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Ch 4. Security Analysis
Security Analysis
Technical Analysis Eficient Market Theory
Technical analysis
Technical Analysis (Page 4.14)
Technical Analysis is a method of share price movements based on a study of price
graphs or charts on the assumption that share price trends are repetitive, that since
investor psychology follows a certain pattern, what is seen to have happened before is
likely to be repeated.
(a) Arithmetic Moving Average (AMA) (Page 4.26)
An n-period AMA, is the simple average of the last n period prices.
P1 + P2 +⋯+ P𝑛
Arithmetic moving average =
n
(b) Exponential Moving Average (EMA) (Page 4.27)
Unlike the AMA, which assigns equal weight of (1/n) to each of the prices used for
computing the average, the Exponential Moving Average (EMA) assigns decreasing
weights, with the highest weight being assigned to the latest price.
EMAT= {(Closing Price of today – Previous Day EMA) x Exponent} + Previous day EMA
Here, EMAT = EMA of today
2
Exponent =
(1+ no. of day for which exponent is calculated)
• If value of exponent is not given in question, then it can be calculated as above. For
e.g., question may have data for 8 days but it will ask to calculate exponent for 15
Days EMA then exponent = 2/(15+1) = 2/16 = 0.125
Method of solving
Closing Difference in closing Difference ×
Previous EMA
Date price of price and EMA Exponent
Day’s EMA (C ± E)
Index (B – C) (D × exponent)
A B C D E F
• AMA & EMA cannot be calculated for no trading days
• If AMA & EMA is rising -> Rising Market (Bullish trend) -> Buy share
• If AMA & EMA is falling -> Falling Market (Bearish trend) -> Sell Shares
Question based on above concept: TYK 1*
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Efficient Market Theory
Efficient Market Theory (Efficient Market Hypothesis) (Page 4.29)
As per this theory, at any given time, all available price sensitive information is fully
reflected in securities' prices. This theory states that no one can "beat the market"
hence making it impossible for investors to either purchase undervalued stocks or sell
stocks for inflated prices as stocks are always traded at their fair value on exchanges.
Empirical Evidence on Weak form of Efficient Market Theory
According to the Weak form Efficient Market Theory, there is no relationship between
the past and future price movements.
Three types of tests have been employed to empirically verify the weak form of Efficient
Market Theory- Serial Correlation Test, Run Test and Filter Rule Test.
(a) Serial Correlation Test: To test for randomness in stock price changes, one has to
look at serial correlation. For this purpose, price change in one period has to be
correlated with price change in some other period.
Step 1: Divide the period given in question in two parts (For eg. If data of 20 days is
given then divide it into 1 to 10 days & 11 to 20 days.
Step 2: Calculate the return for each day.
Change in Change in
Period 1 Closing Price Period 2 Closing Price
closing prices closing prices
Step 3: Based on return calculate the correlation between 2 periods.
Deviation Deviation Product of
Period 1 Deviation square of Period 2 Deviation square of deviation
Return of period 1 period 1 Return of period 2 period 2 1&2
(B2) (E2) (B × E)
A B C D E F G
Sum of (Deviation2 ) ̅ )2
∑(X−X
Variance (σ2) = =
Number of year N
̅ )(Y−Y
∑(X−X ̅)
Covariance (CovXY) =
N
CovAB
Correlation (rAB) =
σA σB
Step 4: If the value of correlation is more than 0.2 then we can say that correlation exist
between the past and future prices hence, market does not show the weak form of
efficiency.
Question based on above concept: AQ1
Telegram: https://t.me/carohitchipper Security Analysis CA Rohit Chipper AIR 17 (YouTube)
(b) Run Test (Page 4.37): To test a series of price change for independence, the number
of runs in that series is compared with a number of runs in a purely random series of
the size and in the process determines whether it is statistically different.
Step 1: determine the sign of closing price change (+ / -). If price increase from
previous day then sign will + and if price decrease then sign will be –
Step 2: Count the number of runs, + ve sign and – ve signs
Number of runs (r) = A run occurs when there is no difference between the sign of two
changes. When the sign of change differs, the run ends and new run begins.
n1 = No of Positive changes
n2 = No of Negative changes
For e.g., in below table: r = 4, n1 = 3 & n2 = 2
Date Closing Index value Sign of price Change Run Count (r)
1.10.07 2800
3.10.07 2780 - 1
4.10.07 2795 + 2
5.10.07 2830 + 2
8.10.07 2760 - 3
9.10.07 2790 + 4
Step 3: Calculate
• Average or expected number of runs (μ)
2𝑛1 𝑛2 𝑛1 𝑛2 + 𝑛1 𝑛2
μ= +1= +1
𝑛1 + 𝑛2 𝑛1 + 𝑛2
• Standard deviation of number of runs (σ)
(μ−1)(μ−2) 2𝑛1 𝑛2 (2𝑛1 𝑛2 − 𝑛1 − 𝑛2 )
σ=√ or √
n1 + n2 −1 (n1 + n2 )2 (n1 + n2 −1)
Step 4: Calculate the range of runs (r) which reflect weak form of market efficiency
Upper limit = μ + (σ × t) & Lower limit = μ - (σ × t)
t = Confidence value at given level of significance and degree of freedom (value of t will
be given in question)
Degree of freedom = No. of data used in standard deviation ( n1 + n2 − 1)
Step 6: If number of runs (r) as calculated in step 1 lies between upper & lower limit,
then it reflects weak form of market efficiency
Question based on above concept: TYK 2*
*Question may give high, low, opening and closing prices of the day but we have to use
only closing price in our run test calculations
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