The Mathematics of Financial Modelingand Investment Management

19-EquityPort Page 572 Friday, March 12, 2004 12:40 PM

572 The Mathematics of Financial Modeling and Investment Management

average price over the 200 days is determined. A more complex moving

average can be calculated by giving greater weight to more recent prices.

Advance/Decline Line

On each trading day, some stocks will increase in price or “advance”

from the closing price on the previous trading day, while other stocks

will decrease in price or decline from the closing price on the previous

trading day. It has been suggested by some market observers that the

cumulative number of advances over a certain number of days minus the

cumulative number of declines over the same number of days can be

used as an indicator of short-term movements in the stock market.

Relative Strength

The relative strength of a stock is measured by the ratio of the stock

price to some price index. The ratio indicates the relative movement of

the stock to the index. The price index can be the index of the price of

stocks in a given industry or a broad-based index of all stocks. If the

ratio rises, it is presumed that the stock is in an uptrend relative to the

index; if the ratio falls, it is presumed that the stock is in a downtrend

relative to the index. Similarly, a relative strength measure can be calcu-

lated for an industry group relative to a broad-based index. Relative

strength is also referred to as price momentum or price persistence.

Short Interest Ratio

Some technical analysts believe that the ratio of the number of shares sold

short relative to the average daily trading volume is a technical signal that

is valuable in forecasting the market. This ratio is called the short interest

ratio. However, the economic link between this ratio and stock price move-

ments can be interpreted in two ways. On one hand, some market observ-

ers believe that if this ratio is high, this is a signal that the market will

advance. The argument is that short sellers will have to eventually cover

their short position by buying the stocks they have shorted and, as a result,

market prices will increase. On the other hand, there are some market

observers who believe this a bearish signal being sent by market partici-

pants who have shorted stocks in anticipation of a declining market.

Market Overreaction

To benefit from favorable news or to reduce the adverse effect of unfa-

vorable news, investors must react quickly to new information.^12

(^12) Werner DeBondt and Richard Thaler, “Does the Market Overreact?” Journal of Finance
(July 1985), pp. 793–805.