Exponential Smoothing

Problem Definition

To develop a statistically proved trading strategy for unseasoned Investors that gives the signal to buy and sell the stock of IBM.

Model

Ñ"Ю This Model is based on the directional changes in the short term and long term trend lines.

Ñ"Ю It determines an ideal time to buy and sell stock of IBM.

Ñ"Ю It can be used as a decision making tool.

Ñ"Ю It is 3 step process

(1) Identification of Trend,

(2) Confirmation of Trend, and

(3) Buy & Sell Signal

Model & Methodology

Ñ"Ю Last 15 years from 1990 till 2004 historical adjusted actual prices were used to test the model

Ñ"Ю Adjusted actual day-end price and trend lines are plotted on a chart.

Ñ"Ю The direction of actual prices and trend lines is used to identify the changes in trend line.

Ñ"Ю The relative positions of the lines on the chart is used to confirm change in trend line.

Ñ"Ю Buy & Sell signal is determined once the trend is confirmed.

Trend Lines

Ñ"Ю Exponential Smoothing or Exponential Moving Averages (EMA) technique to plot the trend lines.

Ñ"Ю A technique where more weight is given to the most recent data.

Ñ"Ю A 21 day EMA line (EMA 21 line) is used as a short term trend.

Ñ"Ю A 200 day EMA line (EMA 200 line) is used as a long term trend

Ñ"Ю Formula:

Future Period Value = Last Period Value + SF (Last PeriodÐŽ¦s Actual Close Price ÐŽV Last Period Value)

Ñ"Ю Smoothing Factor (SF) = 2 / (n+1)

21 day EMA, SF = 2/(21+1) = 9.09%

200 day EMA, SF = 2/(200+1) = 0.995%

Ñ"Ю EMA values should not be used as forecasted stock prices.

Step 1 - Trend Identification

Step 2 ÐŽV Confirmation

Ñ"Ю Confirmation indicates start of a new trend.

Ñ"Ю If the trend is changing, the short term trend moves from one side of the long term trend line to another.

Ñ"Ю In this case, confirmation is obtained when the EMA 21 line crosses the EMA 200 line at a particular point.

Ñ"Ю E.g. Confirmation of an Upward Trend

Ñ"Ю EMA 21 moves from being below the EMA 200 line to above the EMA 200 line

Step 3 ÐŽV Investment Signal

Ñ"Ю Timing the investment.

Ñ"Ю EMA 21 line crosses the EMA 200 line confirming change in trend.

Ñ"Ю Buy Signal

Trend confirmed as upward trend.

Ñ"Ю Sell Signal

Trend confirmed as downward trend.

Testing the Model

Ñ"Ю Historical actual prices from 1993 to 1996 was used to test the model.

Ñ"Ю We bought approximately $ 10,000 of stock at each buy signal. Once bought, the stock was sold at following sell signal. Gains/losses made were not reinvested.