Lecture 1

Question 1

What are the two main portfolio allocation approaches?

Answer 1

Top down and bottom up approach.

Question 2

What is the top down approach in portfolio allocation?

Answer 2

Investors first look at the macroeconomic variables, then subsequently favor some sectors based on the macroeconomic indicators and finally pick specific firms.

Question 3

What are the PROS and CONS of the top down approach?

Answer 3

PROS: ‘easier’ to start from the big picture. More macro-ortiented and qualitative. CONS: if starting point is wrong, the entire approach is wrong. And even if the starting point is correct, the selected companies might be wrong.

Question 4

What is the bottom up approach in portfolio allocation?

Answer 4

Investors focus on picking securities based on the attribute of an individual firm (search for firms with ‘good’ potential’).

Question 5

What are the PROS and CONS of bottom up approach in portfolio allocation?

Answer 5

PROS: more flexible, micro-oriented and quantitative approach. CONS: difficult to ‘cherry pick’ the right stock at the right time. Big events (such as financial crisis 2007) can still impact the selected companies.

Question 6

What is the second broad classification on trading strategies?

Answer 6

To technical and/or fundamental analysis.

Question 7

What is technical analysis?

Answer 7

Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. It goes against the weak form of market efficiency, since chartist believe they can predict future prices since they adjust to news slowly.

Question 8

What are the 3 premises on wich the technical analysis is based on?

Answer 8

1. Market action discounts everything (anything that impacts the share price is reflected in it, thus price is all that is needed). 2 Prices move in trends (identify trends early on and trade in their direction). 3. History repeats itself (trade based on bullish or bearish psychology of the market).

Question 9

What are the key differences in technical analysis applied to futures as compared to stocks?

Answer 9

1. Pricing strucutre is much more complex for futures. 2. Futures have limited life span. 3. Future trading depends on margins and is thus impacted by leverage. 4. Trading on TA in futures has a shorter time frame.

Question 10

Define support and resistance levels.

Answer 10

Support level: a price level below the current price. The area where the buying pressure is sufficiently strong to overcome the selling pressure. Resistance level: a price level above the current price. The area where the selling pressure is sufficiently strong enough to overcome the buying pressure and a price advance is turned back.

Question 11

Define breakout, trend, and trend reversal.

Answer 11

Breakout: when price crosses prior support or resistance levels. Trend: when price movements tend to persist in one direction for an extended period of time. Trend reversal: when price movements change direction for an extended period of time.

Question 12

What is the role of volume when examining the support/resistance levels?

Answer 12

The higher the volume of a support/resistance level the more important (sure) is the level.

Question 13

What are the 3 main elements of a candle in a candlestick chart?

Answer 13

Body, determined by the opening and closing prices. Shadow: determined by highest and lowest prices. Color: gives the visual indication of the direction of movement (bullish-up, bearish-down).

Question 14

How can a long candlestick be interpreted?

Answer 14

Long shadow indicates momentum. Lack of shadow indicates consensus among traders. Long positive candle indicates momentum in an uptrend and long negative candle indicates momentum in a downtrend (reversal).

Question 15

How can a short candlestick be interpreted?

Answer 15

Short body with no shadow: agreement among investors. Both buyers and sellers agree on the price. More meaningful if there is a series of short candlesticks moving sideways.

Question 16

How can a doji be interpreted?

Answer 16

Looks like a cross (+) with an almost unexisiting body and short shadows. Reflects the fact that the open and close prices were almost the same. Mostly seen as a warning indicator that represents uncertainty in the market.

Question 17

How can a long lower/upper shadow be interpreted?

Answer 17

A short body with a long lower shadow (hammer) indicates failure of sellers to move price lower. A short body with a long higher shadow (handman) indicates a failure by buyers to move price higher.

Question 18

Explain the Dow Theory trading strategy.

Answer 18

Prices are simultaneously affected by 3 forces. Primary trend: long-term movement of prices (several months to years, can be bullish or bearish). Secondary trend: caused by short-term deviations from the primary trend. These trends are corrected when prices revert back to trend values (days to some months). Tertiary trends: daily fluctuations of little importance. This theory is the basis of majority others in TA.

Question 19

What is a moving average and what is its purpose?

Answer 19

Moving average is the average of a given amount of past prices with a fixed time window on a rolling basis. It’s purpose is to reduce noise.

Question 20

What are the PROS and CONS of a short(long) moving average? How can we select the right length?

Answer 20

PROS of short MA are: higher sensibility allows for earlier trend detection. CONS of short MA are: more sensible to outliers and can pick up noise, produce false signals and too many costly trades. The PROS and CONS of a long MA are the opposite. The right length of a MA is one that is sensitive enough to generate early signals but insensitive enough to avoid random noise. It depends on the asset traded and trading frequency.

Question 21

How is the exponential moving average calculated?

Answer 21

EMA = current price * y + EMA(t-1) * (1-y), where y = 2/(1+N) and N is the rolling window.

Question 22

What are the 3 ways we can use moving averages for trading (to check for buy and sell signals)?

Answer 22

1. Prices crossing moving average. Bullish signal when price breaks through the MA from below. Bearish signal when price breaks through the MA from above. 2. MAs themselves change direction (bullish if from down up and bearish if from up down). 3. Different MAs cross each other. Buy when shorter-term MA crosses longer-term MA from below up (golden cross). Sell when shorter-term MA crosses longer-term MA from up to below (death cross).

Question 23

What are the main advantages of moving averages as a trading strategy?

Answer 23

1. Simple enought for investors to understand. 2. Mechanical enough for investors to remain subjective in their decision making (removes emotion).

Question 24

What is the main driver of the MA strategy for its better performance compared to the just holding the S&P500?

Answer 24

Its lower volatility (aka fewer occurances of both large gains and losses and more occurances of small gains and losses). It avoids the far left tail of big negative losses.

Question 25

What do Bollinger Bands consider that the Moving Averages don’t?

Answer 25

MA only accounts for the first movement (mean), while BB also consider second movement (volatility).

Question 26

Describe Bollinger Bands as a technical indicator.

Answer 26

BB are plotted n standard deviations around (up and down) the MA. They serve as an self-adjusting indicator. They widen when volatility increases and contract when volatility decreases.

Question 27

Based on the time of the analysis (short-, intermediate-, and long-term), how are Bollinger Bands typically drawn?

Answer 27

For short-term analysis: 10 days with 1.5 STD away from the SMA. For intermediate term: 20 days with 2 STD away from the SMA. For long term: 50 days with 2.5 STD away from the SMA.

Question 28

How can the Bollinger Bands be used as a signal?

Answer 28

Sharp price changes occur after the bands tighten as volatility lessens. When prices move outside the bands, a continuation of the trend is expected. Bottoms (tops) outside the BB followed by bottoms(tops) inside the BB call for reversals.

Question 29

What is the trading range break-out rule?

Answer 29

The main idea is to find a range of prices that creates a resistance and/or a support and to be ready to then trade as soon as the price breaks one of the two. A previous peak is a resistance or a support level: a) prices will continue to increase if they cross the maximum from below (buy signal, current price exceeds recent max/resistance) and b) continue to drop if they cross the minimum from above (sell signal, current price falls below recent min/support).

Question 30

Describe the Head and Shoulder pattern.

Answer 30

It is a sequence of 3 peaks. 1. Left shoulder. 2. Head. 3. Right shoulder. The head is the highest, with two local lows in between on approximately the same level (neckline). If the price subsequently goes below the neckline, a negative trend has been initiated. Volumes support the analysis.

Question 31

What are the 5 categoreis of technical indicators?

Answer 31

1. Trend indicators (moving averages). 2. Momentum indicators (relative strength index). 3. Volume indicators. 4. Volatility indicators (Bollinger Bands). 5. Sentinment indicators (Currency Strength Indicators)

Question 32

What is the problem of using too many and too many of the same type of technical indicators?

Answer 32

Using too many technical indicators can lead to confusion. Using too many technical indicators of the same type can lead to collinearity problems.

Question 33

What is Fundamental Analysis?

Answer 33

Fundamental analysis attempts to determine the value of a company or a stock by using economic and financial quantitative and qualitative data related to the company.