Possible Nifty retracement levels

First the bad news. FIIs were net sellers of equity worth a huge Rs 127 Billion during the previous five trading sessions (Jan 22, 25, 27-29). That is the main reason for Nifty shedding 1150 points (7.8%) from its Jan 21 lifetime top (of 14753.5) to close just below its 50 day EMA.

Now the good news. Despite the sharp correction, the index is trading well above its rising 200 day EMA. That means the bull market is alive and kicking.

So, is this index dip a good time to buy? That would depend on an investor's risk tolerance and investment time horizon. The best time to buy is when you have money to spare. 

While timing the market is always difficult, it helps not to buy near market tops. Experienced investors have the patience to wait months (sometimes even years) for better buying opportunities.

For those not so experienced, having some idea of index (or stock) retracement levels can help to decide about entry points. 

Typically, Fibonacci retracement levels of 38.2% and 50% seem to work on technical charts. What are these levels for Nifty?

Let us make a couple of assumptions. The first assumption is that the index is correcting the gains made from its Sep '20 low (of 10790). A 38.2% retracement gives a figure of around 13250; a 50% retracement means about 12800. By touching a low of 13600 on Fri. Jan 29, Nifty has almost retraced 38.2%.

Note that the index has penetrated the lower Bollinger Band. Also, the Slow stochastic indicator is well inside its oversold zone. So, a technical bounce is very much within the realm of possibilities. 

Question is: Will the likely bounce rise to a new high, or get terminated at the 20 day SMA (middle Bollinger Band, marked by green dotted line)? In the latter case, the correction may resume and the index can drop to lower levels.

That leads us to our second assumption - that Nifty is actually in the process of correcting all gains made since its Mar '20 low (of 7511). A 38.2% retracement gives a figure of around 12000; a 50% retracement can drop the index to 11150.

That leaves the door open for a test of support from the 200 day EMA - currently at 12200. What if the 200 day EMA is breached and the index does fall to 11150 (however unlikely it may seem now)?

Then we may need to reassess the sustainability of the current bull phase. The annual budget on Feb 1 can have some short-term effect on the market. Long-term, it is profitability and earnings growth of India Inc. that will decide the winners and losers.

Sticking to large-cap market leaders won't hurt.

Market Timing Tips Every Investor Should Know

It's a long-held belief that market timing and investing are mutually exclusive, but the two strategies work well together in producing solid returns over a number of years. 

The effort requires a step back from the buy-and-hold mindset that characterizes modern investing and adding technical principles that assist entry timing, position management and, if needed, early profit taking.

This set of technical tips can guide your investments through a gauntlet of modern market dangers:

https://www.investopedia.com/articles/active-trading/043015/market-timing-tips-rules-every-investor-should-know.asp

Are the movements of a stock market index predictable?

That may sound like a strange question coming from some one who regularly writes about the movements of Sensex, Nifty, S&P 500, FTSE 100. Nevertheless, it is a pertinent question.

Many small investors spend an inordinate amount of time and energy in trying to figure out in which direction a stock market index is going to move next. Some do it out of curiosity. Others, because they have taken a position in the F&O market. Some are trying to 'time the market' by fine tuning their entry or exit.

Those who have spent a long enough time in stock investing - whether using fundamental analysis, or technical analysis, or both - already know that predicting index (or stock price) movements is like tossing a coin. You only have a 50% chance of success at best.

(That may be good enough to make money. However, the 50% success rate comes from averaging multiple tosses/predictions. You may get 7 'heads' in a row and feel that you have mastered the art of coin tossing/predicting. But then you may get 12 'tails' in a row that will wipe out all your investments!)

What should a small investor do? Whether you are an inexperienced or an experienced investor, you need to accept the fact that index movements can not be predicted or controlled.

So, concentrate your time and energy on stuff that can be predicted and controlled. Like, how much you are likely to earn over the next 5-10-15 years. How much you need to save each year to achieve your financial goals. What kind of assets you should invest your savings in to get the required rate of return.

In other words, make an investment plan and then stick to that plan regardless of index movements. The plan may need to be tweaked to optimise returns - but such tweaking should not be done more than once or twice in a year.

It takes a lot of mental strength, faith and discipline to stick to a plan when an index goes through its periodic turmoil. Specially when a 15 months long bear phase decimates your stock portfolio.

But over the long term, a planned investment strategy will generate better returns than an unplanned strategy based on predicting index movements.

That was the long answer. The short answer is: Not really.  

8 Common Investing Mistakes and How to Avoid Them

There is an oft-quoted stock market adage: There are two kinds of investors in the market - those who have money and those who have experience. The ones with the experience get the money. The ones with the money get the experience.

The stock market is a place where history keeps repeating itself. In every bull cycle, hordes of new investors enter the market without a clue about how the market works. They make some money in one or two unknown stocks. Profits are booked quickly and immediately redeployed in the next 'sure thing'.

Once the bear cycle starts and stock prices fall, they buy more to reduce their 'average' cost till the stock collapses in a heap. 'Short-term' players become 'long term' investors in the hope of getting back their invested amounts. Eventually, they sell out at a big loss.

When the next bull cycle starts, a new set of investors enter the market and repeat the mistakes of their predecessors. And so it goes on. Is there a way out of this cycle of mistakes and losses?

In an article in investopedia.com, William Artzberger discusses about 8 common investing mistakes:

1. Investing in something you don't understand
2. Falling in love with a company
3. Lack of patience
4. Too much investment turnover
5. Market timing
6. Waiting to get even
7. Failing to diversify
8. Letting your emotions rule the process

Artzberger also discusses how to avoid these mistakes:

1. Develop a plan of action
2. Put your plan on automatic
3. Have some 'fun' money

Read the complete article at this link. 

Are sugar sector stocks turning sweeter? - a guest post

Most small investors will be wise to stay away from sugar sector stocks for several reasons. Like most commodities, sugar's price moves in cycles. That makes long-term investing a challenge. One needs to carefully time entry and exit to make money from sugar stocks.

The other major reason is government interference and price control. Sugar manufacturers are not always at liberty to decide whether they will sell in the domestic or export markets and at what prices. Government also dictates what prices producers have to pay farmers for their sugarcane produce. As an agricultural produce, weather plays an important role in sugar production.

However, experienced investors who are not risk-averse and are adept at timing their entry or exit can take a look at sugar stocks now. In this month's guest post, Nishit explains why the current water scarcity and drought-like conditions in several states may benefit stock prices of sugar companies. 

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Summer is a time of drought and water scarcity in many regions of India. While the main reason for this is deficient rainfall, the impact has been higher - especially in Maharashtra - because a lot of water has been diverted to water-guzzling sugarcane crops.

The most drought-affected areas are the sugarcane belt and Maharashtra Government has declared a moratorium on new sugarcane factories for the next 5 years. Sugarcane output may fall to 50% of what it was 2 years back in Maharashtra, which is supposed to be one of the highest producers of sugar within the country.

Sugar stocks are in the limelight and they should be. Lower production leads to higher prices. That means bigger profits for sugar companies.

In Maharashtra, the drought cycle will continue till the farmers switch to cash crops which require less water. Sugarcane farming will lead to more droughts. Often it takes a crisis for us Indians to act. We have a crisis staring at us right now in terms of drought.

The sugar cycle is a long cycle and the prices have still not gone up very much. Global sugar prices had peaked at around US $35 in 2011 and are currently at US $15 after touching a low of US $10.

With increasing population and lower production, sugar sector is looking up. One of the issues which need to be considered is the debt of Sugar Mills. During the last price rise in 2011-2012, this debt factor prevented many sugar stocks from gaining ground.

Sugar producing companies in the southern part of the country need to be looked at also. With water scarcity unfolding and production of sugarcane dropping, sugar sector stocks cannot be ignored.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan. You can reach him at nish.stockid@gmail.com)

7 investing mistakes to avoid in this rampaging bull market

There has been a sea-change in market sentiments ever since the Modi-led BJP received a majority in the general elections. The chaos, confusion and scams of coalition governments of the past many years have come to an end.

Modi is expected to usher in a new dawn of corruption-free, growth-oriented and economically inclusive administration that will restore India to the top echelons of world leadership. In anticipation, a new bull market has started – and as per consensus estimate of experts, it will be a multi-year bull market.

Even after 100 days – during which not much has changed on the ground (it may be too short a time to expect major changes) – the feeling of hope and expectation of ‘acche din’ persists. The setback for the BJP in the recent by-elections may be a temporary aberration. Today’s strong rally in the market has confirmed bullish sentiments.

For small investors who have not been able to participate in the bull rally so far, or the few smart ones who managed to get in early but are experiencing their first ‘real’ bull market, this is as good a time as any to be aware of some easily avoidable investing mistakes in a bull market. Here are 7 of them, not in any particular order:

Mistake 1: Taking expert opinion at face value

It is the job of market experts to voice their opinions – even if they contradict each other. Many have vested interest in the stock market, in spite of their disclaimers. Do not consider any such opinion as gospel truth. Use your intellect and common sense. Particularly regarding buy/sell recommendations, one should do their own due diligence and act only if convinced.

Mistake 2: Believing that a ‘new’ bull market has started

In a post three months ago, it was explained why this bull market may be 5.5 years old from a long-term perspective, and at least 1 year old from a short-term perspective. In other words, it can’t be considered ‘new’. That means, most of the low-hanging fruit have been plucked. One needs to be extra careful in selecting individual stocks for investment now.

Mistake 3: Thinking that a rising tide lifts all boats

In a bull market, small companies with low equity and questionable management start flying through the roof. The rise in stock price is often the result of circular trading among a few entities working in cahoots. These are leaky boats. They may rise when the tide comes in, but will sink soon – leaving small investors with a useless entry on their demat statements.

Mistake 4: Buying individual stocks on a limited budget

If you are a small investor getting your feet wet in the market, you probably don’t have much savings to spare. You may want to buy 10 shares of Tata Motors or 100 shares of Ashok Leyland. Don’t do it. If the stock price rises 10%, you will be tempted to book profits – missing out on a bigger payday. If the stock falls 10%, you may get into a panic and sell, instead of buying more. Better to start a SIP in a good equity fund. Build up your capital for 4-5 years, then think of buying individual stocks.

Mistake 5: Taking a personal loan to invest in stocks 

Don’t have enough savings? Still itching to enter the market? Forget about taking a personal loan. The interest cost will be prohibitive, and will need to be paid regardless of your portfolio’s performance. Buying an iPad or a fancy cellphone on EMI is bad enough – but you will at least have a useful asset. But once a stock starts falling like a stone, you may not have the will power or discipline to sell at a loss.

Mistake 6: Waiting for a correction to enter

Timing the market is difficult, if not impossible. It requires several years of investing experience to understand which correction to invest in and which correction to sit out. Investing at or near a market top may not give good returns in the near term, but investing your savings regularly and having a long-term (3-5 years) outlook is likely to provide inflation-beating returns.

Mistake 7: Investing without a plan

When you think about going on a vacation, you tend to plan well in advance to avail of cheaper air-tickets and better hotel deals. But when it comes to investing, you probably don’t even think about how deep the water is or whether there are sharks lurking before diving in. It is imperative that you make a financial plan and an asset allocation plan before buying a single stock or fund. The plans should reflect your financial commitments, aspirations and risk tolerance. Buying stocks or funds according to your plans will provide better returns and enable you to reach your financial goals.

Related Post

How to reallocate your assets

5 enduring stock market myths debunked

The quote: “A lie repeated often enough becomes the truth” has been variously attributed to Vladimir Lenin and Joseph Goebbels. Adolf Hitler wrote in Mein Kampf: “The greater the lie, the greater the chances that it will be believed.”

Is a myth the same as a lie? Not quite. A lie is a deliberate attempt to suppress or conceal truth. Oxford Dictionary has this definition of myth: ‘A widely held but false belief or idea.’  So, a myth probably evolves from a lie.

Why do stock market myths exist, and why is it necessary to debunk them? One of the ploys used by analysts and fund managers is to propagate myths so that less-educated investors (in terms of stock market knowledge) remain confused.

Some times, analysts and fund managers hide behind these myths because they are confused about the price movements in the market and don’t want to look like fools if they predict something and the opposite happens.

It is the small investor who starts believing these myths and gets taken for a ride in the process. So, it is important to understand the difference between what is a myth and what is truth.

Here are some enduring and oft-repeated stock market myths, and the truth behind those myths:

1. The stock market is a ‘zero sum’ game because for every buyer there is a seller

Wikipedia defines a ‘zero sum’ game thus: ‘In game theory and economic theory, a zero-sum game is a mathematical representation of a situation in which a participant's gain of utility is exactly balanced by the losses of the utility of the other participant(s).’

The myth is not the ‘zero sum’ part, but the ‘for every buyer there is a seller’ part. Any one who has bought or sold a large lot knows that. If you try to sell 1000 M&M or L&T shares in the market, it is unlikely that some buyer is just waiting to buy those 1000 shares from you. Chances are, there are several buyers each wanting to buy 50 or 100 shares each.

If the stock price falls after you complete your selling, then you ‘win’ and the several buyers ‘lose’. If after a few days, the stock price starts to rise and goes above your selling price, then you ‘lose’ and the several buyers who bought from you ‘win’.

2. There is plenty of cash waiting in the sidelines

The myth is to justify why Nifty should move higher. The truth is: cash waiting on the sidelines will always remain on the sidelines in the secondary market. Why? Imagine you have just received a fat bonus due to excellent performance at work, or have made a big profit after selling some real estate. You now wish to enter the stock market to buy some shares, but are hesitant because of high prices.

So, you have cash waiting on the sidelines, right? Now, a correction sets in and you find some attractive buys to deploy your cash. What happens to the cash that you had on the sidelines? It just changes hands and goes to sellers of the stocks. Now you know why a stock market is actually called a stock exchange.

You exchange your cash for stocks. The seller(s) exchange their stocks for cash. The cash goes back to the sidelines – minus some STT and brokerage. (In the primary market, cash does go from the sidelines into a company conducting an IPO. That cash will be used for purchasing productive assets and hopefully won’t get stolen.)

3. Time in the market is better than timing the market

Say that to a Japanese investor (the Nikkei has gone nowhere for many years) and he will probably call you a ‘bakayaro’ or even a ‘chikuso’! This myth works great for fund managers, because the longer investors stay invested in a fund the better it is for the fund manager. He has more funds to invest and can make some long-term bets.

But if you want to generate market beating returns, you have to resort to ‘timing’ your entries and exits. That doesn’t mean frequent churning of individual portfolios. But exiting if the Nifty P/E moves above 22 or buying when Nifty P/E falls below 14 can significantly improve your returns.

4. This is a ‘hope’ rally, or a ‘liquidity-driven’ rally

This is what analysts say when they have advised investors to book profits at every rise, and Nifty keeps moving higher and higher. I mean, talk about stating the obvious! Has there ever been a rally without hope or liquidity? Investors buy because they have the money to invest and hope that the index will move up.

When liquidity gets sucked out of the market – whether due to profit-booking or bunching together of IPOs (though that hasn’t happened for some time) - what happens to the rally? It stalls. You don’t need a degree in Nuclear Physics to understand that.

5. This is a stock picker’s market

Except for the period between Oct and Dec 2007, when even cats and dogs turned into lions and tigers overnight, I can’t recall a time when it wasn’t a stock picker’s market. If you wish to build wealth for the long-term (as opposed to enjoying the adrenaline rush in day trading), you have to learn how to pick stocks that can and will stand the test of time.

How will you know that beforehand? The best way is to choose stocks that have already withstood the test of time – like HUL, Colgate, ITC, M&M, Tata Motors. Does that mean you should stay away from mid-cap and small-cap stocks? Yes, and no.

Yes, if you are not confident about the process of stock picking. No, if you follow these simple and well-documented steps. However, following those steps will require discipline and diligence. The eventual rewards will be much more than adequate.

An imaginary Q&A session about the current state of the Indian stock market

Q. The Sensex index has closed above the 25000 level for the first time ever. Are we in a new bull market – as some of the experts on business TV channels are claiming?

A. The short answer is, strangely, ‘No’. Why? Because it is a bull market all right, but not a ‘new’ bull market.

Q. Why not?

A. A ‘new’ bull market begins after a bear market ends – not when the Sensex touches a new high.

Q. So, when did the previous bear market end?

A. That depends on whether you are a short-term, medium-term or a long-term investor.

Q. Why should the end of a bear market change depending on one’s investment viewpoint?

A. That question can be best answered with an analogy. If you stand a couple of feet away from the trunk of a large tree in a garden, all you will see is wood. If you look at the same tree by standing 30 feet away from it, you will notice details like branches, leaves, flowers, bird’s nests.

Now, if you go to the roof of a high-rise building and try to look at the same tree, you may not be able to see it at all because there may be several hundred trees in the garden. So, viewpoint does make a difference.

Q. But how does this relate to the stock market?

A. Good question. Let us look at the Sensex chart of the past 16 years.

The 200 day EMA (in green) is superimposed on the Sensex chart because in simplistic technical terms, an index (or stock) trading above the 200 day EMA is in a bull market, and trading below the 200 day EMA is in a bear market.

• From Jan 2000 to May 2003, Sensex was in a bear market
• From May 2003 to Jan 2008, Sensex was in a bull market
• From Jan 2008 to Mar 2009, Sensex was in a bear market
• From Mar 2009 to Nov 2010, Sensex was in a bull market
• From Nov 2010 to Dec 2011, Sensex was in a bear market
• From Dec 2011 onwards, Sensex has been in a bull market

Q. So far so good. But how is the viewpoint different?

A. Note the bear markets between Jan 2000 – May 2003 and Jan 2008 – Mar 2009. They look like strong bear periods with significant corrections (in percentage terms) from their respective tops. However, the bear market between Nov 2010 - Dec 2011 was much milder.

In fact, it looks like a ‘rounding bottom’ bullish consolidation pattern – which is clearly visible on the 200 day EMA. So, from a long-term perspective, the ‘new’ bull market actually started back in Mar 2009!

Q. Will the shorter-term viewpoints be different?

A. Let us see from the Sensex 5 yr. chart below.

From this viewpoint, the period between Nov 2010 and Dec 2011 looks more like a bear market and less like a consolidation.

Now, the 1 yr Sensex chart.

Here, it seems like the entire month of Aug ‘13 was spent in a bear market.

Q. So, what is the real point of these three charts?

A. From the long-term view point (16 yr chart), the ‘new’ bull market started in Mar 2009. From the medium-term view point (5 yr chart), the ‘new’ bull market started from Dec 2011. From the short-term view point (1 yr chart), the ‘new’ bull market started from Sep ‘13.

Regardless of what your view point may be, Sensex has been in a bull market for quite a while.

Q. Why are the TV experts calling the current market as a ‘new’ bull market?

A. If I wanted to be mean, I would say that they are absolutely clueless. But I don’t want to be mean. So, in their defence, all that can be said is that their extreme short-term perspectives can not distinguish the wood from the trees.

Q. Should small investors enter the market now, or should they wait for a correction?

A. That would be the same as ‘timing the market’, which most small investors should avoid. The smart thing to do is to make a financial plan and an asset allocation plan. Based on the plans, invest your savings systematically.

Related posts

Why Sensex should touch 25000 – a long-term view

Sensex touches 25000 – ready for a drum roll?

How to reallocate your assets

Some strategies about selling stocks

Why discuss stock selling strategies just when the Sensex is showing some signs of life after an 8 months long corrective move? Isn’t this a good time to buy and make some money?

The answer depends on what type of investor you are. If you want to play the momentum in the short-term, by all means buy and book profits after a gain of 3 or 5 points. May be even 8 or 10 points. Which isn’t bad at all – if you are trading thousands of shares. Such a strategy can be followed at any time.

But many small investors don’t have big money at their disposal. They can buy 200 or 500 shares at a time (I’m not talking about penny stocks here). A 5 or 10 point gain is neither here nor there – compared to the risks involved. May be this isn’t such a great time to buy after all – since the index is just about 10% below its all-time high.

Instead of having an ad-hoc hit-and-miss strategy, have a plan. For buying, holding and selling. The ‘Margin of Safety’ concept works well for buying. P/E bands work well too – for buying, holding and selling. I prefer to use an asset allocation plan for timing buy-sell-hold decisions.

Today, I want to discuss a few selling strategies. Before you buy any stock, decide on a selling plan – based on your risk tolerance, time horizon and individual preference. As a long-term investor, I prefer to have a three years time horizon for any stock to perform. You can just as well choose a one year or two years time frame. Anything less than a year, and you will be treading the fine line between an investor and a speculator.

Once you decide on a time frame, pick a realistic price point. 100% gain in 1 year may happen once or twice, but is not a realistic goal. But a 50% gain in two years, or a 100% gain in three years may be more achievable. When the price target is reached, it is best to sell out entirely. But if you feel that more upside is left, book partial profits, and hold on to the rest with a trailing stop-loss. If the price target is not reached, don’t hold on with the hope that it will be reached ‘some day’. Just sell.

If by partial profit booking you have withdrawn your original investment, don’t ever think that the balance holding is ‘free’. It isn’t. It has an opportunity cost. If the market dives and your balance holdings drop by 50%, you have lost real money. A trailing stop-loss will save you from such a calamity.

Supposing you have a two years time frame with a 50% appreciation target. After six months, the stock suddenly starts to flare up and gains 50%. What should you do? Wait for your two years time frame, or sell now? Sudden flare-ups in stock prices occur for different reasons - insider buying, some company-specific news that you may not have heard yet, a fundamental change in the sector, a merger or acquisition.

Why bother with reasons? If your target is reached, sell – even if it means paying short-term capital gains tax. After all, tax is paid from profits – so you are still ahead.

So far, I have discussed selling strategies when your stock is in profit. What if you buy a stock and it keeps falling down? Have a strict selling strategy – a 3% or a 8% or a 15% stop-loss, depending on the type of stock and the planned period of holding. Have the discipline to sell as soon as the stop-loss is hit on a closing basis.

Learn to be unemotional and unexcited about your buy-sell-hold decisions. Treat them like any monetary transaction – like buying a cup of coffee or getting a hair-cut.

Related Posts

What exactly is the Margin of Safety?

How to reallocate your assets

Investors may find something fishy about this post

I was pondering about the current uncertain state of the stock market, when I remembered the story of the three fishes that was part of my school curriculum many many moons ago.

There were several ponds within a large tract of land owned by a wealthy land-owner. In one of the ponds lived three large fishes. One was called 'Anagatavidhata'. The second was called 'Pratyutpanyamatitwa' and the third was called 'Jadvabishya'.

Not being literate in the Sanskrit language at that early age, the names sounded rather complicated and unnecessarily long for fishes. The purpose of such strange-sounding names may become clear from the story.

One day, some fishermen were standing near the pond where the three fishes lived and were chit-chatting about the impending wedding of the landowner's daughter. One said: The wedding will surely include a huge feast. Another said: If we can catch some big fishes alive, the landowner will surely give us a nice tip.

Over-hearing such talk, the three fishes went into a huddle to decide the next course of action. Anagatavidhata didn't want to take any chances and decided to escape into the neighbouring pond, which was much larger and deeper and would be easier to hide in. He immediately started to burrow in the mud to dig a hole into the next pond.

Pratyutpanyamatitwa would have none of it. He knew that the wedding was still a couple of months away, so there was no immediate danger of getting caught. Jadvabishya believed that it was the destiny of all fishes to get caught and slaughtered, so why get all worked up about it?

Two months later, the fishermen came with a huge net and cast it into the pond and caught all the fishes in it. Anagatavidhata had already escaped into the neighbouring pond and was saved.

Pratyutpanyamatitwa decided to play dead and did not struggle at all when the net was pulled in. The fishermen took all the fishes that had died struggling to get out of the net, and threw them back into the pond.

Pratyutpanyamatitwa also got thrown back in with the dead fishes and lived happily ever after. Jadvabishya kept desperately struggling to get out of the net, and became a part of the wedding feast.

Moral of the story? When the market starts to tank after making an intermediate top, it is better for conservative investors to book their profits and stay out, so that they can live to invest again at lower prices.

The smarter investors can remain in the thick of it and use their market timing and asset allocation strategies to reap maximum benefit.

Those investors who believe that being able to profit from the stock markets is pre-ordained and depends more on luck than strategy, are destined to lose money.

Try to avoid the simultaneous switch

What is a simultaneous switch? It is when you sell a stock to immediately buy another. The simultaneous switch is quite a common practice amongst small investors - usually followed by the less experienced ones. But it is a mistake, and needs to be avoided if you want to succeed as an investor.

Why is an investment mistake to be avoided? Because you end up losing money. And avoiding losses is the only rule of investing. Remember that the stock market is not a zero-sum game.

Each buy order needs a sell order for the transaction to be completed. But if you buy 1000 shares, it doesn't mean a single seller sells the entire 1000. There could be several sellers of 100-200 shares each. If the stock shoots up after your purchase, you 'win' and 5 or 6 investors 'lose' (or, 'win' a much smaller amount).

A smaller percentage of investors make money. The majority lose. To make money from stocks, there has to be lots of losers. You don't want to be one of them!

Why is the simultaneous switch a mistake? It is a form of 'timing' the transaction which is fraught with risks. One is trying to make a sale and trying to make a buy at the same time. It is a rare occasion when a good time for selling one stock is also a good time for buying another.

The 'need' for a simultaneous switch occurs during bull markets. Small investors often enter late. In an effort not to miss the bus, they end up spending all their spare cash in buying some of the 'hot stocks' that have already run up a lot.

These 'hot stocks' may not provide great returns over the short-to-medium term. As sector rotation occurs and a different set of 'hot stocks' shoot up, investors get rid of a few of the non-performers (or the ones in which they have made small profits) and simultaneously re-deploy the money into another set of stocks.

This may provide a lot of excitement, but doesn't greatly enhance wealth building. When the next correction comes, there is hardly anything left in the kitty to pick up the bargains.

In a previous article, I had mentioned three reasons why one should sell a stock. Those reasons can not be reasons for buying. Learn the mental discipline of separating the reason for selling from the reason for buying, and avoid the temptation of the simultaneous switch.

(Note: If you are not sure how to time your selling, you need to learn about and implement an asset allocation plan. Read Chapter 12: How to Reallocate your Assets from my eBook. Haven't got your copy yet? Get your FREE eBook before it is too late.)

How strong is the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a popular momentum oscillator, mainly used in tracking technical charts of commodities (much like other technical indicators, such as Japanese Candlesticks). It seems to work pretty well with stocks also.

Developed by J Welles Wilder in 1978, the RSI calculates the velocity (i.e. speed) and momentum (i.e. the rate of rise or fall) of closing prices/index levels in upward and downward directions. In simpler words, the RSI compares the magnitude of the recent gains and losses of a stock or index, and converts it into a numerical range.

The Relative Strength Index (RSI) does not measure the relative movements between two different stocks or indices. Rather, it measures the internal strength of a stock or index in the up or down direction. So it is a bit of a misnomer.

Being an oscillator, its value oscillates (varies) between 0 and 100. A value of 70 or higher is considered 'overbought' and a value of 30 or lower is considered 'oversold'. Some analysts use 80-20 as the overbought-oversold values.

The oscillator tends to form chart patterns like head-and-shoulders and triangles - some times much before similar patterns form in the stock or index charts.

Whenever the RSI enters the overbought or oversold regions, a trend reversal is likely to follow. Another important indication provided by the RSI is divergence from the pattern of a stock or index.

Enough theory. Now on to some practical examples by looking at the 6 months closing price of the BSE Sensex chart pattern along with a 14 day RSI:-

First, a look at the oversold and overbought regions. In early Mar '09, the RSI entered the oversold region (below 30) as the Sensex was making a low. A reversal of the previous down move followed. In late Mar '09, the RSI entered the overbought region (above 70) but remained at or near this region till the middle of Jun '09 while the Sensex rallied.

This is an indication of the imperfect nature of technical analysis. The reversal from oversold region was swift. But a reversal from overbought region took much longer. This is the reason for using several different technical indicators before coming to a conclusion about buying or selling.

Now let us look at three different divergences between the BSE Sensex chart pattern and the Relative Strength Index. During mid-Dec '08 and early Jan '09, the Sensex made a slightly higher top. The RSI made a slightly lower one. This negative divergence caused a short reaction.

From early Jan '09 to the middle of Feb '09, the Sensex made a lower top but the RSI made a higher one. The positive divergence. along with the RSI entering the oversold region led to the huge rally.

The rally continued, and from mid-may '09 to mid-June '09, the Sensex made higher tops, but the RSI failed to make higher tops. The inevitable correction is the result of this negative divergence.

It is a lot easier to sit back and analyse after the event. A lot tougher to place buy/sell bets as these patterns occur in live markets. No wonder it is so difficult to make money by day trading!

It also reinforces my view that for ordinary small investors, neither technical analysis alone, nor fundamental analysis alone can work well over long periods of time.

A combination helps you to identify good stocks through fundamental analysis, and then use technical indicators like the Relative Strength Index (RSI) and slow stochastic to time your entry and exit.

I have deliberately not marked another instance of divergence on the above chart. Observant readers should be able to find it! The reward for correct identification will be a special mention in my blog.

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About Volume and On-Balance Volume (OBV)

Why you need to learn about the Stochastic Oscillator

Why you need to learn about the Stochastic Oscillator

I have been planning to write about the Stochastic oscillator for quite some time. Reader Nikesh deserves special thanks for reminding me about it every once in a while.

In an article last July, identifying stock market trends using exponential moving averages (EMAs) and their crossovers was explained. A problem that one often faces with EMAs is that before they can confirm a change of trend, price levels often rise (or fall) by a significant amount.

I discovered that the Stochastic oscillator worked very well with EMAs to give early buy/sell indications and was very useful for timing entry into (or exit from) individual stocks. There are other indicators that can be used as well. But the stochastic oscillator provides clear and simple visual guidance.

Let us take a look at the 6 months bar chart pattern of Balrampur Chini, a sugar stock which I discussed last Wednesday, to find out the utility of the Stochastic oscillator:-

 

(Please right-click on the image; open it in a new tab or window for a better view.)

The Stochastic oscillator compares the closing price level of a stock (or index) with its price range over a given time period - say 10 days. It comprises two lines - the main '%K' line (in blue) and the '%D' line (in red); the '%D' line is a moving average of the '%K' and acts as a 'signal' line. When the '%K' moves above the '%D', it is considered bullish; when it moves below, it is bearish.

Both the lines 'oscillate' (i.e. alternatively go up and down) between values of 0% and 100%. The zone between 0-20% is considered 'oversold'; the zone between 80-100% is overbought.

(The actual calculations of '%K' and '%D' are slightly complicated, and I don't want to confuse any maths-shy readers unnecessarily. One can use the oscillator without understanding the underlying maths - much like driving a car without any idea of the function of the carburettor. Those who are maths-happy, and love to know the gory details, can email me.)

In Nov '08, Balrampur's stock price was well below the 20 day EMA, which in turn was below the 50 day EMA. The 50 day EMA was significantly below the 200 day EMA and all three EMAs were moving down. The bear grip on the stock was strong.

Look what happened in early Dec '08. The stock had a 'reversal day' (i.e. a lower low at Rs 30 and a higher close) and spurted up on small volumes. The '%K' (blue) line first moved above the '%D' (red) line, and then both lines moved up above the 'oversold' zone. That was a 'buy' signal, much before the stock moved above its 20 day EMA to confirm a 'buy'.

When the stock moved above its 50 day EMA in end-Dec '08, the stochastic oscillator was already in the 'overbought' zone. Before the big market correction came due to the Satyam scam news in Jan '09 (that caused all stocks, including Balrampur, to fall) the stochastic oscillator made an early downward break from the 'overbought' zone.

In Feb '09, the Balrampur stock was making new highs and getting resisted by the 200 day EMA. The stochastic oscillator had a lower high, indicating a negative divergence and a 'sell' signal. A 30% correction followed.

In Mar '09, the stock was consolidating sideways when the stochastic oscillator gave an early 'buy' signal by moving up from the 'oversold' zone. The stock price nearly doubled within a month.

In May '09, the stock made a new high above Rs 80 but the stochastic oscillator made a lower high - again a negative divergence and a 'sell' signal. A price correction should follow.

In the example above the 'slow' stochastic oscillator - that uses a 3 day average of the %K - has been used. I find it more useful than the 'fast' stochastic which tends to fluctuate more, giving false signals.

For timing entry/exit there are few technical indicators that can provide such 'leading' (i.e. early) indications. But I must reiterate that technical indicators work best when several of them are used together to determine trends.

In future posts, I plan to write about two other useful technical indicators - the MACD and the RSI.

"Time in" vs. "Timing" the market

This is one of those investment debates that has been waged through the years, with no sign of a resolution in sight. With strong opinions on either side, it is quite likely that the controversy will endure for a long time.

The dilemma arises because of the way most experts and analysts define 'timing' - they mean selling out your equity portfolio completely at market tops, and buying the same portfolio back at market bottoms.

Common sense - which is not so common among the majority of investors - dictates that such a plan is doomed to failure. Why? Because consistently deciding when a market has reached a top or bottom over several economic and stock market cycles is pretty nigh impossible.

The stock market moves on its own logic, reflecting the collective sentiments of various market participants who have differing agenda. The hedge funds are in it for the short term (i.e. less than one year). Some of the Foreign Institutional Investors (FIIs) may invest for a longer term of 3-5 years. Pension funds tend to be real long term investors who stay in for 10 years or more.

As an individual investor it will be quite futile to try and outguess what these big boys are up to at any point of time. Chances are that they are better informed and have more research and financial resources. Therefore they can enter and leave the market in droves - driving up or smashing down prices before you can say 'Jack Robinson'.

Research has proven that those who stay invested for the long term perform much better than those who try to exit and enter the stock market frequently. No wonder most fund managers say that 'time in the market' is preferable to 'timing the market'.

While I can not disagree with such strong logic, backed by academic research, my investment experience has been otherwise. It arises from the basic definition of market timing.

For long term investment success it is imperative that you try and time the entry into and exit from individual stocks. But do not try to exit from your entire portfolio or try to buy the whole portfolio back.

If you've read my earlier post (Dec 1: Market cycles and Sectors), you will know that different sectors - and therefore, stocks from those sectors - get prominence depending on the state of the economic and market cycles.

Like now, when the Sensex is trying to find a bottom, FMCG stocks are hitting their 52 week highs whereas metal stocks are hitting their 52 week lows. So this is a good time to exit from FMCG stocks and enter metal stocks. (You don't have to sell your entire holding in a sector. Partial profit booking works pretty well.)

Now, experts and fund managers will tell you that FMCG is a good defensive sector to enter in a bear market and metals will face a lot of pain over the next couple of years. They will be quite correct from the short term view of the market. But a small investor with a long term outlook has to play contrarian. That is the only way to 'beat' the market.

While the 'time in' vs. 'timing' debate rages, my solution to the controversy is to replace the 'vs.' with 'and'; i.e. stay invested for the long term but time the entry into and exit from individual stocks.

In a future post, I will discuss about a technical indicator that helps lay investors to become master timers.