This is the place where the investor actually gets the “SMC Diksha”. The Global Investment Solutions and Services Company will shower him with whatever insight he thought was necessary to enter in the arena of exciting world of investment solutions.
What is saving?
A. In common usage, saving generally means putting money aside. For example, by way of putting money in the bank or investing in some avenue. Thus it is that part of the disposable income which is not spent on current consumption; i.e disposable income less consumption.
Why do I save at all?
A. You need to save because when you do so you are putting something of yours into something else in order to achieve something greater. In simple words you need to save because the money you save can be used for investment. When you invest your savings in a stock, bond, mutual fund or real estate you do so because you think its value will appreciate over time.
What is an Investment?
A. Investing money is putting that money into some form of "security" – an oft quoted word for anything that is "secured" by some assets. Stocks, bonds, mutual funds, certificates of deposit - all of these are types of securities. As with anything else, there are many different approaches to investing. For the purposes of this explanation, there are three basic styles of investing: conservative, moderate, and aggressive. In brief, a conservative investor wants to protect principal and earn income; a moderate investor is willing to take a certain amount of risk to achieve some stock price appreciation as well as current income; and an aggressive investor is primarily concerned with high overall returns even though it means taking more risk.
What are the different modes of Investment?
A. There are three basic types of investments, also known as asset classes, all of which we are going to discuss. These investments are stocks, bonds and cash. You can buy stocks and bonds as individual investments, or you can invest in them by buying mutual funds that own stocks, bonds or a combination of the two. If you invest in cash, you can put money into bank accounts and money market mutual funds or you can buy what are known as cash equivalents: Treasury bills, Certificates of Deposit and similar investments.
While you may not think of bank accounts as investments because they currently pay an abysmally low rate of interest. On the other hand, stocks and stock mutual funds have been the most profitable investments over time.
What are the basic investment objectives, which drive the investor?
A. The options for investing our savings are continually increasing, yet every single investment vehicle can be easily categorized according to three fundamental characteristics - safety, income and growth - which also correspond to types of investor objectives. While it is possible for an investor to have more than one of these objectives, the success of one must come at the expense of others. Here we examine these three types of objectives, the investments that are used to achieve them and the ways in which investors can incorporate them in devising a strategy.
Probably there is truth in the fact that there is no such thing as a completely safe and secure investment. Yet we can get close to ultimate safety for our investment funds through the purchase of government-issued securities, or through the purchase of the highest quality commercial papers. Such securities are arguably the best means of preserving principal while receiving a specified rate of return.
However, the safest investments are also the ones that are likely to have the lowest rate of income return, or yield. Investors must inevitably sacrifice a degree of safety if they want to increase their yields. This is the inverse relationship between safety and yield: as yield increases, safety generally goes down, and vice versa. In order to increase their rate of investment return and take on risk above that of money market instruments or government bonds, investors may choose to purchase corporate bonds or preferred shares with lower investment ratings. Most investors, even the most conservative-minded ones, want some level of income generation in their portfolios, even if it is just to keep up with the economy's rate of inflation.
What is Inflation?
A. Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power of money is falling. As inflation rises, every rupee will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a Re.1 worth of a good will cost Rs.1.02 in a year.
Growth of Capital
This discussion has thus far been concerned only with safety and yield as investing objectives, and has not considered the potential of other assets to provide a rate of return from an increase in value, often referred to as a capital gain. Capital gains are entirely different from yield in that they are only realized when the security is sold for a price that is higher than the price at which it was originally purchased. (Selling at a lower price is referred to as a capital loss.) Therefore, investors seeking capital gains are likely not those who need a fixed, ongoing source of investment returns from their portfolio, but rather those who seek the possibility of longer-term growth.
What is a Capital Gain?
A. An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short term (one year or less) or long term (more than one year) .It is to be noted that the money invested grows with the passage of time. However the value of money received says n years later may not be of same value as it is today. This concept is explained in Time Value of Money.
An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden.
Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.
Explain the Concept of Time Value of Money which you talked just a while ago.
A. You have two payment options:
(A) Receive Rs.10, 000 now OR (B) Receive Rs.10, 000 in three years. Which one would you choose? If you’re like most people, you would choose to receive Rs.10,000 now. After all, three years is a long time to wait. Why would any prudent person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
By receiving Rs.10,000 today, you can expect to increase the future value of your money by investing and gaining interest over a period of time. For option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided the diagram of the timeline.
If you are choosing option A, your future value will be Rs.10, 000 plus any interest acquired over the three years. The future value for option B, on the other hand, would only be Rs.10, 000. But listen patiently to the subsequent part of Diksha to find out how to calculate exactly how much more option A is worth, compared to option B.
Future Value Basics
If you choose option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is Rs.10,450, which of course is calculated by multiplying the principal amount of Rs.10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:
Future value of investment at the end of first year:
= (Rs.10, 000 x 0.045) + Rs.10, 000
= Rs.10, 450
If the Rs.10, 450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the Rs.10, 450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have Rs.10,920:
Future value of investment at end of second year:
= Rs.10, 450 x (1+0.045)
= Rs.10, 920.25
The above calculation is equivalent to the following equation:
Future Value = Rs10,000 x (1+0.045) x (1+0.045)
Think back to mathematics class in your high school, where you learned the rule of exponents, which says that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to1. Therefore, the equation can be represented as the following:
Future Value=Rs.10,000x (1+0.05)(1+1)
We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:
Future Value=Rs.10,000x(1+0.05) (1+1+1)
This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:
Future Value=Original Amount x (1+Interest Rate per period) Number of periods
Present Value Basics
If you received Rs.10, 000 today, the present value would of course be Rs.10, 000 because present value is what your investment gives you now if you were to spend it today. If Rs.10, 000 were to be received in a year, the present value of the amount would not be Rs.10, 000 because you do not have it in your hand now, in the present. To find the present value of the Rs.10,000 you will receive in the future, you need to pretend that the Rs.10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future Rs.10,000, we need to find out how much we would have to invest today in order to receive that Rs.10, 000 inthefuture.
To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the Rs.10, 000. To achieve this, we can discount the future payment amount (Rs.10, 000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) as follows:
FV=PV X (1+i)n
Final Equation: PV=
Let's walk backwards from the Rs.10,000 offered in option B. Remember; the Rs.10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the Rs.10,000 to be received in one year is represented as the following:
Present value of future payment of Rs.10,000 at end of two year:
Rs.10,000 x (1+0.045) -1
Note that if today we were at the one-year mark, the above Rs.9, 569.38 would be considered the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of Rs.10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of Rs.10,000 payment expected in two years would be the following:
Present value of Rs.10,000 in one year:
Rs.10,000 x (1+0.045)-2
Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the Rs.10,000 investment at the third year. We could put the equation more concisely and use the Rs.10, 000 as FV. So, here is how you can calculate today's present value of the Rs.10, 000 expected from a three-year investment earning 4.5%:
PV of three year investment=Rs.10,000x(1+0.05)-3
So the present value of a future payment of Rs.10,000 is worth Rs.8,762.97 today if interest rates are 4.5% per year. In other words, choosing option B is like taking Rs.8,762.97 now and then investing it for three years. The equations above illustrate that option A is better not only because it offers you money right now but because it offers you Rs.1,237.03 (Rs.10,000 – Rs.8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from option A, your choice gives you a future value that is Rs.1, 411.66 (Rs.11, 411.66 – Rs.10,000) greater than the future value of option
MORALE OF THE STORY: “A BIRD IN HAND IS WORTH TWO IN THE BUSH”. These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.
Would you please elaborate on the various Investment Options available for me?
A Yes, one can go for the following options:-
1) Investment in various instruments offered by Banks.
6) Mutual Funds. Any way do you think its necessary for me to tell you about the investment options in banks?
NO THANKS SIR. O.K, then regarding other options I will be providing you with Deeksha in the subsequent pages.
Tell me more about Stocks.
A Lets define what a stock is. Simply speaking, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. Holding a company's stock means that you are one of the many owners called shareholders of a company. Generally, we are concerned with two types of stocks namely common stock or equity shares and preferred stock or preference share. Stock prices are determined by market forces of supply and demand. The system of trading stocks is an anonymous screen based order driven trading system, which eliminates the need for physical trading floors, i.e. open outcry systems. Brokers can trade from their offices, using fully automated screen based processes. Their workstations are connected to a Stock Exchange’s central computer system via satellite using Very Small Aperture Terminus (VSATs) The orders placed by brokers reach the Exchange’s central computer and are matched electronically. Such kind of trading system exists in two of the national level stock exchanges i.e, Natonal Stock Exchange (NSE)&Bombay Stock Exchange (BSE).
It seems investing in stock is purely speculation as it’s quite uncertain that I will have some return on my investment or I MAY EVEN LOOSE MY CAPITAL.Is’nt it?
A. No, NOT AT ALL! Investing in stock is an art as well as science. Choosing a stock requires lot of analysis and skills. Basically, share price movement is analysed broadly by two approaches, namely fundamental Analysis & technical Analysis.
Explain me about the Fundamental and Technical Analysis.
A. Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry, and companies. As with most analysis, the purpose is to derive a forecast and profit from future price movements. The fundamental analysis is done on three levels namely economy, industry, and company. At the economy level, fundamental analysis focuses on economic data to assess the present and future growth of the economy. At the industry level, there is an examination of supply and demand forces for the products offered entry or exit restrictions, etc. in that particular industry. At the company level, fundamental analysis involves examination of financial data, management, business concept and competition. Fundamental Analysis includes financial statement analysis, shareholding pattern analysis, analysis of Company business & Competitive environment, SWOT analysis & Risk associated.
It’s seems to be interesting…Explain me more…
A. Well, Financial analysis includes analysis of Profit & loss statement & Balance sheet. It includes analyzing historical performance of the company & determining what the company is presently doing to predict about the future prospects of the company. The profit & loss statement shows direct impact on the company’s share value. If the company is performing well & generating good profit the share value of the company will be respectively higher than the loss making companies. General investors see net profit of the company but if we need to do in-depth analysis of the company’s actual performance then one should track the net operating profit of the company. It is because the net operating profit is the actual profit which company generates from its actual business or operations. Net profit includes other income, which is not generated from the actual operations of the business. Other income includes interest earned from the investment etc. Balance sheet analysis gives whole information about the companies assets & liabilities. Shareholding pattern also state that what amount of total outstanding shares different groups such as FII’s, Promoters, public etc are holding. Analysis of Company’s business & the industry to which it belongs is yet another important issue in fundamental analysis. With the help of the above analysis, an idea can be drawn on the health of the company.
How can we proceed for such analysis?
A. The analysis is done with either of the two approaches: Top Down Approach & Bottom UP Approach. In case of Top down approach, an investor looks at a country's economy before considering an industry to invest in. After choosing the industries or sectors that will provide return well because of the economic conditions, then the investor choose stocks from that particular industry or sector that are attractive within that industry/sector and are likely to provide better returns. The approach is quite useful in determining which sectors are attractive for particular period of time. Bottom-up investing involves the investor’s attention on a specific company rather than on the industry in which that company operates or on the economy as a whole. The approach assumes that individual companies can do well irrespective of the performance of the industry or economy even when the industry is not performing very well.
In order to forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. In technical terms, this fair value is known as the intrinsic value. The purpose of analyzing a company's fundamentals is to find a stock's intrinsic value, as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price or the stock is undervalued and that it makes sense to buy the stock. On the other hand, if the intrinsic value is less than the current share price, your analysis is showing that the stock is worth less than its price or the stock is overvalued and that it makes sense to sell the stock. There are various different methods available for finding the intrinsic value; the premise behind all the strategies is the same i.e. a company is worth the sum of its future cash flows discounted at an appropriate discount rate. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not need the advice of the random walkers and believe that markets are weak form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies. Fundamental analysis is the process of looking at a business at the fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock. Investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock.
Now I can understand how valuable fundamental analysis is? Can you tell me how can one pick scrip for doing fundamental analysis?
A There are various strategies for picking stock; the following are the generally accepted among the investors. Value investing is supposed to be the one of the best-known method available for picking stocks. The method is based upon the simple concept that invest in those companies that are trading below their inherent worth. The value investing involves the picking those stocks having strong fundamentals like earnings, dividends, book value, and cash flow ,etc., and is selling at a low price. Value investing involves the selection of those companies that seem to be incorrectly valued by the market and therefore carries the potential of price appreciation when the market corrects its error in valuation. As the method is revolved around the determination of the true value of the underlying asset, value investors does not pay any attention to the external factors affecting a company. Value investing assumes that external factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run. This is in contradiction with the Efficient Market Hypothesis (EMH), which claims that stock prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies.
Growth investing is yet another important strategy. It focuses on the future potential of a company and gives much less emphasis on its present price. In contrast to value investing, growth investing suggests the picking of those companies that are trading higher than their current intrinsic worth based on the assumption that the company’s intrinsic worth will grow and therefore share price will increase. Growth investing involves the picking of those stocks that are likely to grow substantially faster than others. It is mainly concerned with young companies. A growth investor looks for investments in rapidly expanding industries. Objective of such investing is to earn profits by way of capital gains but not dividends as almost all growth companies reinvest their earnings and do not pay a dividend.
The GARP (Growth at a Reasonable Price) investing is a combination of both value and growth investing. The strategy involves the picking of those stocks that look somewhat undervalued and have solid sustainable growth potential stored in. The strategy lies right in between the value and growth investing strategies. GARP investing, like value investing, is concerned with the growth prospects of a company and are like to see positive earnings numbers for the past few years, coupled with positive earnings projections for forthcoming years.
GARP investing looks like the perfect strategy but it is not so easy as it sounds because combining growth and value investing is very tough when it comes to practice.
CANSLIM acronym actually stands for a very successful investment strategy which are elaborated hereunder:
C = Current Earnings
The strategy emphasises on the importance of choosing stocks whose earnings per share in the most recent quarter have grown. The model maintains that investors must study the company’s financials deeply and should recognize the window dressing, if any, done in the balance sheet.
A = Annual Earnings
The strategy also acknowledges the importance of annual earnings growth as the current earnings. The system maintains that a company should have shown respectable annual growth in past few years.
N = New
The next acronym stands for anything new happening to or in the company. Any change for the betterment of the company is necessary for the company to become successful. The new may be anything like a new management team, a new product, a new market, or even a new high/low in its stock price.
S = Supply and Demand
The method takes into account the analysis of supply and demand. The method assumes that keeping all other things unchanged, it is easier for a smaller firm, with a smaller number of shares outstanding or equity, to show outstanding gains. The reason oblivious that a large-cap company requires much more demand than a smaller cap company to show the same percent of gains.
L = Leader or Laggard
The method covers the important part of making distinction between the market leaders and market laggards. In every sector or industry there are always certain stocks that lead, providing high returns to investors, and those that lag behind, providing relatively low returns.
I= Institutional Sponsorship
The strategy recognised the importance of companies having some institutional ownership. The idea behind such a criteria is that if a company has no institutional sponsorship, all of the thousands of institutional money managers have passed over the company. Other side of the interpretation is that if a very large portion of the company’s stock is owned by institutions then the company can be recognized as institutionally over-owned and it is too late to buy into the company.
M = Market Fancy
This criterion is based upon the overall market direction or conditions. It is important to consider the fact that the human psychologies do play its role in stock market, so therefore it is necessary to recognize the overall mood of the market and move consistent with the trend. This may be judged by the analysis of the price-volume chart of the stock.
Is it enough for doing fundamental analysis?
A Fundamental analysis could be as deep as possible depending upon how much you can extract from the financial number reported by the company & it also includes doing Ratio analysis. Ratio analysis is a tool used to evaluate a firm’s financial condition & performance.
Why bother with a ratio? Why not simply look at raw data?
A. Ratio is calculated because we get a comparison that may prove more useful than the raw data. For different types of analysis, various kinds of Ratios are used.
Explain me in brief about P/E Ratio.
A. P/E is simply the ratio of a company's share price to its earnings per-share. Mathematically it can be calculated as:
P/E Ratio =
Market Value per share
Earnings per share
Theoretically, a stock's P/E depicts how much investors are willing to pay per Re. of earnings. Due to this very reason, the ratio is also termed as the "multiple" of a stock. For example, a P/E ratio of 20 suggests that investors in the stock are willing to pay Rs.20 for every Re.1 of earnings that the company generates. The method is simple to analyse but it fails to take into account the company's growth prospects and other fundamentals. Generally P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. Sometime EPS is calculated from estimated earnings expected over the next four quarters. This calculation is known as the projected P/E. In third variation the PE is estimates of the next two quarters based on the EPS of the past two quarters. There isn't any significant difference between these variations. However, it is important to know that, the first calculation is based on the actual historical data. The other two calculations are based on analyst estimates that may or may not be perfect or precise.
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is somewhat more than a measure of a company's past performance. The ratio also takes into account market expectations for the future growth of a company. The ratio helps us determine whether a company is over-valued or under-valued. A stock is supposed to be under valued if its PE ratio is lower than the PE ratio of other stocks belonging to the same industry. In the similar way, a stock is supposed to be over valued if its PE ratio is higher than the PE ratio of other stocks belonging to the same industry. But P/E analysis is only valid in certain circumstances and it has some shortcomings attached with it. Some of the shortcomings are as hereunder:
The EPS can be manipulated, twisted, poked and squeezed into various numbers depending upon the accounting policies. As a result of which, we often don't know whether we are comparing the same figures.
During the times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rises with the general level of prices. Thereby, P/E ratios look like lower during times of high inflation because the market believes earnings are artificially distorted upwards.
A High P/E ratio does not necessarily imply that a company is overvalued. Rather, it could mean that the market believes the company is headed for good time ahead. Similarly, a low P/E ratio does not necessarily imply that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. So, we can conclude that the P/E often doesn't tell us much, but when it comes to comparing one company to another in the same industry or to the market in general or to the company's own historical P/E ratios, the same is quite useful. Stock analysis requires a great deal much more than understanding a few ratios. It should be kept in mind that the P/E is one part of the game.
And what is this PEG Ratio?
A While the PE ratio is a commonly used ratio, some investors for more analysis make use of the PEG ratio. The ratio helps in determining a stock's value while taking into account earnings growth. It can be mathematically calculated as:
Annual EPS Growth
The ratio is a widely used analytical tool for determining the true potential of the stock. It is more acceptable as compared to the PE ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG implies that the stock is undervalued and otherwise overvalued. The PEG ratio compares a stock's P/E ratio to its expected EPS growth rate. PEG ratio is equal to one implies that the market price of the stock fully reflects the stock's EPS growth. PEG ratio greater than one indicates that the stock is overvalued or that the market expects future EPS growth to be greater than what is in current. PEG ratio less than one indicates that the stock is undervalued or that the market expects future EPS growth to be less than what is in current. As in PE ratio, here also we can use the ratio for comparison in the peer group or industry. It is important to note that the PEG ratio should be used as additional information to get a clear perspective of the investment potential of a company. The ratio can give you a clear picture if you know how to handle it.
Then what is P/BV ratio?
Ans: Likewise other ratios the P/BV ratio is also a useful tool in analyzing a stock. The ratio can be calculated mathematically as follows:
Current Market price
A P/BV ratio indicates how much investors pay for what would be left of the company if it went out of business immediately. If a stock is trading for more than their book value or in other words P/BV ratio is more than 1, it generally implies that the stock is overvalued. However, it may also tell differently that investors expect the company to have a very good return on its assets. Whereas, if a stock is trading for less than their book value or in other words P/BV ratio is less than 1, it generally implies that the stock is undervalued. It may also imply that investors expect the company to have a very poor return on its assets. P/BV ratio may not be so meaningful if a company has a large percentage of intangible assets, as they are very difficult to quantify, thereby making the book value uncertain.
Now what’s technical analysis?
A. Technical analysis is a process of identifying trend reversals to formulate the buying & selling strategies. Technical analysis includes various tools through which one can analyse the relationship between supply & demand for stocks & can predict the future movement of the same. Technical analysis is based on the charts of individual stocks. The market value of the stock is ascertained by the supply & demand factors. The movement in security shows the sentiment of market players in it. Basically we study trend of the stocks. Trends simply indicate the change in investor expectation. It is a kind of direction of movement. The share prices either decreases, increases or remains flat. Technical Analysis is based on three assumptions.
1) The market value of the scrip is determined by Interaction of supply & Demand.
2) Market discounts everything.
3) Market always moves in a trend.
Trend…is that something related to fashion? But what is the link between fashion & Stock market?
A. Oh yes… you can say that. Fashion also follows some trend. Same with the stock market. It moves in a trend. Stock market trend is divided into three parts i.e Primary waves, Secondary waves, Tertiary waves. The primary wave remains for a period of at least One year. The Secondary wave remains for at least 6 months. Time frame for the Tertiary waves is limited to one month. For making a perfect trend line, one should consider whether while making a trend line if more points are met, the more accurate would be the trend line. The bullish trend can be drawn by joining lows of the waves whereas the bearish trend can be drawn by joining highs of the waves as depicted in the following diagram. At least two points should be met while making trend line. Remember, Trend line cannot be horizontal or vertical. Always draw trend line from lowest or from highest points, never from in between as shown in the graph.
Do you know graphs plays an important role in technical analysis? How come?
Well, technical analysis is based on company’s price-volume chart.
Can you tell me how can we use charts to do Technical analysis?
A. Well, technical analysis is basically a study of company’s chart. The chart can be represented in various forms such as bar charts, Candlestick chart etc. In bar chart, the closing is displayed on the right side of bar & opening price is shown on the left side of the bar. Top of the bar represents the high of the bar and down of the bar represents the low of the bar. It can be clearer with the help of the following bar.
Same is with Candlesticks pattern. It also displays the open, close, high and low. Bullish candle and bearish candle can be differentiated by the color of the body of the bar. Generally green color represent bullish candle whereas red color represents bearish candle. These Japanese candles can send out warning signals not evident on bar charts. It can be clearer with the help of following diagrams.
I cannot understand the basis of the Technical Analysis? Can you explain this a little further?
A. Yes the technical analysis is backed by various proven theories & principles. One of them is Dow Theory. Dow Theory was developed by Charles Dow. Dow Theory is divided into 2 parts. Dow Theory part I states that the scrip moves in a trend & the trend of a scrip is divided into primary trend, intermediate trend & short-term trend. The primary trend may be in the upward or downward direction that may last for a year or more than that. It can be understood with the help of following diagram. It’s clear from this that movement of scrip is in trend. Whenever the scrip breaks its trend line, its trend gets reversed.
Dow theory part II states that if the market is making successive higher-highs and higher-lows the primary trend is up. If the market is making successive lower-highs and lower-lows, the primary trend is down. It can be understood with the help of following diagram.
That’s interesting. I never had an Idea that there would be any field like this. Is there any other theory related to technical analysis?
A. Yes, yet another widely recognized theory is Elliot waves theory. It was developed by Ralph Nelson Elliot. The theory believes that the market movement can be divided into two types of waves i.e Primary Bullish wave & Primary Bearish wave. A Primary wave (bullish / bearish) consists of Secondary wave & tertiary Wave. Secondary waves are of two types of wave namely impulsive waves & Corrective waves Impulsive Wave consists of five tertiary waves & Corrective wave consist of three tertiary waves.
Elliot waves theory states that the movement of scrip occurs in five waves in the direction of the primary bullish trend & in three waves in primary bearish waves. The primary bullish trend is followed by 5-3 waves movement divided into Impulsive & Corrective waves. This 5-3 waves movement is further divided into tertiary waves. Waves 1, 3, and 5 are called Impulsive tertiary waves & 2 and 4 waves are called Corrective tertiary waves. Waves a, b, and c are the tertiary trend made by corrective waves. According to Elliot waves theory, the third wave can never be a shortest wave of the three waves.
But how can we know at what point to buy or sell?
A. For this you need to know about support & Resistance levels also.
What is Support & Resistance!?
Support & resistance levels are those levels, which help in determining the exact buy & sell point in the scrips. A support level exists at a price where demand for a stock is expected to prevent further fall in price levels. The fall in the price may be stopped for the time being or it may result even in change in the trend of scrip. Support levels are made taking in consideration the past trend of the scrips. A resistance level is the point at which sellers take control of prices and prevent them from rising further. At a resistance level the supply of the scrip is greater than the demand & further price rise is prevented. The selling pressure is greater & the increase in price is stopped for the time being. (Watch diagrams for more insight)
When a stock touches certain level & drops down then the level is called Resistance level & when the stock reaches down to a certain level & then rises, that level is called support level. If the stock breaks the support level & then moves downward, it means that the selling pressure has overcome the potential buying pressure. If the scrip breaks its resistance level & price move further then it means buying pressure would be more than the selling pressure. The support & resistance level need not to be formed only on tops or bottoms. They can also be formed on the trend lines. Support levels represent the price where the majority of investors feel that prices will move higher and resistance levels represent the price at which a majority of investors feel that the prices will move lower.
How can we decide that is it a right time to buy or not?
A. Yes, for this you need to know about the various indicators in technical analysis that will tell you about the movement of the stock. Mainly there are two types of indicators: Lagging Indicators & Leading Indicators.
Can you explain me about Leading & Lagging Indicators?
A. Well, Leading Indicators are those, which generate Buy or Sell signal before the stock starts to follow a particular pattern or trend whereas Lagging Indicators are those which generate Buy or Sell signal after the stock starts to follow a particular pattern or trend. One should use leading indicators during trading markets & lagging indicators during trending markets. Some popular lagging indicators include moving averages and MACD & some of the popular leading indicators include Commodity Channel Index (CCI), Relative Strength Index (RSI), Stochastic Oscillator and Williams’s %R.
Please explain to me about these lagging Indicators.
A. One of the most popular lagging Indicator is Moving Average & MACD.Moving averages are the average prices of scrip at a given time. The market indices do not rise or fall in straight line. Moving average includes the recent data in its observation. For example if we are using 13 days moving average then on 14th day the data of the first day will automatically be eliminated from the first observation. When we calculate a moving average we used the closing price of the stock & while calculating moving average one must specify the time period to calculate the average price.Through moving averages we study the movement of the market as well as the movement of the individual scrip. We use different time period for moving average for analysing scrip movement for different time period. For example for short-term trend we use 10 to 30 days moving average, for medium term we use 50 to 125 days moving average & for long term we generally use 200 days moving average. We can use combination of different moving average for predicting scrip movement. 5/13 days moving average is considered to be the bestcombination for predicting market movement.
The two most popular types of moving averages are:
1) Simple Moving Average (SMA).
2) Exponential Moving Average (EMA).
1) Simple Moving Average (SMA)
A Simple moving average is calculated by dividing the summation of security’s prices for the most recent "n" time period. For example, Summation of the closing prices of a security for most recent 13 days and then dividing it by 13 will result in the average price of the security in the last 13 days.
2) Exponential Moving Average (EMA):
Exponential Moving Average is similar to a simple moving average except that more weight is given to the latest data. EMA apply more weightage to recent prices as compared to older prices. The shorter the EMA's period, the more weight that will be applied to the most recent price. We can calculate EMA with the help of following formula
Current EMA = (K * (Current Price - Previous period's EMA) + Previous period's EMA; where
K = 2/(1+N) &
N = Number of periods for EMA
And what about MACD?
A MACD is trend-following momentum that shows the relationship between two moving averages of prices. Mathematically, it is the difference between 26-days exponential moving average (EMA) from the 12-days EMA of price. The line so drawn is termed as MACD. There is another line called signal line or trigger line and is calculated as the 9-days EMA of the MACD. With the help of these two lines one can easily generate buy and sell signals.
The indicator can be interpreted in following ways:
1. Crossovers - Whenever the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell. On the other hand, when the MACD lies above the signal line, the indicator gives a bullish signal, suggesting that the price of the asset is likely to move u.
2. Divergence - When the security price diverges from the MACD there is an indication of change in the current trend. In order to thoroughly understand the indicator one must closely watch the relationship between the two lines i.e MACD & trigger line. The two lines tend to crossover each other from time to time signaling buy and sell action. It is clearly understood that crossovers will signal the beginning of a new trend and end the current trend. There is another line called average line and is helpful in determining the strength of the signal generated by the crossovers. If the MACD line crosses over the trigger line above the average line, it is understood that a bullish trend will continue. If the MACD line crosses over the trigger line below the average line, it indicates a slight change in price but not change in direction of the trend.
What about Leading Indicators? Explain me about them.
A. Well, first of all I’ll explain you about CCI i.e Community Channel Index. Donald Lambert developed the Community Channel Index. The Community Channel Index evaluates the variance in the present stock price from its statistical mean. The indicator in advance indicates that the stock is in the overbought zone if the above 100 & in oversold zone when it is below –100. If it is above 100 then it means that prices are high compared to its average prices & if it is below –100 it means that prices are low compared to it’s average prices. In short, it generates buy signal when it rises above –100 & generates sell signal when it drops below +100.
I got your point. What about other indicators?
A. Next one is RSI….Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a popular price momentum oscillator. The indicator oscillates in a range between 0 and 100 representing a comparison of the magnitude of a stock's recent gains to the magnitude of its recent losses.
The Formula use for the calculation of the RSI is as follows:
RSI = 100 - 100 / (1 + RS)
RS is calculated as the ratio of two exponentially smoothed moving averages
RS = AG / AL
AG = Average Gain over RSI Period
Gain = Price - Price.x (when Price > Price.x)
AL = Average Loss over RSI Period
Loss = Price - Price.x (when Price < Price.x)
x is the Momentum Period
Overbought / Oversold
The RSI indicator ranges in value from 0 to 100, with numbers above 70 indicating overbought conditions and below 30 indicating oversold. If the RSI rises above 30, it is considered bullish, while if the RSI falls below 70,it is considered bearish.
Crossing the Center Line
Different investors have different views regarding the interpretation of RSI; some investors view a move above50 as a bullish confirmation, and a move below 50 as a bearish confirmation. This is backed by the logic that a move above 50 represents average gains overtaking average losses, while a move below 50 signifies that average losses have taken the lead.
Are these indicators sufficient for doing technical analysis?
A. Well, all the indicators can be used for the second confirmation of the results generated by the first indicator. One of the most important indicators is Stochastic Oscillator. George Lane developed this indicator. It measures the relationship between an issue's closing price and its price range over a predetermined period of time. It is a technical momentum indicator that compares a security's closing price to its price range over a given time period. Generally, 14 days period is used while any time period can be used according to the perception of the analyst.
The mathematical calculation involved is as hereunder:
%K = (100) * [(C - L14) / (H14 - L14)]
C = the most recent closing price
L14 = the lowest of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.
Transaction signals occur when the %K crosses through a three-period moving average called the "%D".
The %D calculated as hereunder:
%D = 100 * (H3/L3)
The logic behind this indicator revolved around the theory that in an upward-trending market prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Analyst favors this indicator the indicator tells in advance when a stock has moved into an overbought or oversold territory. The indicator is highly popular as it is easy to perceive with a high degree of accuracy. There are two line namely K line & D line. The K line is the fast line and the D line is the slow line. In order to generate signals from the indicator, the investor needs to see the movement of the D line and when the price of the issue begins to change and move into either the overbought (over the 80 line) or the oversold (under the 20line) positions.
And what about Williams’s % R?
A. It is also one of the interesting indicators to predicting stock movement. Williams %R, developed by Developed by Larry Williams, is a momentum indicator that works much like the Stochastic Oscillator. The indicator is popular for measuring overbought and oversold levels. The scale ranges from 0 to -100 with range from 0 to -20 considered overbought, and range from -80 to -100 considered oversold. It, is also sometime referred to as %R, shows the relationship of the close price in relation to the high-low range over a set period of time. The nearer the close is to the top of the range, the nearer to zero (higher) the indicator will be. The nearer the close is to the bottom of the range, the nearer to -100 (lower) the indicator will be. If the close equals the high of the high-low range, then the indicator will show 0 (the highest reading). If the close equals the low of the high-low range, then the result will be -100 (the lowest reading).
The mathematical calculation involved is:
%R = (high over period - close) / (high over period – low over period)
Generally, 14 days period is used while any time period can be used according to the perception of the analyst. The indicator in advance indicates that the stock is in the overbought zone or in oversold zone. If it is in overbought zone then it means that prices are high compared to its average prices and hence time to exit & if it in oversold zone then it means that prices are low compared to its average prices and hence time to enter.