Technical Analysis of Stock

Technical analysis of a stock is about studying the patterns developing in stock market to predict the future. An analogy is to predicting the climate based on developments happening in the atmosphere. Before venturing into technical analysis, the first mental block to cross is whether one should believe it or not. At times there are random events, which take all the theories completely out of hook, or is it? Once one decides that technical analysis do have a grounding behind it, it becomes much easier to appreciate, understand and apply it. Till one remains a staunch believer of randomness, it becomes difficult to believe on technical analysis. Another mental block to overcome is that technical analysis is an exact science and can be easily mapped in terms of formulas and set patterns.It might be, but the field has not advanced yet to find the formula which can fit in itself the nature of movement. This is similar to trying to find the elusive formula in physics, which can tie micro and macro mechanics. A formula which can predict the movement of a photon and electron to the movement of large objects like stars. At the moment, technical analysis is more of an art than a science. Acceptance of this fact helps to apply it in a better way, including understanding its limitations.

Technical analysis is about studying the market action in terms of price, volume and open interest. The happenings in the above three variables helps in understanding the future price movements.

Technical analysis is based on two important premises:

• In price action, the market discounts everything. There might be moment of incongruence, but that is quickly covered up by market. This is very important to understand. If some news reaches to you, the chances are that it has already been discounted. One exception is insider information and that is illegal. Refrain from it.

• The price action follows certain patterns time and again. It's like saying, History repeats itself again and again. This premise should be understood more from the perspective of psychology. In fact, technical analysis is more about understanding the combined reaction of a crowd and it's the same crowd which was there in the last hour, yesterday, day before, year before, century before. What is important to understand that basic human nature has not changed a bit from the time of Neanderthels.

The other issue that is often raised is about technical analysis vs fundamental analysis. Both has there place under the sun. Fundamental analysis is the cause of price movement. In the longer term, the movement will happen based on fundamental factors. Here please understand that fundamentals does not mean just the fundamentals of the stock but of general economy. With respect to that, technical analysis is about studying the price pattern, the effect of it and than trying to predict the future as it is playing on the price action.

If you are of the "buy and forget" type than you can rely on the fundamental analysis. The two important criteria in this is the general outlook of underlying economy and the growth potential of the company. But if you are playing for short term, especially the derivatives market, than it's important to understand both the fundamental and technical aspect of the stock. In the fundamental side, the important thing to understand is the sentiments than anything else.

Psychology in Stock Market

It would not be an exaggeration if we say that Stock market is more of a psychological game. The primary tenet on which the market works is the concept of demand and supply. The demand and supply is determined by the sentiments of the crowd against existing conditions. Also market loves extremes. On bad news, it will hammer a stock as if there is no bottom till it bottoms out. On the way up, it's taken to dizzy heights for no rhyme and reason. It's often said that in the longer term market acts as per the fundamentals of the company. But sometimes that longer term might be beyond the life time of an individual. I am not saying to ignore the fundamentals but just trying to bring out a point that fundamental is just one of the elements affecting the price action. So look for everything, the long term, medium term and short term before deciding your action.

The other often said statement is that History repeats itself and it is fairly true and has been proven

Stock Maket Technical Indicators

Bollinger Band

Bollinger Band consists of three lines. The center line is Exponential Moving Average. The top and bottom line represent the standard deviation. The three line represent a band.

• When stock prices continuously touch the upper line, it is considered as overbought condition. In case it touches continuously touches the lower line, it is considered as oversold condition.
• Typical value of the time period is 20 days.
• When the band widens, it indicates more volatility.

Exponential Moving Average

Simple Moving average has a flaw that they are susceptible to price hikes and also give equal weightage to the data in the history. Exponential Moving Average (EMA) fixes this by giving more weightage to the data of the recent past.

KDJ Indicator

Please see stochastic oscillator before KDJ indicator. KDJ introduces a new J line on top of K and D line of Stochastic oscillator. J line represents the divergence of %D value from %K value. J value can go beyond 0,100 range.

• Negative value of J with K and D on the bottom range indicates an over sold condition.
• J beyond 100 and K and D on the top range indicate an over bought condition.

Moving Average Convergence Divergence

The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. This is known as fast line. A signal line is plotted over the top of MACD, which is 9 day EMA of fast line. The fast line shows the short term consensus and the signal line depicts the long term consensus.

The buy and sell signals come when the MACD does a crossover over the signal line.

A rising MACD-Histogram shows that bulls are becoming stronger. A falling MACD-Histogram shows that bears are becoming stronger.

Related to MACS is MACD histogram which is the difference between fast and slow line. If it is positive it is plotted over the zero line and the negative difference is plotted below the zero line. A rising histogram peaks confirms a bullish trend, whereas the constantly lowering of histogram peaks on the negative side confirms the down trend.

Divergence between MACD histogram and prices occur only few time but it is a strong signal of reversing sentiments. When prices go to new high, but MACD-Histogram makes a lower top, it creates a bearish divergence. A lower top in MACD Histogram shows that bulls are weak even though prices are high. Bearish divergences shows weakness at market tops. This is a strong sell signal though many traders might feel that it is going to make new highs. Similarly the situation can be reversed when the stock makes a new low but the divergence occurs by making a lower low on the MACD histogram.

Relative Strength Index

It tells about the overbought and oversold condition. RSI value ranges from 1- 100.

• Overbought - RSI > 70
• Oversold - RSI < 30
• A large surge in prices in any direction can give a false signal.

RSI = 100 - (100/(1+RS))

RS - (Sum of closing Prices of Up days/n)/(Sum of closing prices of down days/n)

n - Trading days, usually taken as 14 days, but can be adjusted.

Stochastic Oscillator

---

Stochastic Oscillator is uses to track the momentum, the oversold and overbought condition. It is mapped on a scale of 0 to 100.

• > 80 - overbought condition
• < 20 - oversold condition.

There is a slow and fast moving stochastic oscillator. Fast (%K) is similar to Williams (%R). Fast moving one uses the actual price. Slow Moving Oscillator (%D) uses the moving average and is more smooth.

Stochastic Oscillator = 100*(closing price - price low)/(price high - price low).

The usual period is 4, 9 or 15 days.

Volume Moving Average

It's an average of the volume of a certain period. As new variables are included in the series, the oldest one is deleted.

Williams %R

It tells about the oversold and overbought condition. It is represented on a negative scale from 0 to -100. For convenience, 100 is added to it to make it 0 to 100. It is usually calculated on a 10 day period.

• %R > -20 is overbought (In 0 to 100 it is above 80)
• %R < -80 is over sold. (In 0 to 100 it is below 20).

Investment Approach of Graham vs Buffet

Benjamin Graham

---

Benjamin Graham comes from an era where there was more data underground than in the public. The computational tools were not available to a large extent and whatever was available was for select few only. Graham's approach was to pick the stocks which are quite undervalued based on couple of aspects. The aspects include price earning ratio, dividend history, prior profitability etc. and pick them up before the crowd spots them. It's is much similar to excavating for oil/diamond. However in the modern world with so much data in public, it's is very difficult for anyone to find the underdogs. Also there is a notable difference between the investing community approach in Graham's time and todays. In Graham's time, the valuation of the stock was based on the present asset value of the company. the current approach values the stock more on the future prospects that the company holds.

Warren Buffet

---

Warren Buffet approach to investment lies in looking into how best to deploy the capital, so that it earns maximum return. This approach brings the advantage that it helps in making more objective decision, without getting trapped into prior notions, inclinations or commitments. However the aspect of objectivity has to be objective, as it is very easy to cook numbers and build plans. And than wherever one deploys capital, find the right set of people to work with.

Dow Theory in Stock Market

Dow theory is an interpretation of articles written by Charles Dow in Wall Street journal. In fact the term Dow theory was coined later on by people.

The basic premises of Dow theory is trend. And trend basically reflects the barometer of the trend in economic environment. The important concepts of Dow theory are:

• Price has everything: This is most popular tenets of Dow theory. It says that the price has everything known factored in it.
• The trend in a market is classified into three stages. The first phase accumulation represents the phase when the market has bottomed out and astute investors accumulate them. When the general public catches the trend, the trend moves into a public participation phase. At the peak, when markets are going to reverse, the original astute investors start selling and the phases happen the other way round.
• A trend has a long intermediate and short term trend built into it. The long term trend is more of a barometer of long term economic outlook. Intermediate and short term trend should be looked more as technical corrections in market to adjust the overbought or oversold conditions.A long term trend is basically an economic cycle.
• Dow used to track two indicators. The manufacturing and rail companies. For an economy to be in trend, both indicators should trend in the same direction. Any divergence in the indicators points to a reversal.
• Trend exists till they are reverse.
• Look for volume to validate the trend. The large volume in the direction of expected trend validates the trend. However beware at tops and bottoms.

There are again many studies which prove or disprove Dow theory and its earning potential. Mathematics and Statistics has a lot of tools to prove or disprove many things in stock market. The important take from Dow theory is about trends. The corollary is that never try to fight the trend. One will burn its finger. This has been repeated time and again by all the famous brokers and traders. Never fight the trend.

The big question still is how to find the trends. It's usually very difficult to identify medium and short term trend as they come from technical extremes, like oversold or overbought condition. However its easier to identify the long term trend. One golden rule is that when it looks that the world is going to end tomorrow and there is no solution to the problem, we have bottomed out in economy. The market may show the reaction near to it. And when it looks that we have found the never ending road to prosperity and growth the tides has turned. Also the up trend is usually slower and painful to patience. The down trend is violent and volatile. Take an analogy of climbing a hill and getting down from it.

Why retail investor loose in Stock Market

Where the stock market will go next is the question which everyone wants to answer because in it lies the road to immense wealth. Unfortunately no one gets it right not even Warren Buffet. Every day morning the analyst in all the business channels give targets one after another as if they are putting butter on their bread. Most of these analysts are bearish or bullish based on how their investment is lied up. This has nothing to do with the reality. It's a perception which is driven by their vested interests. An investor who is fully invested will be bullish whereas an investor with cash will be bearish. This is same thing that anyone of us would do. The difference is that we do not speak on news channel. If I am holding stocks, I will expect for the stock market to go up and if I have cash I will expect it to go the other way round.

Many times we hear about valuations not supporting fundamentals. I wonder if valuations ever support fundamentals. And actually no one knows what is the mathematically precise definition of fundamentals. And if stock will start supporting fundamentals than only time the share price will move will be during the quarter results. Otherwise everyone is hoping that some one else shows more greed than they have got. And usually its the retail investor who has the maximum greed and loose the most. When you ask a retail investor about the huge pile of loss that they are sitting on they will happily tell you that they only believe in going long. They are investor and are for long term in the market. It's not that the institutional investor do not loose, but the incidents of losses is more prominent with retail investors.

The two biggest mistake a retail investor does is:

• To enter the market very late.
• To forget to sell.
• To act on tips given by their hair dresser.

Retail investors are usually one who enter the market very late, usually the last of the lot before the market starts downward. People get frightened when the market is making lows and become highly optimistic when its making highs. The higher the market the higher people expect it to go. And when it starts coming downwards, it comes so fast that the retail investor is caught off guard.

Another mistake retail investor does is to forget to sell.So many people catch cold feet when the market starts going up. They just forget to sell the stock in spite of getting good return. The greed becomes so heavy that they start building castle in the air. Every second they will click their portfolio and feel happy over the virtual money. And than suddenly the market starts going down. They still hold on in thinking that the dip is momentarily and the stock will again start going up. And one fine day it's so low that they stop looking at the portfolio. The feet are more colder. Than they start quoting Warren Buffet that they believe in only going long. They will vociferously argue about the virtue of long term investment. Most of them do not look back to their portfolio for years or for life.

Why retail investors fall in this trap time and again and how to avoid them? The main reason for this is that retails investors start looking for infinite returns. They blindly assume that the market is there for them. Also they start relating the returns to the dreams and needs of their life. The moment you move the expectation from achieving a realistic percentage term return from your investment to owning a Ferrari from the stock value, you are never going to sell your stock till you can buy Ferrari out of it. The stock value may take you to buying a Toyota Corolla and than brings back to the place where you can hardly buy a second hand car.

How to avoid these risks and hazard associated with it? Follow some basic steps and principals and you will be better off.

• Never assume that stock market is for you only. Consider it like your employer who is going to pay you till you are going to put efforts. At every moment you have to compare your risk and reward ratio. This will make you realize that the rewards are higher when the market are at historic bottoms and the risks are higher when the market are making highs. And when the ratio starts turning towards risk, its time to exit.In Warren Buffet words - "Be greedy when other are frightened and get frightened when other become greedy"
• Put Stop losses. It's important to cut down the losses before it becomes too big and also safeguard your profit to an extent. For example you have bought a stock at 25 and the stock goes to 100. Now put a strict stop loss say if it goes below 80 or 90 you are going to sell it now matter what happens. This is a discipline which needs to be inculcated.
• Retail investor buy their stocks recommended by anyone in the street. The tips reaches to them when it would have lost its relevance and already has run up or down. Also the retail investor never bothers to understand the company behind the stock. It would be a good practice to at least verify the source of tip and at whether it still is relevant. A little bit of caution would help in safeguarding the profit as well as minimizing the losses.

What markets work on?

Markets work on:

• Facts - May or may not be known to the wider public but certainly is known to some set and that's where the movement starts. Sometimes facts are created also to move the market. Facts could be an insight of someone about future events.

• Expectation - Expectations are about the possibility of something happening. It may or may not happen and which might trigger a knee jerk reaction. Expectations are build over time. Usually things happening as per expectations are factored in but not happening as per expectation can set chain reactions.

• Fads - The world acts like a big sheep flock. Tulip syndrome is a classical example of this. People has herd mentality, because it gives comfort to be in the crowd.

• Emotional makeup - We are all wired biologically. Each one of us to act and behave in certain way and to react in certain way. And we all have be trained to be socially acceptable and for that to conform to what all are doing.

My dear Rating Agencies

Imagine a movie hall where it has just caught fire, and the people are trying to rush out from every conceivable door and window. At that point, the fire safety officer comes and yells in top of his voice, that he is declaring the movie hall as unsafe from fire. That's how the rating agencies are working now. Fresh from their failure on mortgage backed bonds, and trying to build their reputation back, they are going overboard in the other direction now. In the run up to 2008, the more you rate high the more credibility it brings to you. It is quite looking convincing to me that the rating agencies are not at all forward looking but they are the followers of the street. The mortgage bonds were darling of the street at one time so it would be foolish to say that they are of junk grade. Let's give them the highest grading, and if everyone in the street is rating them high then why should not we.

The wheel has turned completely. Now the rating agencies are running the race in the other direction. Degrading countries and banks one after another and trying to grab more and more headlines. If the competing agency downgrades one country, I will downgrade two. That too after the fact that in the street everyone knows about if for some time now. The rating agencies would have been more impressive if they would have downgraded the things 8-9 months before and actually would have started upgrading the banks and institutions and sovereigns for the effort they are trying to put now to come back.

In fact, I think an important lesson can be that buy when the rating agencies start downgrades and sell when the rating agencies will start upgrading. They are so buys in themselves that they act only when the street is reached in pinnacle in terms of celebrations or gloom.