Expect More Bounce in the Short Term

The Nifty opened flat, went up in the first 15-20 minutes after opening but soon started coming down. The support at 3882/3878 was soon broken and it took the Nifty to make a new low at 3848 before it started moving up again. And what a rally it was! A 200 point rally in just 2 hours of trading (between 1PM and 3PM) ensued without any correction whatsoever. On the 5 minutes charts, there were only two candles during that period which had a low lower than the low of the previous candle. In the last 30 minutes the Nifty did display some resistance near 4100.

I have attached the 30 minutes chart of the Nifty today which shows the fantastic rally that took place today. There were no complaints from the rally today, except that it fell just short of confirming the uptrend. As we can see from the charts, the rally stopped exactly at the resistance line. Thankfully, the Relative Strength Index (RSI) has given an indication that the rally may go past the resistance line. It has done so by itself going above the line that was providing resistance to it. A confirmation using the trendline technique will come if the Nifty were to cross this resistance line. If we are using the Dow Theory then a short term uptrend would be confirmed only if it were to cross its most recent pivot high which lies at 4325 as shown by the dashed green line. But one should remember that would be confirmation of only a short term uptrend. An intermediate term uptrend would be confirmed only if the Nifty were to cross 4680.

But why did the market bounce back today? Why were we not expecting a bounce back? Well, the answer is that’s what happens in a capitulation. The capitulation day makes the market so negative that everybody is expecting it to go down. All investors are bearish, all analysts are bearish, all charts are bearish and there is a lot of pessimism around. Though, there are signals available that capitulation is coming, yet the market decides when it has capitulated completely. As mentioned in yesterday’s post, capitulation like symptoms were visible, but I personally feel the market hasn’t completely capitulated yet. Of course, that is my personal opinion and I could be wrong too. I support my reasoning with the logic that a capitulation is much sharper and lasts much longer than what was seen in the last 3-4 days.

The main reasons why the markets went up today, in my opinion, were mainly political and also valuation based. It seems certain now that the Samajwadi Party (SP) would provide support to the government on the nuclear deal issue in case of a Left pull-out. It also seems certain that the government would not fall even if the Left pulls out and that the nuclear deal might go through. While this rally is just discounting the positive developments, we should see a big rally when the nuclear deal goes through without the government falling. Looking at the valuations, Nifty, which was trading at a P/E (Price to Earnings Ratio) of over 28 in early January was down to 16.66 yesterday (based on current earnings – Forward P/E would be even lower). The Nifty Midcap 50 Index was even more attractive. The P/E which was close to 25 in January was down to only 10.15 yesterday. And a P/E of 10-15 times is a very good level to pick up stocks. But fundamentally speaking, high crude prices and inflation still remain areas of concern.

So, what do we do? Is it a bear market rally or the beginning of a bull market? We don’t know for sure right now and the best thing to do would be to follow the market and wait for it to tell us what to do. We should go long in the short term if a short term uptrend is confirmed (with proper stop losses, of course). More positions for a longer term can then be added when an intermediate term uptrend is also confirmed. In case the market comes down without confirming an intermediate term uptrend, we would know that it was just a bear market rally.

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Nifty Breaks Important Support

Before I start this edition, I must apologize for not being able to post my views on this blog on Thursday night for Friday due to some personal problems. Rest assured, I’ll try to be as regular as I’ve been in the past. I’ll continue with my plan to post a newsletter for every market day and an extra on a weekend. The Nifty, on Friday, did open slightly in the green but soon started losing ground. It managed to hold on to the support between 5000 and 5050 for a couple of hours but soon after noon it started slipping quite heavily and from there it was a unidirectional decline for the Nifty.

The chart of the Nifty has suddenly changed in the last two days. If we ignore the last two candles in the chart, we can see that we were pushing against the resistance line and the blue candle had a long lower shadow which showed that the price did go down but buying came in at lower levels and that actually took the price past the day before’s close. Suddenly, that day was followed by two red candles which changed the chart completely. Now we have broken through the support line near 5000, as signified by the solid green line, which is highly negative. A lower high is now already in place and below 4913 we will have a lower low too, thus signifying the start of a new downtrend according to the Dow Theory. According to the trendline theory, we have now entered an intermediate term downtrend. The target for this downtrend may be somewhere between 4500 and 4550. However, support also comes in at previous lows of 4913, 4630 and 4470. There is a reasonable good support at current levels near 4950. It is important that the previous low of 4913 is not broken if we are want some stability in the markets.

A lot of the current fall in the markets has been attributed to inflation which has been on the rise due to the jump in prices of crude oil. Crude Oil has almost doubled in the last 10 months and the jump has been exponential in the last two months. What actually has been happening in crude oil? Is it likely to come down? Well, some people say it is likely to come down now and there are others who say a price of $150 per barrel is likely in the next few days. Who do we believe? The best thing, I would believe, is to look at its chart and decide for ourselves.

Given above is the daily chart of crude oil futures as traded on the Multi Commodity Exchange (MCX). The price is in Rupees but the chart, whether in Rupees or in Dollars will remain the same. As seen in the chart, the thick red line is the line chart (close) of crude oil and we can see that it has now found some resistance near 5650 near the blue line. We can see that the support trendline is too far down near 4800 (which will reach 4900-5000 by the time the price comes down). A fall to 5000, though, may not be possible but a fall to 5100-5150 is likely. 5150 also happens to be the 23.6% Fibonacci retracement level of the rise seen from the February lows. That would correspond to roughly $120 per barrel. Also embedded on the chart in the gray line is the chart of Gold futures on MCX (the scale for Gold has not been shown). As seen by the chart, the price of both Gold and Crude is moving in tandem and a fall in crude could also make the yellow metal cheaper.

Buying should be avoided for now since the short term trend is now down and it is likely that the intermediate trend may also turn to down, if it already hasn’t. Keep strict stops on all open long positions.

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The Probability of Profitability

Let us understand technical analysis in a different way today. We always knew that technical analysis is the study of charts and trying to predict the future. But does it work? Is it accurate? How often does it work? What is the probability of making a profit every time? What is the probability of being profitable after a year? Well, we have all the answers here. Come, let us understand probability in very simple terms.

We all have been studying since grade 6 that probability means the likelihood or chance of an event happening or not happening. We all know the example of the flipping of a coin and throwing a dice or drawing a card. For those who don’t know, here it is. When we flip a coin, only two possible things can happen. Either we get a heads or a tail. Since there is one chance of getting a heads out of 2 outcomes, the probability is ½ or 0.5. Similarly the probability of getting a six on the throw of a dice is 1/6 or 0.1667, the probability of drawing a card of hearts from a pack of cards is 13/52 or 0.25 and the probability of drawing an ace is 4/52 or 0.0769.

But, have we ever thought what is the probability of making a profit if we pick up a stock at random? Let us see what the possible outcomes are when we buy a stock. It can either go up or come down. Which means the probability of making a profit is ½ or 0.5 or 50%, which is a very high probability. Then why do we do so much of research and ask people to give us tips or spend hours looking at charts? Just for a simple reason that we want to increase our probability of making a profit to 0.7-0.8 or 70-80%. But, does it help us? Are we able to increase our profits? Actually speaking, no. Believe me, we are still better off picking up stocks at random and let the probability remain at 50%. I will give you a very simple formula. You pick up any stock at random, have a well-defined exit strategy and an equally well defined profit booking strategy. Let us say that our rules are that we will pick up a stock at random and book a profit if the price goes up by 10% and keep a stop loss 5% below our purchase price. Believe me, with such a strategy, you will never never make a loss.

Is the above system acceptable? It is not very difficult to follow. All we have to do is to book our profits and losses as defined by our rules. I am sure, we can all follow these simple set of rules to make profits. But, before you go ahead and implement it, let us talk about the drawbacks also. Over the years that I have been involved in the stock markets, I have not only studied technical analysis, I have studied human psychology too (as it works in the stock markets). I have learnt that the drawbacks lie in your mind. Firstly, you will never be able to come to terms with the fact that you have made money. You will always be thinking that it was this system that made money. The thrill of investing in the stock markets will be missing because the decisions are automatic and not your own. Secondly, you will be tempted to book profits at 9% (or lower) instead of 10% while when it comes to executing your stop losses, you will be reluctant to do so even at 8%. Thirdly, the returns are too low – only 2.5% on your total investment. You get more in a savings account. And last, the system will work well in bull markets and will be terrible in bear markets. God save you from the bear markets if you follow this system.

So, is fundamental option the best option? Well, it does help. But it has its own drawbacks. Fundamental analysis tells you whether to buy or not to buy a stock. But it has no clearly defined entry and exit strategies. So, you may never know when to book profits and when to cut your losses. The human psychology is such that it forces you to take your profits quickly before your profits turn into losses. And if you are in a loss, you will keep riding your losses because you are thinking that you had done proper research and that sooner or later the price should follow the fundamentals, so you keep holding on to your losing positions. No doubt, on some stocks you can get profits many times your investment but in some you could lose a lot too.

That leaves us with technical analysis. Technical analysis has well defined entry and exit levels and with proper discipline you can continue to ride your profits and cut your losses early and you can make a lot of money. But like any other method, this has its own set of drawbacks. The hit rate is not very good. If you choose 10 stocks, it is likely that only 3 or 4 calls out of those 10 will come out to be correct. But the advantage is that those 3 or 4 calls give you enough profits to cover not only all your losses from the remaining 6-7 calls but also gives you enough profits to give you a good return. Many technical analysts keep trying to develop methods which will give maximum profits. I am currently developing a system which will give me small profits but the hit rate would be between 85-90%. The details of the system are ready and I am currently testing it with my own money to fine tune it a little and it can then be given to a few selected subscribers who are disciplined enough to follow it and once they have also tested it for sometime and some more fine tuning is done, it can be shared with all others. This system, for convenience sake, shall be referred to as 'System A' from now on.

We should consider our trading to be a business. The objective of any business is to make money and that’s what will be the objective of our business. Like in any other business you will have some centers which will be your profit centers (which give you lots of profits) and some as your cost centers (which earn no profits but only cost you money). The objective is to maximize the profits from your profit centers and minimize the costs in your cost centres. Similarly, in this trading business there will be some stocks which will give you a lot of profits and some which will only give you losses. So, as long as you maximize the profits and minimize the losses, you will end up in a profit. And that is what technical analysis helps us achieve. Helps us to ride our profits and minimize our losses.

We have learnt today that there are many methods which help us to make profits. But all of them have their own advantages and disadvantages. Within Technical Analysis (which I consider to be the best, though this is a debatable topic) too, there are many methods but the Dow Theory is the oldest and the easiest method of technical analysis. According to Martin Pring, as mentioned on buddycom, if an investor had invested $44 in the Dow in 1897 and liquidated his position after 93 years in Jan 1990 (pure buy and hold strategy, as happens in fundamental analysis), he would have got $2,500 after 93 years i.e. 56.82 times his investment, while another investor who invested and liquidated at the same times and who sold on every sell signal and bought on every buy signal would have got $51,268, a whopping 1165.18 times of his initial investment. That is the power of technical analysis and that shows how our probability of profitability increases with technical analysis. And technical analysis requires only one skill. Discipline.

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Simple Rules for Analysing Stock Charts

Some people have started becoming bullish now. Fundamental analysts have started saying that markets are fairly valued now and valuations have now reached at 2004 levels. But there are still many who continue to be bearish and say that the worst is still not yet over and there may be a retest of last week’s lows. I personally feel that after such a deep correction, the confidence of a lot of people has been shaken up and it will take time to build up that kind of confidence again. So we may just consolidate between 4500 and 5500 (Nifty) for sometime. The markets do go up now but with low volumes and there is a lot of selling coming in at higher levels. This is what happened yesterday. The markets did go up but with dry volumes. There was no strength in the move as far as the volumes are concerned. We can expect the volumes to increase once the crucial level between 5500-5600 is crossed.

Generally, those who have lost the confidence in the markets (because of the recent fall) do not enter at these levels. They keep waiting till the markets improve and till they feel that nothing could go wrong now. And then they enter. In fact that is the time to sell. The correct time to buy is now. Invest when the markets are beaten down, when the valuations are low and when there is panic in the markets. Be a contrarion to the general public. That is the way to make money.

My technical software is not working today and there are no charts to see and analyse and give my inputs for Monday. However, for all of you who want to learn to look at charts, I’ve consolidated a few simple rules which anybody could apply.

Though, you really do not need a charting software (there are so many charts available online) but you do need to study them. Apply a few simple rules and you are ready to go. But there will be some people who would like to buy a software and study everything in detail. Whenever you buy a charting software, it will come equipped with all the technical analysis tools and indicators. Many of you would have gone through some technical analysis books and would be raring to have a go at analyzing charts with one indicator, and another, and another and yet another.

Well, that is the first step to go the wrong way. The most important rule to remember while analyzing charts is that you have to keep them simple. Remember: “Too much of analysis leads to paralysis.” The best way to study charts is to apply only one or two rules/indicators or at the most three. My personal favorites are trendlines, RSI and MACD.

For those who just want to do it as fun and learn without any real investment in a software, here are a few simple rules you can apply.

Dow Theory: This theory was given by Mr. Charles Dow in 1931. He was the man who started it all. He used to say that stock prices move in trends and one should buy when the trend is up and sell when the trend is down. His definition of an uptrend was when the price made a higher low and then a higher high. Similarly, a lower high and a lower low signified the beginning of a downtrend. This theory can be applied to charts of all time frames.

Trendlines: Trendlines are those lines which connect at least 3 lows or at least three highs. An uptrending line should be drawn by connecting the lows and a downtrending line should connect the highs. The signal that one gets from trendlines is the breakthrough of prices. When prices penetrate an uptrend line, it is time to sell and when they go through a downtrend line, it is time to buy.

Moving Averages: Moving averages, in short, are moving trendlines. You simply calculate the average of the closing prices of the last x days (depends on what period you want to choose. Most common are 10, 21, 50, 100 and 200) and that is the value of the moving average for the last day. And you will be surprised to see how regularly prices find support/resistance at these levels.

For more indicators, it will become too complicated to calculate yourself and it would be best to buy a charting software and then we can probably hold a meeting/seminar and go into the details of analyzing charts. But one should remember that there is no such thing as a PERFECT INDICATOR. It does not exist. But it does not mean that indicators don’t work. All indicators are good and all indicators give very good signals. You just have to be consistent using them.

I hope this article was of some help to all of you. Do leave a comment in case you would like more such articles on a regular basis. Also leave a comment if you don’t like the article and would prefer not to be disturbed with such topics which don’t have any recommendations.

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