Sunday, July 13, 2008

Why you need to follow the latest trends to become a better investor

There is an old market cliché: The trend is your friend. So how does one identify stock market trends?

The simple concept of a moving average gives a clear visual image of what the stock market has been doing and what it is likely to do next. A moving average is an average of the index level (or share price) over a specific number of days, updated daily by replacing the oldest day’s level with the most recent day’s level.

So for a 20 day (short term) moving average, the 21st day’s level replaces the 1st day’s level in the average; the 22nd day’s level replaces the 2nd day’s level, and so on. Likewise for a 50 day (medium term) or a 200 day (long term) moving average. An exponential moving average (EMA) provides more weightage to the recent prices/levels.

Why not a 13 day moving average or a 100 day moving average? No reason. You are free to choose which averages you wish to follow. Through trial and error, I found that the 20 EMA / 50 EMA / 200 EMA combination works best for me. Of the three, the 200 EMA is the most important average because it confirms transition from a bull to a bear market (and vice versa).

Now, do a little exercise to understand the power of moving averages. Open a new tab (assuming that you are familiar with tabbed browsing) or a new window on your browser.

Go to the Yahoo! Finance site (http://in.finance.yahoo.com) which allows you to draw charts for the Sensex, Nifty and most shares listed on the two exchanges. Click on ‘BSE Sensex’ below the thumbnail chart. On the next page, under ‘Charts’ on the left panel, click on ‘Technical Analysis’. Now you’ll get to see the full 1 year chart of the Sensex. Click respectively on 200, 50 and 20 next to ‘EMA’. The three averages will get superimposed on the Sensex chart.


During Aug ’07 to Jan ’08 the last leg of the 5 year bull run played out. All three averages – 20 EMA / 50 EMA / 200 EMA moved up in tandem with the short term average on top and the long term average at the bottom. The last bull market correction happened in Aug ’07. The 20 EMA took support on the 50 EMA while the Sensex took support on the 200 EMA.

The wide gap of more than 2000 points between the 50 EMA and 200 EMA in Nov & Dec ’07 when the Sensex crossed 20000 was the first warning sign of a forthcoming correction. The 20 EMA dipped below the 50 EMA in Jan ’08 warning of trouble ahead. Both the Sensex and the 20 EMA went below the 200 EMA in Mar ’08 confirming that the market was changing trend from bull to bear.

After the bear market rally in Apr - May ’08 from 15000 to 18000 levels, the Sensex briefly nosed above the 200 EMA. All three averages bunched together - which is a sign of change. What followed thereafter was a confirmed bear market with all three averages moving down in unison – this time with the short term average at the bottom and the long term average on top.

2 comments:

stock_logic said...

You said the huge gap of 2000 between 50 day EMA and 200 day EMA was an indicator of a correction. I understand the gap signifies a possibility of a rally or a correction. Can you please quantify the critical gaps in % terms which could trigger such reversals ? e.g. 2000 is 10 % of the index. That ways.

Subhankar said...

A widening gap between the 50 day EMA and 200 day EMA signifies overbought and oversold situations. Such situations can persist for a while, but eventually a move in the opposite direction ensues.

On longer term charts, I have observed that a 2000 point gap is usually followed by a correction or trend change.

Technical analysis is not a science, and often inaccurate. It tries to measure sentiments - which can't be measured. So chart patterns made earlier and repeated several times are expected to repeat in future.

But percentages or mathematics can't predict the exact time of reversal on any consistent basis.