Investing in stocks has always been tricky
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If financial statements play a key role in fundamental analysis of shares, then the interplay between demand and supply is the cornerstone of technical analysis. The trend evolving from these two opposing forces provide invaluable clues to the direction of the stock prices. Last week, we had discussed some factors that would tell us about the health of the stock. Today, we present some more ways to understand the price pattern of the stock and the markets.
Moving Average:
Simple and decisive: this is how a moving average could be described as a tool in deciding when to buy or sell a security. The moving average is the average of a series of consecutive closing prices and can be calculated for 5, 10, 20, 50, 100 or 200 days. The average moves as the oldest price would be deleted and latest price would be added for calculation.
For example, take a five-day moving average of stock ‘X’. The closing prices were 100, 120, 110, 100 and 110 for the past five days. The moving average would be 108 — total of prices divided by five. Let’s say on the sixth day the closing price is Rs 105. Then the price of the first day, Rs 100, would be deleted and that of the sixth day, Rs 105, would be added.
The new average would be Rs 109. As the price changes, the average price moves up and down. When the average moving price is plotted on the graph against the movement of the stock price, we can find out whether to hold or exit. For example, if the stock price falls through the moving average line, it shows that the price momentum has switched to the downside, giving a sell indication in order to retain capital gains. If the price rises above the moving average line, then the price movement has switched to the upside and an investor can buy.
Volume Analysis:
Trading volume is an important factor affecting the prospects of the stocks. An investor should be aware of the quantum of shares traded to know the levels of price fluctuations. If the Sensex rises coupled with an increase in trading volume, it’s an indication that the market is bullish. It is good to buy then. On the other hand, if the Sensex rises and the trading volume remains flat or declines, the chances are that the market would not go much further, giving a sell indication.
An indicator that uses volume flow is the on-balance volume, which works on the premise that when volume increases without a market change, the price would move north and vice versa. It’s very important to know the average trading volume of a stock you intend to buy or hold. For example, suppose the average trading volume of shares of a company is 1,000 per day. But, suddenly if there is hectic trading to the tune of close to 5,000 shares per day, it shows that something positive is happening and you can invest in the company.
The point to be noted is that an exponential increase in volume shows an upside price move as large investors would start selling and retail investors would start buying. The information relating to trade volume could be sourced from stock exchange websites or from a demat account, if you have one.
The Relative Strength Index:
This index is a momentum oscillator that takes into consideration the impact of average gains and average losses of a stock. This would give a clear picture as to whether a share is oversold or overbought. The RSI oscillates on a scale of 0 to 100. RSI = Average of ‘X’ days’ up closes / Average of ‘X’ days’ down closes.
When the index is above 70, the stock is considered to be overbought and the investor can sell the share. And if the index is below 30, an investor can look to buy that share as it is oversold. Usually the RSI is calculated for a period of 14 days. If the value of a stock is 0, it means that the share dipped on all 14 days and if the index is 100, it shows that the prices increased during the period. Though the name suggests that it’s a relative strength, the index looks at the internal prowess of a stock.
Moving Average Convergence:
The moving average convergence divergence includes two exponential moving average and the indicator is the difference between these two averages. The exponential moving average gives weightage to the recent prices of stocks unlike the simple moving average, which gives equal weightage to all prices.
The index is computed usually with a 12-day or 26-day EMA. The MACD comprises of two lines — ‘fast’ and ‘slow’ — while plotted on a graph. The ‘fast’ line is the difference between 26-day EMA and 12-day EMA; the ‘slow’ line, also called the signal line, is a 9-day simple moving average. Generally, if the fast line crosses the slow line, it’s buy for the investor and if the slow line crosses the fast line, it's sell for the investor. In this age of automation, the graph is a just a click away after entering the relevant information.
Bollinger Bands:
Another tool used is the Bollinger bands. This also heavily depends on the moving average to follow the trends of a security. The Bollinger band consists of three bands — upper band, lower band and middle band. The middle band is the simple moving average and other two bands measure deviation from the middle path. Many traders use the Bollinger bands to find out overbought and oversold shares. An investor should sell when the prices touches the upper band and buy when the prices hit the lower band.
(The writer is the CEO of Bankbazaar.com)
( Source : deccan chronicle )
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