Question

You are given the following information concerning the share price and returns for Cubic Technologies Ltd:

Day	Share Price	Return		Day	Share Price	Return
1	230			7	233	-0.104
2	250	0.087		8	221	-0.052
3	232	-0.072		9	201	-0.090
4	241	0.039		10	218	0.085
5	247	0.025		11	219	0.005
6	260	0.053		12	227	0.037

1.1Determine and describe the trading behaviour of an investor who follows the Dow Theory which recommends investing in securities when the market begins to rise and selling securities when the market begins to fall. What return would this strategy make over the 12 day period above? (13 %)

1.2 Calculate the return earned by an investor who uses a Buy-and-Hold portfolio starting at the same time as the Dow Theory investor above. (3 %)

1.3 Comment briefly on the performance of the Dow Theory against a Buyand-Hold strategy in this particular case as well as in general. Advise your client on the suitability of the two strategies. (5 %)

1.4 Discuss the techniques of moving averages and filter rules as they are used by technical analysts. Include in your answer a discussion of technical analysis for an investor wishing to invest in emerging markets.

Answer 1

1.1 Trading behaviour of an investor following Dow theory:

.a Buy at 250

       .b Sell at 232

       .c Buy at 241

        .d Sell at 233

      .e buy at 218

Return

Buy at 250 and Sell at 232: Return=- 8

Buy at 241 and sell at 233: return=-8

Buy at 218 and price on day 12(price 227) Return=9

Net gain/(loss) in 12 days=(7)

1.2 Return for investor with buy and hold strategy:

Buy at 230 and hold . Price on day 12=227

Net gain/(loss) in 12 days=(3)

1.3 In this case the amount of loss is less with buy and hold strategy than with Dow theory.

In general, buy and hold strategy gives a better return and strategy of Dow theory. Moreover, transaction costs of buying and selling as per Dow theory is high. It is advisable to follow strategy of buy and hold. It is very difficult to time the market accurately

1.4

The stock prices vary randomly on daily basis. But if one sees overall pattern it either moves up or down over time. Moving averages eliminate the daily random movement and capture the trend of the market .

Technical analysts use the moving averages to determine the overall trends and reversal of trends of the market.

A 50 day, 100 day or 200 day moving average can act as support level. If the price fall below these moving averages it signifies a trend reversal and gives a sell signal.

If the price is above the moving average , the trend is up and it is a buy signal.

Moving average can be explained with an example .

Let us consider 5 day moving average of the daily closing price of 12 days.

We need to calculate average price of last 5 days to find the moving average of the day as shown below.

We can see that volatility of share price is smoothen out.

There is trend reversal on 6^th day and there is continuos decline thereafter.