. Intrinsic value is a term employed in axiology, the study of quality or value.

Accelerated Depreciation

Petr Houstecky — Mon, 28 Jun 2010 06:44:41 +0000

Depreciation

Accelerated depreciation is a method used in accounting for costs and assets. Through depreciation a company’s accounting reflects the fact that the assets the company holds (for example some machines used in producing the output) decrease in value over time (as they get old and their condition may deteriorate through using them). Technically depreciation is a decrease in asset‘s value in the accounts which at the same time is recorded as a (non-cash) cost or an expense.

Straight-line depreciation

Depreciation is often made evenly over the life of the asset – such depreciation method is called straight-line depreciation. For example in the beginning the company purchases a machine for 1 million dollars and it expects to use it for the next 5 years. Therefore the company’s accountants will every year decrease the value of the machine by one fifth or 200,000 and these 200,000 will be recorded as costs in that year.

Accelerated depreciation

But in some cases the accelerated depreciation method can be used and as the name suggests, the asset’s value will now decrease faster in the early years and slower in the end of the asset’s life. In our example, instead of 5 times 200,000 the depreciation can be 300,000 in the first year, and in the following years it can be 250,000 – 200,000 – 150,000 – 100,000. As a result, the company will show higher costs and therefore a lower profit in the first years and lower costs and higher profits in the later years.

Accelerated depreciation and taxes

Companies like using accelerated depreciation for tax purposes, because it makes their profits (calculated for tax purposes) in the early years smaller and in this way they can pay part of their taxes later. Of course the pre-tax cash flow is unaffected, as depreciation is a non-cash expense. Using accelerated depreciation for tax purposes is regulated (in the US there is the Accelerated Cost Recovery System (ACRS).

Breadth of the Market

Petr Houstecky — Sun, 27 Jun 2010 10:25:26 +0000

Breadth of the market definition

Breadth of the market represents the number of stocks participating in a particular market’s move as a percentage of the total number of stocks.

For example, let’s take the S&P500 index, which contains 500 stocks. If the S&P500 index is rising on a particular day and of the 500 stocks included in the index 450 stocks are increasing, the market has a very good breadth (90% of stocks).

Conversely, if the S&P500 is rising, but only 100 out of the 500 individual stocks record gains, it means that the market’s increase is driven only by a small number of large issues and the breadth of the market is small.

Using market breadth as an indicator

In traditional technical analysis, high market breadth (the market’s move shared by majority of the stock issues) is a sign of confirmation of the move’s direction. For example, if the stock market is falling and 80% of the individual stocks also record losses for the day, it is a sign of weakness and of the market continuing to move down.

On the other hand, if the stock market is falling, but only 30% of individual stocks are losing, the breadth of the market is quite small for the down move and it is the sign that the market might turn upwards soon, as the downtrend does not have a good foundation.

Advance/Decline line or index

A variation of the market breadth concept is the advance/decline index (or advance decline line or advance/decline indicator), which equals the number of advancing stocks less the number of declining stocks plus the previous day’s advance/decline index. The A/D line represents the continuous indicator of market breadth – it rises when more stocks are advancing, and it falls when more stocks are falling – regardless of the direction of the stock market index (like the S&P500).

Accounts Receivable Turnover Ratio

Petr Houstecky — Sat, 26 Jun 2010 12:51:53 +0000

Accounts Receivable Turnover Ratio calculation

Accounts Receivable Turnover Ratio is the ratio of net credit sales to average accounts receivable.

Net credit sales represent the value of company’s products sold to customers without collecting the cash (on credit) in a particular time period (there are two kinds of sales: cash sales, which you now don’t include, and credit sales). Net credit sales equal gross credit sales less sales discounts related to credit sales less returns and allowances related to credit sales.

Average accounts receivable are just what they sound – the average balance of accounts receivable in a time period, calculated by adding up the beginning and ending balance of accounts receivable and dividing the result by two.

Practical use of Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio is used for analyzing how fast the company’s customers pay for the products they bought, or in other words, how successful the company is in making its customers pay as soon as possible.

Measuring Directional Exposure with Delta: Single Option and Option Spreads

Petr Houstecky — Fri, 25 Jun 2010 16:52:29 +0000

Delta as a measure of directional exposure

The relationship between the underlying stock’s price changes and the option’s price changes is measured by the well known Greek letter delta. In general, delta measures by how much the value (market price) of an option or an option spread position changes when the market price of the underlying asset (e.g. a stock) changes by 1 dollar. You can see a more detailed introduction to delta here: Measuring Directional Exposure with Delta.

Besides individual options, delta can be used to measure the directional exposure of whole option spreads or other positions combining multiple options on the same underlying asset.

Delta of call options

For call options delta can reach values from zero (far out of the money options) to one (deep in the money options). At the money options have delta around 0.50. This means that when the underlying stock increases by 1 dollar, the option’s market price rises by 50 cents.

Delta of put options

For put options delta has values between negative one (deep in the money puts) and zero (far out of the money puts). At the money put options have delta around -0.50. When the underlying stock decreases by 1 dollar, the put option’s market price rises by 50 cents (same as with calls, just inverse).

Measuring directional exposure of option spreads

Options’ delta is additive and therefore it is an effective tool for measuring directional exposure also for more complicated option spreads and combinations of multiple options. You simply add all deltas of your long options and subtract all deltas of your short options and the result is the total delta of your position. You can see an example here: Option Portfolio Delta and Delta Hedging.

Bullish and bearish option spreads and delta

If the total delta is positive, you have bullish exposure to the underlying asset (you make a profit when the price of the underlying asset rises). If it is negative, you are bearish (you profit from decline of the underlying asset’s price). Unlike the delta of a single option, the total delta can be higher than one or lower than minus one for combinations of multiple options.

4 Benefits of Alternative Investments as Part of Your Portfolio

Petr Houstecky — Mon, 21 Jun 2010 13:02:39 +0000

Benefits of alternative investments

Alternative investments represent an aggregate of hedge funds, private equity, real estate, commodities, managed futures, and a growing number of other types of (often exotic and mysterious) investments. Alternative investments have become increasingly popular and talked-about in the recent past – not only due to stories about billionaire fund managers and star traders, but also because of distinct benefits alternative investments can bring to a portfolio:

Diversification potential.
Inflation hedge.
New exposures and opportunities.
Higher returns.

Benefit 1: Diversification potential of alternative investments

The popular belief that hedge funds and private equity funds are extremely risky investments on a standalone basis is justified to great extent. However, when you think about these investments in the context of total portfolio, you will find that many types of alternative assets have great diversification potential. Their returns show low correlations to traditional asset classes like stocks and bonds and therefore adding alternative investments to a portfolio can reduce volatility without sacrificing part of return. Diversification is among the strongest reasons why some types of institutional investors (including pension plans, endowments, or foundations) invest in alternative assets.

Benefit 2: Alternative investments as a hedge against inflation

Some alternative asset classes are a good inflation hedge (their returns are highly correlated to inflation). Infrastructure investments provide a low, yet stable long-term real return. Commodities are also believed to be a good inflation hedge, though you must be ready to accept much higher volatility with commodities.

Benefit 3: New exposures and opportunities

Because alternative investments are so diverse, you have plenty of opportunities to find new exposures, which are not accessible with traditional investments. Besides stocks and bonds, you can invest in commodities, infrastructure, real estate projects, or start-up business ideas.

Benefit 4: Higher returns on alternative investments

Some kinds of alternative investments are very risky on a standalone basis, but investors are rewarded for this risk by higher returns. Like all the other above listed benefits, this only applies to some types alternative investments (e.g. some hedge fund strategies or venture capital investments). Like those of traditional investments, returns of alternative investments vary over time depending on market conditions and economic cycle.

There are problems with alternative investments too

The benefits of adding alternative investments to a portfolio are so significant that many investors invest in alternative assets in spite of the difficulties that investing in alternative assets represents. These issues include low liquidity, difficult pricing and benchmarking, legal constraints, and costly due diligence process. Here you can read more about some issues with alternative investments in detail.