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Investopedia ============ Copyright © 2011 Remy Noulin. Introduction =============== The document contains notes on pdfs from Investopedia. Economic Indicators ====================== - <http://www.federalreserve.gov/FOMC/BeigeBook/2009/> - Consumer Confidence : <http://www.conference-board.org/economics/consumerConfidence.cfm> - Consumer credit : <http://www.federalreserve.gov/releases/g19/current/default.htm> - Consumer Price Index : <http://www.numbeo.com/common/> - US <http://www.bls.gov/news.release/cpi.toc.htm> - France <http://www.insee.fr/en/themes/indicateur.asp?id=29&type=1&page=indic_cons.asp> - Sweden <http://www.riksbank.com/templates/Page.aspx?id=27404> - Existing-Home Sales <http://www.realtor.org/research/research/ehsdata> - GDP <http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm> - Industrial Production <http://www.federalreserve.gov/releases/g17/current/default.htm> - Jobless Claims <http://www.dol.gov/opa/media/press/eta/main.htm> - Money Supply <http://www.federalreserve.gov/> - Mutual fund flows <http://www.ici.org/research#statistics> - PERSONAL INCOME AND OUTLAYS <http://bea.gov/newsreleases/national/pi/pinewsrelease.htm> - Purchasing Managers Index (PMI) <http://www.ism.ws/ISMReport/> - Retail Sales Report <http://www.census.gov/retail/> - Trade Balance Report (nominal trade deficit) <http://www.bea.gov/international/index.htm> Financial Ratios =================== - Share Price/Earning ratio - Price/Earning to growth ratio - Price/Sales ratio - Dividend Yield - Enterprise value multiple Conference board =================== - <http://www.conference-board.org/> indicators and research in press releases - <http://www.businesscycle.com/> - University of Michigan Consumer Sentiment Index - The Consumer Internet Barometer Dow Theory ============= Technical analysis - chart patterns.\ Trends in the market: up, down, side ways, primary, secondary Exploring Oscillators and Indicators ======================================= MACD -------- The moving average convergence divergence (MACD) is one of the most well known and used indicators in technical analysis. It is used to signal both the trend and momentum behind a security.\ The MACD indicator is comprised of two exponential moving averages (EMA), covering two different time periods, which help to measure momentum in the security. The MACD is simply the difference between these two moving averages, which in practice are generally a 12-period and 26-period EMA. The MACD is plotted against a centerline along with a nine-period EMA, which is referred to as the \"signal line\".\ The idea behind this momentum indicator is to measure short-term momentum compared to long-term momentum to help determine the future direction of the asset.\ Calculation\ MACD = Short-term EMA - Long-term EMA\ \ The most commonly used moving average values are 26-day and 12-day EMAs for the MACD calculation and a nine-day EMA of the MACD for the signal line. These values can be adjusted to meet the needs of the technician and the security. For more volatile securities shorter term averages are used while less volatile securities should have longer averages. Another aspect to the MACD indicator that is often found on charts is the MACD histogram. The histogram is plotted on the centerline and represented by bars. Each bar is the difference between the MACD and the signal line or, in most cases, the nine-day EMA. The higher the bars are in either direction the more momentum behind the direction the bars point.\ \ Buy-and-Sell Signals\ The buy-and-sell signals in regard to the MACD are formed either because of crossovers or divergence. The first signal that is formed by the MACD is when the MACD line crosses the signal line, which is the EMA of the MACD. When the MACD crosses the signal line in an upward direction it is a bullish sign as the asset is gaining upward momentum. When the MACD is gaining upward momentum it reflects that the shorter term moving average (12-day) is increasing at a faster rate than the (26- day) and that the trend is starting to strengthen in the upward direction. When the MACD crosses below the signal line it suggests that upward momentum is weakening with downward pressure increasing. It is signals that the shorter term momentum is falling faster than the longer term average, signaling an increase in short-term selling. The second signal, which also deals with crossovers, occurs when the MACD crosses the centerline. If the MACD line crosses the centerline in an upward direction it signals upward momentum. This upward crossover can also be seen on the price chart at the exact movement when the 12-day moving average is crossing the 26-day in an upward direction. Downward momentum is signaled when the MACD falls below the centerline. This is the point in which the 12-day moving average falls below the 26-day moving average - a sign of increased downward momentum. The third signal that is formed by the MACD line is when it diverges from the price movement in the security. This signals that the momentum in the security is moving in the opposite direction of the true trend and suggests a future weakening in the price trend. If the MACD line is moving in an upward direction while the price is moving downward it is a bullish sign. The opposite is true if the MACD line is moving downward while the price is moving upward. The MACD indicator is by far one of the most well known and commonly used in technical analysis. It is important that anyone using technical analysis become well versed in this momentum indicator. RSI ------- The relative strength index (RSI) is another one of the most frequently used and well known momentum indicators in technical analysis. It is used to signal overbought and oversold conditions in a security. The indicator is plotted between a range of zero to 100 where 100 is the highest overbought condition and zero is the highest oversold condition. The RSI helps to measure the strength of a security's recent up moves compared to the strength of its recent down moves. This helps to indicate whether a security has seen more buying or selling pressure over the trading period. The standard calculation uses 14 trading periods as the basis for the calculation which can be adjusted to meet the needs of the user. If the trading periods used is lowered then the RSI will be more volatile and is used for shorter term trades.\ Calculation\ \ How the RSI is used\ Like most indicators there are two general ways in which the indicator is used to generate signals - crossovers and divergence. In the case of the RSI, the indicator uses crossovers of its overbought, oversold and centerline. The first technique is to use overbought and sold lines to generate buy-and-sell signals. In the RSI, the overbought line is typically set at 70 and when the RSI is above this level the security is considered to be overbought. The security is seen as oversold when the RSI is below 30. These values can be adjusted to either increase or decrease the amount of signals that are formed by the RSI. A buy signal is generated when the RSI breaks the oversold line in an upward direction, which means that it goes from below the oversold line to moving above it. A sell signal is formed when the RSI breaks the overbought line in a downward direction crossing from above the line to below the line. A more conservative approach can be used by setting the overbought and oversold levels at 80 and 20, respectively.\ Another crossover technique used in formulating signals is using the centerline (50). This technique is exactly the same as using the overbought and oversold lines to formulate signals. This technique will often form signals after a movement in the direction they are predicting but are used more as a confirmation then a signal compared to the other techniques. A downward trend is confirmed when the RSI crosses from above 50 to below 50. An upward trend is confirmed when the RSI crosses above 50.\ Divergence can be used to form signals as well. If the RSI is moving in an upward direction and the security is moving in a downward direction it signals to technical traders that buying pressure is increasing and the downtrend may be coming to an end. Divergence can also be used to signal a reversal in an upward trend where the RSI is decreasing signaling increasing selling pressure in an upward trend.\ The RSI is a standard component on any basic technical chart. The relative strength indicator focuses on the momentum underlying the security and is a great secondary measure to be used by traders. It is important to note that the RSI is often not used as the sole generation of buy-and-sell signals but used in conjunction with other indicators and chart patterns. Option greeks ================ - When IV falls, Delta falls and it falls faster for out of the money options. - When time passes, Delta falls amd it falls more for out of the money options. Option volatility ==================== Historical volatility ------------------------- When a big cap stock is having a bearish cycle, the daily price swings typically will expand, generating higher historical volatility. Implied volatility ---------------------- Let's say that an option trader is interested in buying high beta tech stock call options because he or she is bullish on the stock. Because high beta stocks have the potential to make big moves, the trader thinks that the potential for profit is higher when buying call options. However, options on these stocks, especially around pending news, can experience a change in the price even without movement of the underlying. Prices may move higher (again even without a stock price move) simply because there is a big move expected. And this will typically occur on the puts and calls. In this case, IV is going to be high. When the news comes out and the stock moves higher as expected by the trader, the results are often disappointing in terms of changes in the option price and what Delta implies the price should actually be. The reason is that the reverse movement in IV occurs, IV falls after the news (like letting the air out of a balloon) and the IV (and with it lots of extrinsic value) deflates quickly. With this drop in IV, the call buyer is often left miffed as to why he or she did not make much, if anything, on his or her speculative purchase of calls.\ Now, when it comes to put buying, there can be both good and bad surprises. The same process outlined above will operate when buying puts, especially if puts are purchased during bearish cycles in the stock (IV typically for most large cap stocks will be pumped up at this point). If the puts are purchased when they are \"cheap\" in terms of IV levels (this occurs when you buy the puts when the trend has been upward and price action relatively uniform (and assuming no big pending news outcome), then it is possible for IV to rise if the stock enters a bearish cycle. This can lead to a positive surprise in the change of the option price, provided you purchased the option when the IV was low near the market top. Here, the price would increase more than that which is suggested by Delta (leaving any significant changes due to Theta or the rate of time value decay aside for now). IV and Historical Volatility Spikes --------------------------------------- When IV is greater than historical volatility, options are thought to be overvalued, and when IV is less than historical volatility, options are considered to be undervalued. Options Mispricing ---------------------- If actual prices for options are greater than historical volatility modeled theoretical prices, IV will pick up this mispricing. The mispricing can be above or below theoretical prices, which is perhaps the easiest way to understand overvalued options (above theoretical) and undervalued options (below theoretical) pricing. When the market prices are greater than theoretical prices, IV will be greater than historical volatility and when market prices are less than theoretical prices, IV will be less than historical volatility. Volatility conditions for selling and buying options High Implied Volatility Low Implied Volatility High Historical Volatility Low Historical Volatility | \- |High Implied Volatility |Low Implied Volatility |High Historical Volatility |Low Historical Volatility| | -----------------------|-------------------------|------------------------|----------------------------|---------------------------| | Implied \> Historical |Selling Bias |Mixed |Selling Bias |Mixed| | Implied \< Historical |Mixed |Buying Bias |Mixed |Buying Bias| Vega and the Greeks ----------------------- The higher the price, the larger the Vega. This means that as you go farther out in time (imagine LEAPS options), the Vega values can get very large and pose significant risk or reward should volatility make a change. For example, if you buy a LEAPS call option on a stock that was making a market bottom and the desired price rebound takes place, the volatility levels will typically decline sharply (see Figure 11 for this relationship on S&P 500 stock index, which reflects the same for many big cap stocks), and with it the option premium.\ Typical of most big cap stocks that mimic the market, when price declines, volatility rises and vice versa. This relationship is important to incorporate into strategy analysis For example, at the bottom of a selloff, you would not want to be establishing a long strangle, backspread or other positive Vega trade, because a market rebound will pose a problem resulting from collapsing volatility. Vertical Skews ------------------ The options on stock market indexes (i.e., OEX, SPX) have a permanent reverse IV skew. This pattern of IV variability is common to most equity market indexes and many of the stocks that make up those indexes.\ With a reverse vertical IV skew, at lower option strikes IV is higher and at higher option strikes IV is lower.\ The reverse forward skew exists largely in response to the possibility of a market crash that may not be captured in the standard pricing models. That is, risk is priced into the options to take into account the possibility, however remote at any point in time, of a large market decline. Horizontal Skews -------------------- Generally speaking, it is possible for options in any one month to acquire higher IV levels than other months, and as with commodities, it is true for stocks. This phenomenon is largely driven by expected price moves surrounding an impending news event or possibly weather or supply conditions that may impact the price of commodities. These skews can arise and disappear as the news event approaches and then passes. Predicting Big Price Moves ------------------------------ Implied volatility levels were shown previously to move inversely to the price of most big cap stocks and options on major market averages. In the previous chapter on valuation, we presented past implied volatility (IV) and historical volatility levels for Altria Group, Inc. (NYSE:MO) that made this relationship very clear. However, for many stocks and commodities, this relationship does not apply. Often, high IV levels flag an impending price explosion - moves that may be up or down and that are accompanied by a collapse back to normal IV levels. You will see this pattern repeat again and again, most often in biotech stocks, but even in other tech names.\ Historical volatility may even go higher with a big price move following the event, while IV collapses back to a normal level. In Figure 17, IV (blue line) often begins to diverge sharply from historical volatility levels (brown line), and in some instances, historical volatility will move in an opposite direction to IV as the stock price volatility dampens ahead of the explosion in price that follows a run-up in IV.\ Trading this information is difficult because the direction of the price move is not known. While it is possible to try to see what insiders are doing and to mimic their behavior, this is not always easy and may lead to erroneous results. Buying out- of-the-money options is a poor strategy even if you know which way the stock is headed. This is because the options are trading at extreme price levels, as indicated by the sky-high IV. When the move occurs, assuming you bought the right options, the collapse in IV will often erase most of his gains. Selling strategies, meanwhile, may pose a problem because the price moves can be so big that you may find that the risk is not worth the reward. IV as a Measure of the Investor Crowd ----------------------------------------- When investors are fearful, and markets are bearish, VIX will rise. When fear recedes, VIX declines. However, long-term low levels of the VIX have been associated with bull markets, where VIX at extreme lows signaled a major market advance, as seen in Figure 19. In 1994 and 2004, VIX remained below 20 and the market developed significant bullish trends. ------------------------------------------------------------------------ This document was generated by *design* on *July 12, 2011* using [*texi2html 1.82*](http://www.nongnu.org/texi2html/).\