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An option in which the strike price is based on the average price of the underlying is known as an Arithmetic Asian option. Hence when we apply the MA timing strategy we are effectively constructing a dynamic portfolio that replicates the payoff of an Arithmetic Asian protective put option struck as just above the moving average level.
None of this explanation is particularly contentious — the theory behind option replication through dynamic hedging is well understood — and it provides a largely complete understanding of the way the MA market timing strategy works, one that should satisfy those who are otherwise unpersuaded by arguments purely from empirical research. There is one aspect of the foregoing description that remains a puzzle, however.
An option is a valuable financial instrument and the owner of a protective put of the kind described can expect to pay a price amounting to tens or perhaps hundreds of basis points. Of course, in the market timing strategy we are not purchasing a put option per se, but creating one synthetically through dynamic replication.
According to efficient market theory, one should be indifferent as to whether one purchases the option at a fair market price or constructs it synthetically through replication — the cost should be equivalent in either case.
Market timing rules that use classic technical analysis benefit investments and other long-term positions by finding the best prices and times to. Market timing is an investment or trading strategy: the attempt to beat technical indicators or economic data, to gauge how the market is going to move. and full -time investors who use chart analysis, economic forecasts.
And yet in empirical tests the cost of the synthetic protective put falls far short of what one would expect to pay for an equivalent option instrument. This is, in fact, the source of the alpha in the market timing strategy. According to efficient market theory one might expect to pay something of the order of basis points a year in transaction costs — the difference between the CAGR of the market timing strategy and the SPY ETF — in order to construct the protective put. Yet, we find that no such costs are incurred. Now, it might be argued that there is a hidden cost not revealed in our simple study of a market timing strategy applied to a single underlying ETF, which is the potential costs that could be incurred if the ETF should repeatedly cross and re-cross the level of the moving average, month after month.
In those circumstances the transaction costs would be much higher than indicated here. The fact that, in a single example, such costs do not arise does not detract in any way from the potential for such a scenario to play out. Therefore, the argument goes, the actual costs from the strategy are likely to prove much higher over time, or when implemented for a large number of stocks.
If the explanation offered did indeed account for the hidden costs of hedging, it would have been evident in the research findings. Consequently the market timing strategy implies one should continue to hold the market portfolio for the time being, although that could change very shortly, given recent market action.
The empirical evidence that market timing strategies produce significant alphas is difficult to challenge. But on the flip side of this is the perspective of some analysts who believe that markets are perfectly efficient because of which the future prices cannot be determined. When an analyst performs fundamental analysis on a stock or any security for that matter, he puts forward some assumptions which correlate to the timing of the buy or sell decisions pertaining to the stock.
Market timing becomes the function of his assumed variables and thesis. The more accurate his assumptions the more impeccable his timing of the trade. Generally speaking, fundamental analysis forms a mid to long term view of its stocks. Technical analysis is more shortsighted and takes a short to a mid-term view of its subject security.
Market timing in such a case becomes the function of historical performance and investor behavior. When investors do not believe in the fruitfulness of market timing strategies, they tend to use a strategy known as buy-and-hold. This strategy is based on the fact that better market return is possible only in the long run of investment. It is much closely associated with the passive management strategy of investing and is opposite to market timing strategies. However, it should be noted that a buy-and-hold investor will not always be passive in security selection.
He chooses stocks actively as and when he finds worthwhile but takes a long-term position by holding the stocks. Examples of this strategy are the investors who bought shares in Amazon stocks realizing its future potential about a decade ago. Market timing has always been at the center stage of traders and analysts.
If we take an unbiased view of trading, we might agree that it is one of the more important factors. An investment made at the right time comes to fruition more easily and hence requires a greater sense of timing knowledge and analyses in advance. A larger and all-encompassing view of market timing is difficult to take. Not only will this help you to interpret what analysts are talking about, but also to recognise patterns that could impact your own trading decisions.
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View Content Anyway I understand that I may not be eligible to apply for an account with this City Index offering, but I would like to continue. What is technical analysis? Advantages of technical analysis The advantages of technical analysis are that it can be applied to virtually any trading instrument and in any timeframe. Why is technical analysis important? City Index and technical analysis You can see some of the most popular charts and measurements used by technical analysts on our site.
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