Stocks – should I invest?

The following are the steps toward financial stability – earn a regular income, save a portion of your income and grow your savings.

A savings of Rs.1 lakh will be worth much less ten years later; hence it is extremely important to grow your savings. Investments are a way to grow your savings.

Buying a stock of a company will in essence make you a part owner of the company. As the company grows, the stock value increases and your investment grows. Historically, stock investments are shown to have higher growth rates over long time periods.

Also, public companies are regulated by the SEBI and so investing in the stocks of public companies is considered a relatively safe form of investment.

What is the catch?
Investments over a short time period can be risky since share prices are volatile and the investment value can go down.
It is important to pick the right stock to invest and this may require extensive research and analysis.

Technical vs Fundamental Analysis

Investors perform analysis in order to predict market trends in price movements. The 2 most common types of analysis used by investors are: Fundamental and Technical.

FUNDAMENTAL ANALYSIS: Also known as ‘qualitative analysis’, this method primarily focuses on the overall valuation of a company using ‘fundamental’ data. An analyst typically looks at the financial statements of a company to derive its intrinsic value. This intrinsic value is compared with the company’s stock price and the decision to buy or sell is made depending on whether the intrinsic value price is below or above the current market price.

Fundamental analysts use the following information for their analysis:

• Income Statement.
• Balance Sheet.
• Cash Flow Statement.

Fundamental analysis is typically used by long-term investors and it involves analyzing the financial statements of a company over multiple years.

Fundamental Analysis Research Report.

TECHNICAL ANALYSIS: This method is based on the underlying assumption – ‘history repeats itself’. A technical analyst looks for pre-defined patterns in the data to predict future market movement.

Technical analysts use the following information for their analysis:

• Price.
• Volume.
• Time.

Technical analysis can be performed on data for a very short timeline including a few minutes or hours. This method of analysis is used by traders who expect the price to move in a certain direction and make trading decisions accordingly.

Fundamental analysis is widely used amongst institutional investors and other long term investors. Technical analysis is used by day traders and other investors with a short investment time horizon.

Technical Analysis Research Report.

Indian Markets – A 30-minute primer.

Investment in the stock markets can seem risky to some non-investors; it could be intimidating to a few others and some others might question the value behind such an investment.

This article is an initial primer to investing in the Indian stock markets. It helps understand the various aspects involved in the investment process, however, subsequent articles will go into the specifics of each step.

1. PUBLIC COMPANY: A company that has been registered to sell tiny fractions of its ownership as ‘shares’ to the general public.

2. STOCK EXCHANGE: Also known as the equity exchange, this is the market in which ‘shares’ of a public company are bought and sold (traded) by investors.

eg. National Stock Exchange (NSE), Bombay Stock Exchange (BSE).

3. FINANCIAL INSTRUMENTS: An instrument is a device designed to enable a certain business. Musical instruments produce music and medical instruments record or track medical parameters. Likewise, financial instruments are ‘contracts’ that help in conducting some kind of financial business.

A ‘stock’ in a public company is a common example of a financial instrument.

4. SEBI: The Securities and Exchanges Body of India, SEBI, is the Indian government regulator that oversees the trading of stocks and stock related instruments in India.

5. BROKERAGE: A brokerage is a registered firm that mediates between a buyer and a seller of stocks. Brokerages work on a commission basis and there is the option of an online or an offline broker. Commission and other hidden costs should be taken into consideration while choosing a brokerage.

6. DIVIDENDS: A public company can decide to share its profits with its shareholders and thereby ‘declare a dividend’. Each individual investor will receive a payout in proportion to their individual share holding in the company.

6. TAXES: Profits and losses incurred in trading stocks carry a tax liability.

7. MARKET INDEX: In order to track the overall progress of a market or exchange, each exchange has an ‘index’ that is a composition of several stocks traded in the exchange. Statistical and other measures are used to pick stocks that go into the index and hence the performance of the index is generally considered a good measure of the overall performance of the market or exchange.

8. SENSEX: Sensitive Index or SENSEX is the BSE index and it consists of the 30 largest and most actively traded stocks listed in the BSE. The initial value was set to 100 in 1979 and it’s currently valued at 11,403.

Bollinger Bands – A Primer.

OVERVIEW: A trading band is an ‘envelope’ around a certain indicator, generally a moving average. It consists of 2 lines one above and one below the indicator line. Each of these lines is equidistant and parallel to the indicator line. The distance between the indicator and the lines depends on the particular trading strategy. Trading bands are generally used to determine whether the prices are ‘strong’ or ‘weak’.

Bollinger bands is a type of trading band developed by John Bollinger. Bollinger determines the width of the band as a function of the market volatility. The width is normally one or two standard deviations above and below the moving average line.

CALCULATION: Each of the Bollinger band is placed at a distance equal to one or 2 standard deviations from the moving average. For every point in the moving average series, a new point is calculated for the upper as well as the lower band series.

INTERPRETATION: The width of the band and the period of analysis are two variables that will decide the accuracy of the analysis.

The width of the band is calculated as a function of market volatility. It is usually a factor of the standard deviation from the moving average. One or two standard deviations from the moving average is commonly used for analysis.

The period of analysis refers to the number of time slices as well as the total time period over which the analysis is performed. A 20-period time line is the recommended time period for the analysis.

Bollinger bands are used to study the relative ‘high’ or ‘low’ of price with respect to the previous price points. Prices typically move ‘within’ the Bollinger Bands envelope. Whenever the price moves outside of the envelope either upwards, or downwards, it is a sign of market strength or weakness respectively.

Whenever the market volatility decreases the bands move closer together. This in turn increases the possibility of the price moving outside the band. This can be seen in the sharp moves after a relatively calm market. Once investors witness a move in the upward direction, the uptrend will continue since other investors tend to follow suit. This is supported by the fact that the volatility in the market has not caught up with the market activity and hence the Bollinger envelope has not expanded sufficiently to contain the up trend.

The figure below shows the Bollinger band enveloping a candlestick chart.

Bollinger Bands.

Moving Averages – A Primer.

INTRODUCTION: Moving average is one of the most common indicators used by technical analysts to predict the market movement. A moving average is a series of points each of which is an average of a set of price points. For each new price point added to the price series, a new ‘moving average’ point is calculated and added to the moving average series.

The following are different types of moving average indicators.

SIMPLE MOVING AVERAGES: A simple moving average (SMA) is calculated by adding a fixed number, say ‘n’, of price points and dividing by the same fixed number, ‘n’. Each new point in the moving average series is calculated using the last ‘n’ price points. The very first moving average point can be calculated only after the first ‘n’ price points are available.

For eg. a 5-day SMA is calculated as follows:

5-day SMA = SUM(Price(n))/5

where n takes the values 1 through 5 and represents the price for the particular day.

WEIGHTED MOVING AVERAGES: The weighted moving average (WMA) is similar to the SMA, but each price point is assigned a weight. The oldest price point is assigned a weight of 1. The weight for each subsequent price point is increased by 1.

The WMA is calculated by using:

Sum(Price(m) * weight(m))/Sum(weights)

where m is assigned values from 1 to n, n being the number of periods for which the WMA is calculated.

EXPONENTIAL MOVING AVERAGES: An exponential moving average (EMA) is a type of moving average where the the most recent price point is given a higher weight in the moving average calculation. Also, unlike SMA and WMA, the older price points are not dropped out of the moving average calculation.

Each new point in the exponential moving average series is calculated as follows.
(previous EMA value + (2/(n+1) * current price point) )
where n is the number of time periods under consideration.

The EMA is thus more sensitive to the most recent price change than the SMA. This sensitivity reduces with increases in the number of time periods.

The 12 and 26-day EMAs are most commonly used; for longer term analysis 50 or 200-day EMA is used.

The following is a long-term moving average chart.

Moving Averages (Price)

Bulls vs Bears – An Overview.

Bull

A ‘Bull’ refers to an individual investor or trader who believes that the price movement is headed upwards. If the investor’s belief is with respect to a stock, the investor is referred to as being ‘bullish’ about the stock; however, if the belief is with respect to the overall market, then the investor is referred to as being ‘bullish’ about the market.

When a majority of the investors in a market are bullish about the market, the market is then referred to as a ‘bull market’.

A bull market often lures new bullish investors and creates a market rally that trends upward.

Bear

A ‘Bear’ refers to an individual investor or trader who believes that the price movement is headed downwards. If the investor’s belief is with respect to a stock, the investor is referred to as being ‘bearish’ about the stock; however, if the belief is with respect to the overall market, then the investor is referred to as being ‘bearish’ about the market.

When a majority of the investors in a market are bearish about the market, the market is then referred to as a ‘bear market’.

A bear market often creates new bearish investors and creates a market rally that trends downward.

Trader vs Investor – 5 Differences.

Investors view stocks as a form of ‘investment’. They typically look for investments that will yield a reasonable return over a period of time.

Investors are further classified as ‘value investors’ and ‘growth investors’. Value Investors look for ‘bargains’, or stocks that are under priced based on complex valuations. Growth investors on the other hand look for ‘high growth’ sectors and stocks that will typically yield higher than average returns.

Warren Buffet, named as the top money manager of the 20th century, is a noted value investor. In 2008 he was named the world’s richest man with a net worth of $58B.

A trader buys and sells securities with the sole purpose of making a profit. Traders look for opportunities in price fluctuations and make trade to cash in on these opportunities. They typically use technical analysis to identify trading opportunities.

Professional traders are often ‘money managers’ who make trades for clients. They use complex technical analysis tools to predict market movement.

The following is a list of major differences between investors and traders.

1. INVESTMENT GOALS: Investors buy shares with the of holding the shares – typically referred to as a ‘buy and hold’ strategy. They view shares as a form of investment, similar to any other investment eg. real estate investment.

Traders buy shares with the intention to sell as soon as they make a desired profit.

2. RISK PROFILE: Investors are more risk averse and traders are generally more willing to take risks.

3. INVESTMENT TIMELINE: Investors look at a long time frame for investments, while traders are typically looking at anything between a few seconds to a few weeks.

4. OWNERSHIP: Investors look at shares as ‘assets’ that they own, whereas traders do not have a sense of ownership towards share that they purchase.

5. TAXES: Tax liabilities vary widely between investors and traders, primarily due to differences in the holding time frames.

Candlesticks – Overview – 1 of 4.

BASIC CANDLESTICK LAYOUT: Stock prices vary throughout the day and are used in computations and charts as the building blocks of technical analysis. At the end of the day, the price data is recorded and stored as ‘historic’ data. The ‘High’, ‘Low’, ‘Open’ and ‘Close’ are the four different price points of interest to technical analysts.

The Candlestick chart, originally invented by the Japanese, provides a basic layout to represent the H-L-O-C data. Each ‘candlestick’ represents the price data (H-L-O-C) for a single time slice, typically 1 day.

As shown in the figure below, the ‘body’ of the candlestick represents the ‘High/Low’ values, while ‘shadows’ represent ‘Open/Close’. The ‘upper shadow’ represents ‘High’ and the ‘lower shadow’ represents ‘Close’. If the body is green, the lower end is the ‘Open’ and the upper end is the ‘Close’. If the body is red, the lower end is the ‘Close’ and the upper end is the ‘Open’.



Candlestick charts are powerful tools that can be used to visually interpret the price movement. The green candlestick indicates a ‘bullish’ investor sentiment while a red one indicates a ‘bearish’ investor sentiment.

The size of the body as well as the shadows and the pattern formed by multiple candlesticks are used as patterns to predict future price movements in the market.

The figure below shows a 3-month candlestick chart of ABB Ltd. from www.mumbaitrader.com.

ABB Ltd. 3-month candlestick from www.mumbaitrader.com.

Technical Analysis – Learn the language.

1. SUPPORT: Support is defined as the price level at which the price stops going down. It is the price point on a chart at which the downtrend reverses and the price stops going further down.

2. RESISTANCE: Resistance is defined as the price level at which the price stops going up. It is a price point on a chart at which the uptrend reverses and the price stops going further up.

3. TREND: Technical analysis is used to study the strength of a ‘trend’ or ‘directional surge’ in a particular indicator. The sooner the trend is detected the greater the success of the technical analyst.

4. CONGESTION: Congestion is said to happen whenever a stock trades below support or above resistance or both. In this particular scenario, called congestion, there is an excess number of traders looking to exit their contract positions, in comparison to those willing to enter into a new offsetting position. This will force contract holders to sell at a discount, thereby keeping the stock price between the support and the resistance levels.

5. CORRECTION: Correction is defined as a temporary downtrend in the price movement of a stock. The temporary nature of a correction will result in it being ultimately followed by an uptrend . Technical analysts predict corrections so that they can enter into long positions and then benefit from the uptrend that is to follow.

6. BREAKOUT: A breakout is said to happen when the share price moves by a significant percentage outside of the current trading band. A breakout typically happens when the price increases by a significant amount above the current level of resistance.

7. CONTINUATION PATTERNS: A continuation pattern is said to occur whenever there is a temporary break in a certain trend after the price movement reverts back to the original trend.

8. REVERSAL PATTERNS: A reversal pattern is said to occur when after a breakout from a certain trend, the price movement is such that there is a turnaround in the trend.

9. MOMENTUM: Momentum is a technical indicator that measures the abolute difference between today’s closing price and the close from N days ago.

10. DIVERGENCE: A divergence is said to occur whenever the price and an indicator move in opposite directions.

Technical Analysis – does history repeat?

INTRODUCTION: Technical analysts are folks who will swear by the old adage ‘history does repeat itself’. Technical analysis strategies are based on the assumption that investors react the same way to the same types of events. Technical traders thereby use past data and patterns to predict future market movement.

CHARTS: Charts are the basis of technical analysis. Charts are used to study movement in the price and volume data of a stock over a period of time.

PRICE: Price refers to the actual price of the stock for each of the transactions that have occured during the given time period. This is the primary measure used in the different technical analysis studies.

VOLUME: Volume is the number of shares of the stock that have been traded during the given time period. It is a very important measure that is normally studied in connection with price.

For example, say, the price of a during the course of a day increases by 10%. If the volume during the same period also increases, then it is considered a strong trend, versus if the volume during the day had decreased.

TIME: Time refers to the period over which the price and volume data are studied. The ‘time’ can range from a few seconds to a few years. Most commonly used time periods are: intraday, daily, weekly, monthly, quarterly and annually.

Charts are generally used to study indicators, trends and patterns. All of these studies use the price and volume data over a certain time period to predict future market movement.

• A trend refers to the general direction in which the market is headed – ‘up’ or ‘down’ or ‘horizontal’. There are different trends that are studied by technical analysts.
• An indicator is an analysis performed to predict market direction. Indicator values are calculated using price and volume data. Some common indicators are moving average, MACD, RSI and so on.
• A pattern refers to a certain formation in the appearance of a chart. There exists some common patterns that indicate a certain trend in the price movement. Examples of common chart patterns are: Head & Shoulders, Cup & Handle, Double Tops & Bottoms, Triangles, Gaps, Wedge, Rounding Bottom and so on.

There is strong evidence both in favor of as well as against the effectiveness of technical analysis in accurately predicting market movement. However, this is a widely practiced method amongst the analyst community.

The following is an example of a technical chart of WIPRO over a 3-month period as seen in www.mumbaitrader.com.

Wipro technical chart from mumbaitrader.com