Liquidity Measurement Ratios
The first ratios we’ll take a look at are the liquidity ratios. Liquidity ratios attempt to measurea company’s ability to pay off its short-term debt obligations. This is done by comparing acompany’s most liquid assets (or, those that can be easily converted to cash) and its shorttermliabilities.
In general, the greater the coverage of liquid assets to short-term liabilities, the better it is,since it is a clear signal that a company can pay debts that are going to become due in thenear future and it can still fund its on-going operations. On the other hand, a company with alow coverage rate should raise a red flag for the investors as it may be a sign that the companywill have difficulty meeting running its operations, as well as meeting its debt obligations.
The biggest difference between each ratio is the type of assets used in the calculation. Whileeach ratio includes current assets, the more conservative ratios will exclude some currentassets as they aren’t as easily converted to cash. The ratios that we’ll look at are the current,quick and cash ratios and we will also go over the cash conversion cycle, which goes into howthe company turns its inventory into cash.
Current Ratio
The current ratio is a popular financial ratio used to test a company’s liquidity (also referredto as its current or working capital position) by deriving the proportion of current assetsavailable to cover current liabilities. The concept behind this ratio is to ascertain whether acompany’s short-term assets (cash, cash equivalents, marketable securities, receivables andinventory) are readily available to pay off its short-term liabilities. In theory, the higher thecurrent ratio, the better.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S current assets amountedto 13,041 (balance sheet), which is the numerator; while current liabilities amounted to 4030(balance sheet), which is the denominator. By dividing, the equation gives us a current ratioof 3.24 which can be considered very healthy.
The current ratio is used extensively in financial reporting. However, while easy to understand,it can be misleading in both a positive and negative sense - i.e., a high current ratio is notnecessarily good, and a low current ratio is not necessarily bad (see chart below).
Here’s why: contrary to popular perception, the ubiquitous current ratio, as an indicator ofliquidity, is flawed because it is conceptually based on the liquidation of all of a company’scurrent assets to meet all of its current liabilities. In reality, this is not likely to occur. Investorshave to look at a company as a going concern. It’s the time it takes to convert a company’sworking capital assets into cash to pay its current obligations that is the key to its liquidity. Ina word, the current ratio can be “misleading.”
A simplistic, but accurate, comparison of two companies’ current position will illustrate theweakness of relying on the current ratio or a working capital number (current assets minuscurrent liabilities) as a sole indicator of liquidity (amounts in Rs. crs.) :
Company ABC looks like an easy winner in a liquidity contest. It has an ample margin ofcurrent assets over current liabilities, a seemingly good current ratio and working capital ofRs. 300. Company has no current asset/liability margin of safety, a weak current ratio, andno working capital.
However, to prove the point, what if: (1) both companies’ current liabilities have an averagepayment period of 30 days; (2) Company ABC needs six months (180 days) to collect itsaccount receivables and its inventory turns over just once a year (365 days); and (3) Companyis paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).In this contrived example, company ABC is very illiquid and would not be able to operateunder the conditions described. Its bills are coming due faster than its generation of cash.You can’t pay bills with working capital; you pay bills with cash! Company’s ‘s seeminglytight current position is, in effect, much more liquid because of its quicker cash conversion.When looking at the current ratio, it is important that a company’s current assets can coverits current liabilities; however, investors should be aware that this is not the whole story oncompany liquidity. Try to understand the types of current assets the company has and howquickly these can be converted into cash to meet current liabilities. This important perspectivecan be seen through the cash conversion cycle. By digging deeper into the current assets, youwill gain a greater understanding of a company’s true liquidity.
Quick Ratio
The quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity indicator thatfurther refines the current ratio by measuring the amount of the most liquid current assetsthere are to cover current liabilities. The quick ratio is more conservative than the currentratio because it excludes inventory and other current assets, which are more difficult to turninto cash. Therefore, a higher ratio means a more liquid current position.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S quick assets amountedto 13,041 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). Bydividing, the equation gives us a quick ratio of 3.24. XYZ being in the services sector does nothave any inventory on its balance sheet and this quick ratio and current ratio come out to bethe same.Some presentations of the quick ratio calculate quick assets (the formula’s numerator) bysimply subtracting the inventory figure from the total current assets figure. The assumptionis that by excluding relatively less-liquid (harder to turn into cash) inventory, the remainingcurrent assets are all of the more-liquid variety. Generally, this is close to the truth, but notalways. In some companies, restricted cash, prepaid expenses and deferred income taxes donot pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstatesmore liquid assets and inflates its quick ratio.
The quick ratio is a more conservative measure of liquidity than the current ratio as it removesinventory from the current assets used in the ratio’s formula. By excluding inventory, thequick ratio focuses on the more-liquid assets of a company. The basics and use of this ratioare similar to the current ratio in that it gives users an idea of the ability of a company tomeet its short-term liabilities with its short-term assets. Another beneficial use is to comparethe quick ratio with the current ratio. If the current ratio is significantly higher, it is a clearindication that the company’s current assets are dependent on inventory.
While considered more stringent than the current ratio, the quick ratio, because of itsaccounts receivable component, suffers from the same deficiencies as the current ratio -albeit somewhat less. Both the quick and the current ratios assume a liquidation of accountsreceivable and inventory as the basis for measuring liquidity. While theoretically feasible, as agoing concern a company must focus on the time it takes to convert its working capital assetsto cash - that is the true measure of liquidity. Thus, if accounts receivable, as a component ofthe quick ratio, have, let’s say, a conversion time of several months rather than several days,the “quickness” attribute of this ratio is questionable.
Investors need to be aware that the conventional wisdom regarding both the current andquick ratios as indicators of a company’s liquidity can be misleading.
Cash Ratio
The cash ratio is an indicator of a company’s liquidity that further refines both the currentratio and the quick ratio by measuring the amount of cash; cash equivalents or invested fundsthere are in current assets to cover current liabilities.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S cash assets amountedto 9,797 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). Bydividing, the equation gives us a cash ratio of 2.43.
The cash ratio is the most stringent and conservative of the three short-term liquidity ratios(current, quick and cash). It only looks at the most liquid short-term assets of the company,which are those that can be most easily used to pay off current obligations. It also ignoresinventory and receivables, as there are no assurances that these two accounts can be convertedto cash in a timely matter to meet current liabilities. Very few companies will have enoughcash and cash equivalents to fully cover current liabilities, which isn’t necessarily a bad thing,so don’t focus on this ratio being above 1:1.
The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysisof a company. It is not realistic for a company to purposefully maintain high levels of cashassets to cover current liabilities. The reason being that it’s often seen as poor asset utilizationfor a company to hold large amounts of cash on its balance sheet, as this money could bereturned to shareholders or used elsewhere to generate higher returns. While providing aninteresting liquidity perspective, the usefulness of this ratio is limited.
Profitability Indicator Ratios
These ratios, much like the operational performance ratios, give users a good understandingof how well the company utilized its resources in generating profit and shareholder value. Thelong-term profitability of a company is vital for both the survivability of the company as wellas the benefit received by shareholders. It is these ratios that can give insight into the allimportant“profit”.
We look at four important profit margins, which display the amount of profit a companygenerates on its sales at the different stages of an income statement. We’ll also show you howto calculate the effective tax rate of a company. The last three ratios covered in this section- Return on Assets, Return on Equity and Return on Capital Employed - detail how effective acompany is at generating income from its resources.
Profit Margin Analysis
In the income statement, there are four levels of profit or profit margins – gross profit,operating profit, pre-tax profit and net profit. The term “margin” can apply to the absolutenumber for a given profit level and/or the number as a percentage of net sales/revenues.Profit margin analysis uses the percentage calculation to provide a comprehensive measure ofa company’s profitability on a historical basis (3-5 years) and in comparison to peer companiesand industry benchmarks. Basically, it is the amount of profit (at the gross, operating, pre-taxor net income level) generated by the company as a percentage of the sales generated. Theobjective of margin analysis is to detect consistency or positive/negative trends in a company’searnings. Positive profit margin analysis translates into positive investment quality. To a largedegree, it is the quality, and growth, of a company’s earnings that drive its stock price.
All the amounts in these ratios are found in the income statement. As of March 31, 2010,with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of 21,140, which isthe denominator in all of the profit margin ratios. The equations give us the percentage profitmargins as indicated.
Second, income statements in the multi-step format clearly identify the four profit levels.However, with the single-step format the investor must calculate the gross profit and operatingprofit margin numbers. To obtain the gross profit amount, simply subtract the cost of sales(cost of goods sold) from net sales/revenues. The operating profit amount is obtained bysubtracting the sum of the company’s operating expenses from the gross profit amount.Generally, operating expenses would include such account captions as ‘selling’, ‘marketing andadministrative’, ‘research and development’, ‘depreciation and amortization’, ‘rental properties’etc.
Third, investors need to understand that the absolute numbers in the income statement don’ttell us very much, which is why we must look to margin analysis to discern a company’s trueprofitability. These ratios help us to keep score, as measured over time, of management’sability to manage costs and expenses and generate profits. The success, or lack thereof, of thisimportant management function is what determines a company’s profitability. A large growthin sales will do little for a company’s earnings if costs and expenses grow disproportionately.Lastly, the profit margin percentage for all the levels of income can easily be translated into ahandy metric used frequently by analysts and often mentioned in investment literature. Theratio’s percentage represents the number of paises there are in each rupee worth of sales. Forexample, using XYZ’S numbers, in every sales rupee for the company in 2010, there’s roughly35, 31, and 23 paisa of operating, pre-tax, and net income, respectively.Let’s look at each of the profit margin ratios individually:
Gross Profit Margin
A company’s cost of sales, or cost of goods sold, represents the expense related to labour,raw materials and manufacturing overhead involved in its production process. This expenseis deducted from the company’s net sales/revenue, which results in a company’s first levelof profit or gross profit. The gross profit margin is used to analyse how efficiently a companyis using its raw materials, labour and manufacturing-related fixed assets to generate profits.A higher margin percentage is a favourable profit indicator. Industry characteristics of rawmaterial costs, particularly as these relate to the stability or lack thereof, have a major effecton a company’s gross margin. Generally, management cannot exercise complete control oversuch costs. Companies without a production process (ex., retailers and service businesses)don’t have a cost of sales exactly. In these instances, the expense is recorded as a “cost ofmerchandise” and a “cost of services”, respectively. With this type of company, the grossprofit margin does not carry the same weight as a producer type company.
Operating Profit Margin
By subtracting selling, general and administrative, or operating expenses from a company’sgross profit number, we get operating income. Management has much more control overoperating expenses than its cost of sales outlays. Thus, investors need to scrutinize theoperating profit margin carefully. Positive and negative trends in this ratio are, for the mostpart, directly attributable to management decisions. A company’s operating income figure isoften the preferred metric (deemed to be more reliable) of investment analysts, versus its netincome figure, for making inter-company comparisons and financial projections.
Pre-tax Profit Margin
Again, many investment analysts prefer to use a pre-tax income number for reasons similarto those mentioned for operating income. In this case a company has access to a variety oftax-management techniques, which allow it to manipulate the timing and magnitude of itstaxable income.
Net Profit Margin
Often referred to simply as a company’s profit margin, the so-called bottom line is the mostoften mentioned when discussing a company’s profitability. While undeniably an importantnumber, investors can easily see from a complete profit margin analysis that there are severalincome and expense operating elements in an income statement that determine a net profitmargin. It behoves investors to take a comprehensive look at a company’s profit margins ona systematic basis.
Effective Tax Rate
This ratio is a measurement of a company’s tax rate, which is calculated by comparing its incometax expense to its pre-tax income. This amount will often differ from the company’s statedjurisdictional rate due to many accounting factors, including foreign exchange provisions. Thiseffective tax rate gives a good understanding of the tax rate the company faces.As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had a provision for incometaxes in its income statement of 1,717 (income statement) and pre-tax income of 7,520(income statement). By dividing, the equation gives us an effective tax rate of 23% for FY2010.
The variances in this percentage can have a material effect on the net-income figure. Peercompany comparisons of net profit margins can be problematic as a result of the impact of theeffective tax rate on net profit margins. The same can be said of year-over-year comparisonsfor the same company. This circumstance is one of the reasons some financial analysts preferto use the operating or pre-tax profit figures instead of the net profit number for profitabilityratio calculation purposes.
One could argue that any event that improves a company’s net profit margin is a good one.However, from a quality of earnings perspective, tax management manoeuvrings (thoughmay be legitimate) are less desirable than straight-forward positive operational results.Tax provision volatility of a company’s finances makes an objective judgment of its true oroperational net profit performance difficult to determine. Techniques to lessen the tax burdenare practiced, to one degree or another, by many companies. Nevertheless, a relatively stableeffective tax rate percentage and resulting net profit margin, would seem to indicate that thecompany’s operational managers are more responsible for a company’s profitability than thecompany’s tax accountants.
Return On Assets
This ratio indicates how profitable a company is relative to its total assets. The return onassets (ROA) ratio illustrates how well management is employing the company’s total assetsto make a profit. The higher the return, the more efficient management is in utilizing its assetbase. The ROA ratio is calculated by comparing net income to average total assets, and isexpressed as a percentage.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803(income statement), and average total assets of 19,922 (balance sheet). By dividing, theequation gives us an ROA of 29% for FY 2010. The need for investment in current and noncurrentassets varies greatly among companies. Capital-intensive businesses (with a largeinvestment in fixed assets) are going to be more asset heavy than technology or servicebusinesses. In the case of capital-intensive businesses, which have to carry a relatively largeasset base, will calculate their ROA based on a large number in the denominator of this ratio.Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will begenerally favoured with a relatively high ROA because of a low denominator number.
It is precisely because businesses require different-sized asset bases that investors need tothink about how they use the ROA ratio. For the most part, the ROA measurement should beused historically for the company being analysed. If peer company comparisons are made,it is imperative that the companies being reviewed are similar in product line and businesstype. Simply being categorised in the same industry will not automatically make a companycomparable. As a rule of thumb, investment professionals like to see a company’s ROA comein at no less than 5%. Of course, there are exceptions to this rule. An important one wouldapply to banks, which typically have a lower ROA.
Return On Equity
This ratio indicates how profitable a company is by comparing its net income to its averageshareholders’ equity. The return on equity ratio (ROE) measures how much the shareholdersearned for their investment in the company. The higher the ratio percentage, the more efficientmanagement is in utilizing its equity base and the better return is to investors.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 4,845(income statement), and average shareholders’ equity of 19,922 (balance sheet). By dividing,the equation gives us an ROE of 24.3% for FY 2010. XYZ on account of being a debt freecompany has its ROE equal to ROA. If a company has issued preferred stock, investorswishing to see the return on just common equity may modify the formula by subtractingthe preferred dividends, which are not paid to common shareholders, from net income andreducing shareholders’ equity by the outstanding amount of preferred equity.
Widely used by investors, the ROE ratio is an important measure of a company’s earningsperformance. The ROE tells common shareholders how effectively their money is beingemployed. Company peers and industry and overall market comparisons are appropriate;however, it should be recognized that there are variations in ROEs among some types ofbusinesses. In general, financial analysts consider return on equity ratios in the 15-20%range as representing attractive levels of investment quality.
While highly regarded as a profitability indicator, the ROE metric does have a recognizedweakness. Investors need to be aware that a disproportionate amount of debt in a company’scapital structure would translate into a smaller equity base. Thus, a small amount of net income(the numerator) could still produce a high ROE off a modest equity base (the denominator).For example, let’s reconfigure XYZ’S debt and equity numbers to illustrate this circumstance.If we reduce the company’s equity amount by Rs. 9,922 crores and increase its long-termdebt by a corresponding amount, the reconfigured debt-equity relationship will be (figuresin Rs. crores) 9,922 and 10,000, respectively. XYZ’S financial position is obviously muchmore highly leveraged, i.e., carrying a lot more debt. However, its ROE would now register awhopping 58% (5,803 ÷ 10,000), which is quite an improvement over the 29% ROE of thealmost debt-free FY 2010 position of XYZ indicated above. Of course, that improvement inXYZ’S profitability, as measured by its ROE, comes with a price...a lot more debt and thus alot more risk.
The lesson here for investors is that they cannot look at a company’s return on equity inisolation. A high or low ROE needs to be interpreted in the context of a company’s debt-equityrelationship. The answer to this analytical dilemma can be found by using the return on capitalemployed (ROCE) ratio.
Return On Capital Employed
The return on capital employed (ROCE) ratio, expressed as a percentage, complements thereturn on equity (ROE) ratio by adding a company’s debt liabilities, or funded debt, to equityto reflect a company’s total “capital employed”. This measure narrows the focus to gain abetter understanding of a company’s ability to generate returns from its available capitalbase. By comparing net income to the sum of a company’s debt and equity capital, investorscan get a clear picture of how the use of leverage impacts a company’s profitability. Financialanalysts consider the ROCE measurement to be a more comprehensive profitability indicatorbecause it gauges management’s ability to generate earnings from a company’s total pool ofcapital.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803(income statement). The company’s average short-term and long-term borrowings were 0and the average shareholders’ equity was 19,922 (all the necessary figures are in the 2009and 2010 balance sheets), the sum of which, 19,922, is the capital employed. By dividing, theequation gives us an ROCE of 29% for FY 2010.
Often, financial analysts will use operating income (earnings before interest and taxes orEBIT) as the numerator. There are various takes on what should constitute the debt elementin the ROCE equation, which can be quite confusing.
Our suggestion is to stick with debt liabilities that represent interest-bearing, documentedcredit obligations (short-term borrowings, current portion of long-term debt, and long-termdebt) as the debt capital in the formula. Debt Ratios
These ratios give users a general idea of the company’s overall debt load as well as its mixof equity and debt. Debt ratios can be used to determine the overall level of financial riska company and its shareholders face. In general, the greater the amount of debt held bya company the greater the financial risk of bankruptcy. The ratios covered in this sectioninclude the debt ratio, which is gives a general idea of a company’s financial leverage as doesthe debt-to-equity ratio. The capitalization ratio details the mix of debt and equity while theinterest coverage ratio and the cash flow to debt ratio show how well a company can meet itsobligations.
Overview Of Debt
Before discussing the various financial debt ratios, we need to clear up the terminology usedwith “debt” as this concept relates to financial statement presentations. In addition, the debtrelatedtopics of “funded debt” and credit ratings are discussed below.
There are two types of liabilities - operational and debt. The former includes balance sheetaccounts, such as accounts payable, accrued expenses, taxes payable, pension obligations,etc. The latter includes notes payable and other short-term borrowings, the current portion oflong-term borrowings, and long-term borrowings. Often times, in investment literature, “debt”is used synonymously with total liabilities. In other instances, it only refers to a company’sindebtedness.
The debt ratios that are explained herein are those that are most commonly used. However,what companies, financial analysts and investment research services use as components tocalculate these ratios is far from standardized.
In general, debt analysis can be broken down into three categories, or interpretations: liberal,moderate and conservative.
• Liberal - This approach tends to minimize the amount of debt. It includes only long-termdebt as it is recorded in the balance sheet under noncurrent liabilities.
• Moderate - This approach includes current borrowings (notes payable) and the currentportion of long-term debt, which appear in the balance sheet’s current liabilities; and ofcourse, the long-term debt. In addition, redeemable preferred stock, because of its debt-likequality is considered to be debt. Lastly, as a general rule, two-thirds (roughly one-third goesto interest expense) of the outstanding balance of operating leases, which do not appear inthe balance sheet, are considered debt principal. The relevant figure will be found in the notesto financial statements and identified as “future minimum lease payments required underoperating leases that have initial or remaining non-cancelable lease terms in excess of oneyear.” • Conservative - This approach includes all the items used in the moderate interpretationof debt, as well as such non-current operational liabilities such as deferred taxes, pensionliabilities and other post-retirement employee benefits.
Investors may want to look to the middle ground when deciding what to include in a company’sdebt position. With the exception of unfunded pension liabilities, a company’s non-currentoperational liabilities represent obligations that will be around, at one level or another, forever- at least until the company ceases to be a going concern and is liquidated. Also, unlike debt,there are no fixed payments or interest expenses associated with non-current operationalliabilities. In other words, it is more meaningful for investors to view a company’s indebtednessand obligations through the company as a going concern, and therefore, to use the moderateapproach to defining debt in their leverage calculations. Funded debt is a term that is seldomused in financial reporting. Technically, funded debt refers to that portion of a company’s debtcomprised, generally, of long-term, fixed maturity, contractual borrowings. No matter howproblematic a company’s financial condition, holders of these obligations, typically bonds,cannot demand payment as long as the company pays the interest on its funded debt. Incontrast, long-term bank debt is usually subject to acceleration clauses and/or restrictivecovenants that allow a lender to call its loan, i.e., demand its immediate payment. From aninvestor’s perspective, the greater the percentage of funded debt in the company’s total debt,the better.
Lastly, credit ratings are formal risk evaluations by credit agencies such as CRISIL, ICRA,CARE, and Fitch - of a company’s ability to repay principal and interest on its debt obligations,principally bonds and commercial paper. Obviously, investors in both bonds and stocks followthese ratings rather closely as indicators of a company’s investment quality. If the company’scredit ratings are not mentioned in their financial reporting, it’s easy to obtain them from thecompany’s investor relations department.
The Debt Ratio
The debt ratio compares a company’s total debt to its total assets, which is used to gain ageneral idea as to the amount of leverage being used by a company. A low percentage meansthat the company is less dependent on leverage, i.e., money borrowed from and/or owed toothers. The lower the percentage, the less leverage a company is using and the stronger itsequity position. In general, the higher the ratio, the more risk that company is considered tohave taken on.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995(balance sheet) and total assets of 22,036 (balance sheet). By dividing, the equation providesthe company with a low leverage as measured by the debt ratio of 9%. The easy-to-calculatedebt ratio is helpful to investors looking for a quick take on a company’s leverage. The debtratio gives users a quick measure of the amount of debt that the company has on its balancesheets compared to its assets. The more debt compared to assets a company has, which issignalled by a high debt ratio, the more leveraged it is and the riskier it is considered to be.Generally, large, well-established companies can push the liability component of their balancesheet structure to higher percentages without getting into trouble. However, one thing tonote with this ratio: it isn’t a pure measure of a company’s debt (or indebtedness), as italso includes operational liabilities, such as accounts payable and taxes payable. Companiesuse these operational liabilities as going concerns to fund the day-to-day operations of thebusiness and aren’t really “debts” in the leverage sense of this ratio. Basically, even if youtook the same company and had one version with zero financial debt and another versionwith substantial financial debt, these operational liabilities would still be there, which in somesense can muddle this ratio. The use of leverage, as displayed by the debt ratio, can be adouble-edged sword for companies. If the company manages to generate returns above theircost of capital, investors will benefit. However, with the added risk of the debt on its books, acompany can be easily hurt by this leverage if it is unable to generate returns above the costof capital. Basically, any gains or losses are magnified by the use of leverage in the company’scapital structure.
Debt-Equity Ratio
The debt-equity ratio is another leverage ratio that compares a company’s total liabilities toits total shareholders’ equity. This is a measurement of how much suppliers, lenders, creditorsand obligors have committed to the company versus what the shareholders have committed.To a large degree, the debt-equity ratio provides another vantage point on a company’sleverage position, in this case, comparing total liabilities to shareholders’ equity, as opposedto total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means thata company is using less leverage and has a stronger equity position.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995(balance sheet) and total shareholders’ equity of 22,306 (balance sheet). By dividing, theequation provides the company with a relatively low percentage of leverage as measuredby the debt-equity ratio at 9%. A conservative variation of this ratio, which is seldom seen,involves reducing a company’s equity position by its intangible assets to arrive at a tangibleequity, or tangible net worth, figure. Companies with a large amount of purchased goodwillform heavy acquisition activity can end up with a negative equity position. The debt-equityratio appears frequently in investment literature. However, like the debt ratio, this ratio is nota pure measurement of a company’s debt because it includes operational liabilities in totalliabilities. Nevertheless, this easy-to-calculate ratio provides a general indication of a company’sequity-liability relationship and is helpful to investors looking for a quick take on a company’sleverage. Generally, large, well-established companies can push the liability component oftheir balance sheet structure to higher percentages without getting into trouble.
Capitalization Ratio
The capitalization ratio measures the debt component of a company’s capital structure, orcapitalization (i.e., the sum of long-term debt liabilities and shareholders’ equity) to supporta company’s operations and growth. Long-term debt is divided by the sum of long-term debtand shareholders’ equity. This ratio is considered to be one of the more meaningful of the“debt” ratios – it delivers the key insight into a company’s use of leverage. There is no rightamount of debt. Leverage varies according to industries, a company’s line of business and itsstage of development. Nevertheless, common sense tells us that low debt and high equitylevels in the capitalization ratio indicate investment quality.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total long-term debt of0 (balance sheet), and total long-term debt and shareholders’ equity (i.e., its capitalization) of22,036 (balance sheet). By dividing, the equation provides the company with a zero leverageas measured by the capitalization ratio. A company’s capitalization (not to be confused with itsmarket capitalization) is the term used to describe the makeup of a company’s permanent orlong-term capital, which consists of both long-term debt and shareholders’ equity. A low levelof debt and a healthy proportion of equity in a company’s capital structure is an indication offinancial fitness.
Prudent use of leverage (debt) increases the financial resources available to a company forgrowth and expansion. It assumes that management can earn more on borrowed funds thanit pays in interest expense and fees on these funds. However, successful this formula mayseem, it does require a company to maintain a solid record of complying with its variousborrowing commitments.
A company considered too highly leveraged (too much debt) may find its freedom of actionrestricted by its creditors and/or have its profitability hurt by high interest costs. Of course,the worst of all scenarios is having trouble meeting operating and debt liabilities on time andsurviving adverse economic conditions. Lastly, a company in a highly competitive business, ifhobbled by high debt, will find its competitors taking advantage of its problems to grab moremarket share. As mentioned previously, the capitalization ratio is one of the more meaningfuldebt ratios because it focuses on the relationship of debt liabilities as a component of acompany’s total capital base, which is the capital mobilized by shareholders and lenders. Interest Coverage Ratio
The interest coverage ratio is used to determine how easily a company can pay interestexpenses on outstanding debt. The ratio is calculated by dividing a company’s earningsbefore interest and taxes (EBIT) by the company’s interest expenses for the same period.The lower the ratio, the more the company is burdened by debt expense. When a company’sinterest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may bequestionable.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had earnings before interestand taxes (operating income) of 7,520 (income statement), and total interest expense of 0(income statement). This equation provides the company with an Infinite margin of safety dueto lack of leverage. The ability to stay current with interest payment obligations is absolutelycritical for a company as a going concern. While the non-payment of debt principal is aseriously negative condition, a company finding itself in financial/operational difficulties canstay alive for quite some time as long as it is able to service its interest expenses. In amore positive sense, prudent borrowing makes sense for most companies, but the operativeword here is “prudent.” Interest expenses affect a company’s profitability, so the cost-benefitanalysis dictates that borrowing money to fund a company’s assets has to have a positiveeffect. An ample interest coverage ratio would be an indicator of this circumstance, as wellas indicating substantial additional debt capacity. Obviously, in this category of investmentquality, XYZ would go to the head of the class.
Cash Flow To Debt Ratio
This coverage ratio compares a company’s operating cash flow to its total debt, which, forpurposes of this ratio, is defined as the sum of short-term borrowings, the current portion oflong-term debt and long-term debt. This ratio provides an indication of a company’s ability tocover total debt with its yearly cash flow from operations. The higher the ratio, the better isthe company’s ability to carry its total debt.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net cash provided byoperating activities (operating cash flow as recorded in the statement of cash flows) of 5,876(cash flow statement), and total debt of 0 (balance sheet). By dividing, the equation providesthe company with infinite margin of debt coverage. A more conservative cash flow figurecalculation in the numerator would use a company’s free cash flow (operating cash flow minusthe amount of cash used for capital expenditures).A more conservative total debt figure would include, in addition to short-term borrowings,current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirdsof the principal of non-cancel-able operating leases. In the case of XYZ, their debt load isnil so the resulting cash flow to debt ratio percentage is off the chart. In this instance, thiscircumstance would indicate that the company has ample capacity to borrow a significantamount of money, if it chose to do so, as opposed to indicating its debt coverage capacity.Under more typical circumstances, a high double-digit percentage ratio would be a sign offinancial strength, while a low percentage ratio could be a negative sign that indicates toomuch debt or weak cash flow generation. It is important to investigate the larger factor behinda low ratio. To do this, compare the company’s current cash flow to debt ratio to its historiclevel in order to parse out trends or warning signs.
Operating Performance Ratios
The next series of ratios we’ll look at are the operating performance ratios. Each of theseratios have differing inputs and measure different segments of a company’s overall operationalperformance, but the ratios do give users insight into the company’s performance andmanagement during the period being measured. These ratios look at how well a companyturns its assets into revenue as well as how efficiently a company converts its sales into cash.Basically, these ratios look at how efficiently and effectively a company is using its resourcesto generate sales and increase shareholder value. In general, the better these ratios are, thebetter it is for shareholders.
In this section, we’ll look at the fixed-asset turnover ratio and the sales/revenue per employeeratio, which look at how well the company uses its fixed assets and employees to generatesales.
Fixed-Asset Turnover
This ratio is a rough measure of the productivity of a company’s fixed assets (property,plant and equipment or PP&E) with respect to generating sales. For most companies, theirinvestment in fixed assets represents the single largest component of their total assets. Thisannual turnover ratio is designed to reflect a company’s efficiency in managing these significantassets. Simply put, the higher the yearly turnover rate, the better.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of(income statement) and average fixed assets, or PP&E, of 2,342 (balance sheet - the averageof yearend 2009 and 2010 PP&E). By dividing, the equation gives us a fixed-asset turnover ratefor FY 2010 of 5.6. Instead of using fixed assets, some asset-turnover ratios would use totalassets. We prefer to focus on the former because, as a significant component in the balancesheet, it represents a multiplicity of management decisions on capital expenditures. Thus, thiscapital investment, and more importantly, its results, is a better performance indicator thanthat evidenced in total asset turnover. There is no exact number that determines whethera company is doing a good job of generating revenue from its investment in fixed assets.This makes it important to compare the most recent ratio to both the historical levels of thecompany along with peer company and/or industry averages. Before putting too much faithinto this ratio, it’s important to determine the type of company that you are using the ratio onbecause a company’s investment in fixed assets is very much linked to the requirements ofthe industry in which it conducts its business. Fixed assets vary greatly among companies. Forexample, an IT company, like XYZ, has less of a fixed-asset base than a heavy manufacturerlike BHEL. Obviously, the fixed-asset ratio for XYZ will have less relevance than that for BHEL.
Sales/Revenue per Employee
As a gauge of personnel productivity, this indicator simply measures the amount of rupeesales, or revenue, generated per employee. The higher the figure the better. Here again,labour-intensive businesses (ex. mass market retailers) will be less productive in this metricthan a high-tech, high product-value manufacturer.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had generated 22,098 in netsales with an average personnel component for the year of approximately 85,000 employees.The sales, or revenue, figure is the numerator (income statement), and the average numberof employees for the year is the denominator (annual report) and Sales Per Employee comeout to be Rs. 2,500,000.
An ‘Earnings per Employee’ ratio could also be calculated using net income (as opposed to netsales) in the numerator.
Industry and product-line characteristics will influence this indicator of employee productivity.Tracking this figure historically and comparing it to peer-group companies will make thisquantitative amount more meaningful in an analytical sense.
Du-Pont Analysis
The DuPont ratio can be used as a compass in the process of assessing financial performanceof the company by directing the analyst toward significant areas of strength and weaknessevident in the financial statements. The DuPont ratio is calculated as follows:
The ratio provides measures in three of the four key areas of analysis, each representing acompass bearing, pointing the way to the next stage of the investigation.
The DuPont Ratio Decomposition
The DuPont ratio is a good place to begin a financial statement analysis because it measuresthe return on equity (ROE). A for-profit business exists to create wealth for its owner(s). ROEis, therefore, arguably the most important of the key ratios, since it indicates the rate at whichowner wealth is increasing.
The three components of the DuPont ratio, as represented in equation, cover the areas ofprofitability, operating efficiency and leverage.
Profitability: Net Profit Margin
Profitability ratios measure the rate at which either sales or capital is converted into profitsat different levels of the operation. As we have seen, the most common are gross, operatingand net profitability, which describe performance at different activity levels. Of the three,net profitability is the most comprehensive since it uses the bottom line net income in itsmeasure.
The net profitability for XYZ Technologies in 2010 is:
A proper analysis of this ratio would include at least three to five years of trend and crosssectionalcomparison data. The cross sectional comparison can be drawn from a variety ofsources.
Asset Utilization: Total Asset Turnover
Turnover or efficiency ratios are important because they indicate how well the assets of afirm are used to generate sales and/or cash. While profitability is important, it doesn’t alwaysprovide the complete picture of how well a company provides a product or service. A companycan be very profitable, but not too efficient. Profitability is based upon accounting measuresof sales revenue and costs. Such measures are generated using the matching principle ofaccounting, which records revenue when earned and expenses when incurred. Hence, thegross profit margin measures the difference between sales revenue and the cost of goodsactually sold during the accounting period. The goods sold may be entirely different fromthe goods produced during that same period. Goods produced but not sold will show up asinventory assets at the end of the year. A firm with abnormally large inventory balances is notperforming effectively, and the purpose of efficiency ratios is to reveal that fact.
The total asset turnover (TAT) ratio measures the degree to which a firm generates sales withits total asset base. It is important to use average assets in the denominator to eliminate biasin the ratio calculation. Financial ratio bias is commonly present when combining items fromboth the balance sheet and income statement. For example, TAT uses income statement salesin its numerator and balance sheet assets in the denominator. Income statement items areflow variables measured over a time interval, while balance sheet items are measured at afixed point in time. In cases where the firm has been involved in major change, such as anexpansion project, balance sheet measures taken at the end of the year may misrepresentthe amount of assets available and/or in use over the course of the year. Taking a simpleaverage for balance sheet items (i.e., ((beginning + ending)/2)) will control for at least someof this bias and provide a more accurate and meaningful ratio. The limiting assumption is thatthe change in the balance sheet occurred evenly over the course of the year, which may notalways be the case.
The measure of total asset turnover for XYZ is:
Leverage: The Leverage Multiplier
Leverage ratios measure the extent to which a company relies on debt financing in its capitalstructure. Debt is both beneficial and costly to a firm. The cost of debt is lower than the costof equity, an effect which is enhanced by the tax deductibility of interest payments in contrastto taxable dividend payments and stock repurchases. If debt proceeds are invested in projectswhich return more than the cost of debt, owners keep the residual, and hence, the returnon equity is “leveraged up.” The debt sword, however, cuts both ways. Adding debt createsa fixed payment required of the firm whether or not it is earning an operating profit, andtherefore, payments may cut into the equity base. Further, the risk of the equity position isincreased by the presence of debt holders having a superior claim to the assets of the firm.The leverage multiplier employed in the DuPont ratio is directly related to the proportion ofdebt in the firm’s capital structure. The measure, which divides average assets by averageequity, can be restated in two ways, as follows:
Once again, averages are used to control for potential bias caused by the end-of-year values.The leverage multiplier for XYZ is:
.
Understanding Financial Statements
As mentioned in Chapter 1, the most important part of fundamental analysis involves delvinginto the financial statements or financial reports of companies. Financial information, whichaccounting helps to standardize, is presented in the companies’ financial reports. Indian listedcompanies must periodically report their financial statements to the investors and regulators.Why is this so? The laws and rules that govern the securities industry in the India derivefrom a simple and straightforward concept: all investors, whether large institutions or privateindividuals, should have access to certain basic facts about an investment prior to buying it.To achieve this, the Securities and Exchange Board of India (SEBI), the market regulator inIndia, requires public companies to disclose meaningful financial and other information tothe public. This provides a common pool of knowledge for all investors to use to judge forthemselves if a company’s securities are a good investment. Only through the steady flow of timely,comprehensive and accurate information can people make sound investment decisions.
Where can one find financial statements?
Listed companies have to send all their shareholders annual reports. In addition, the quarterlyfinancials of the company can be found on the stock exchanges’ websites and on the websiteof the company. Here are the financial statements of a major IT services company, XYZTechnologies Ltd. (XYZ)
XYZ Technologies Limited
Comparative Balance Sheets
(All figures in Rs. Crs.) Comparative Income Statements
Statement of Cash Flows
The primary and most important source of information about a company are its AnnualReports, prepared and distributed to the shareholders by law each year. Annual Reports areusually well presented. A tremendous amount of data is given about the performance of acompany over a period of time. If an Annual Report is impressive about the operations andfuture direction, if the company has made a profit and if a reasonable dividend has beenpaid, the average investor is typically content in the belief that the company is in good hands.However, for a fundamental analyst or for that matter any investor, this alone must not be thecriterion by which to judge a company. The intelligent investor must read the annual report indepth; he must read between and beyond the lines; he must peep behind the figures and findthe truth and only then should he decide whether the company is doing well or not.
The Annual Report is usually broken down into the following specific parts:1. The Director’s Report2. The Auditor’s Report3. The Financial Statements and4. The Schedules and Notes to the Accounts.
Each of these parts has a purpose and a story to tell. The Director’s Report
The Director’s Report is a report submitted by the directors of a company to shareholders,informing them about the performance of the company, under their stewardship:
1. It enunciates the opinion of the directors on the state of the economy and the politicalsituation vis-à-vis the company.
2. Explains the performance and the financial results of the company in the period underreview. This is an extremely important part. The results and operations of the variousseparate divisions are usually detailed and investors can determine the reasons for theirgood or bad performance.
3. The Director’s Report details the company’s plans for modernization, expansion anddiversification. Without these, a company will remain static and eventually decline.
4. Discusses the profits earned in the period under review and the dividend recommendedby the directors. This paragraph should normally be read with sane scepticism as thedirectors will always argue that the performance was satisfactory. If profits have improvedthe reasons stated would invariably be superior technology adopted, intense marketingand hard work in the face of severe competition etc. If profits are low, adverse economicconditions are usually blamed for the same.
5. Elaborates on the directors’ views of the company’s prospects for the future.
6. Discusses plans for new acquisitions and investments.
An investor must intelligently evaluate the issues raised in a Director’s Report. If the reporttalks about diversification, one must the question that though diversification is a good strategy,does it make sense for the company? Industry conditions, the management’s knowledge ofthe new business must be considered. Although companies must diversify in order to spreadthe risks of economic slumps, every diversification may not suit a company. Similarly, all otherissues raised in the Director’s Report should be analysed. Did the company perform as wellas others in the same industry? Is the finance being raised the most logical and beneficialto the company? It is imperative that the investor read between the lines of the Director’sReport and find the answers to these and many other questions. In short, a Director’s Reportis valuable and if read intelligently can give the investor a good grasp of the workings of acompany, the problems it faces, the direction it intends taking and its future prospects.
The Auditor’s Report
The auditor represents the shareholders and it is the auditor’s duty to report to the shareholdersand the general public on the stewardship of the company by its directors. Auditors are requiredto report whether the financial statements presented do in fact present a true and fair viewof the state of the company. Investors must remember that the auditors are required by lawto point out if the financial statements are true and fair. They are also required to report anychange, such as a change in accounting principles or the non-provision of charges that resultin an increase or decrease in profits. It is really the only impartial report that a shareholderor investor receives and this alone should spur one to scrutinize the auditor’s report minutely.Unfortunately, more often than not it is not read. There can be interesting contradictions. Itwas stated in the Auditor’s Report of ABC Co. Ltd. for the year 1999-2000 that, “As at theyear-end 31st March 2000 the accumulated losses exceed the net worth of the Company andthe Company has suffered cash losses in the financial year ended 31st March 2000 as well asin the immediately preceding financial year. In our opinion, therefore, the Company is a sickindustrial company within the meaning of clause (O) of Section 3(1) of the Sick IndustrialCompanies (Special Provisions) Act 1985”. The Director’s report however stated, “The financialyear under review has not been a favourable year for the Company as the computer industryin general continued to be in the grip of recession. High input costs as well as resourceconstraints hampered operations. The performance of your Company must be assessed in thelight of these factors. During the year manufacturing operations were curtailed to achieve costeffectiveness. Your directors are confident that the efforts for increased business volumes andcost control will yield better results in the current year”. The auditors were of the opinion thatthe company was sick whereas the directors spoke optimistically of their hope that the futurewould be better! They could not, being directors, state otherwise.
At times, accounting principles are changed or creative and innovative accounting practicesresorted to by some companies in order to show a better result. The effect of these changesis at times not detailed in the notes to the accounts. The Auditor’s Report will always drawthe attention of the reader to these changes and the effect that these have on the financialstatements. It is for this reason that a careful reading of the Auditor’s Report is not onlynecessary but mandatory for an investor.
Financial Statements
The published financial statements of a company in an Annual Report consist of its Balance Sheet as at the end of the accounting period detailing the financing condition of the companyat that date and the Profit and Loss Account or Income Statement summarizing theactivities of the company for the accounting period and the Statement of Cash Flows forthe accounting period.
Balance Sheet
The Balance Sheet details the financial position of a company on a particular date; thecompany’s assets (that which the company owns), and liabilities (that which the companyowes), grouped logically under specific heads. It must however, be noted that the BalanceSheet details the financial position on a particular day and that the position can be materiallydifferent on the next day or the day after.
Sources of funds
A company has to source funds to purchase fixed assets, to procure working capital and tofund its business. For the company to make a profit, the funds have to cost less than thereturn the company earns on their deployment.
Where does a company raise funds? What are the sources?
Companies raise funds from its shareholders and by borrowing.
a) Shareholders’ Funds (Total Share Capital in XYZ’s Balance Sheet)
A company sources funds from shareholders by the issue of shares. Shareholders’ funds is thebalance sheet value of shareholders’ interest in a company. For the accounts of a companywith no subsidiaries it is total assets minus total liabilities. For consolidated group accounts thevalue of minority interests is excluded. Minority interest refers to the portion of a subsidiarycorporation’s stock that is not owned by the parent corporation.
Shareholders’ funds represent the stake shareholders have in the company, the investmentthey have made.
Share CapitalShare capital represents the shares issued to the public. This is issued in following ways:
Private Placement - This is done by offering shares to selected individuals orinstitutions.
Public Issue - Shares are offered to public. The details of the offer, including thereasons for raising the money are detailed in a prospectus and it is important thatinvestors read this.
Rights issues - Companies may also issue shares to their shareholders as a matter ofright in proportion to their holding. So, if an investor has 100 shares and a companyannounces a 2:1 rights, the investor stands to gain an additional 200 shares. Rightsissues come at a price which the investors must pay by subscribing to the rights offer.The rights issues were often offered at a price lower than the company’s market valueand shareholders stood to gain. With the freedom in respect of pricing of shares nowavailable, companies have begun pricing their offerings nearer their intrinsic value.Consequently, many of these issues have not been particularly attractive to investors andseveral have failed to be fully subscribed. However, strong companies find subscribers tothier rights issues as investors are of the view that their long term performance wouldlead to increase in share prices.
Bonus shares - When a company has accumulated a large reserves out of profits, thedirectors may decide to distribute a part of it amongst the shareholders in the form ofbonus. Bonus can be paid either in cash or in the form of shares. Cash bonus is paidin the form of dividend by the company when it has large accumulated profits as wellas cash. Many a times, a company is not in a position to pay bonus in cash (dividend)in spite of sufficient profits because of unsatisfactory cash position or because of itsadverse effects on the working capital of the company. In such a case, the company paysa bonus to its shareholders in the form of shares. Bonus shares are shares issued free toshareholders by capitalizing reserves. No monies are actually raised from shareholders.Nothing stops a company from declaring a bonus and dividend together if it has largeaccumulated profits as well as cash.
Reserves - Reserves are profits or gains which are retained and not distributed. Companieshave two kinds of reserves - capital reserves and revenue reserves:
• Capital Reserves – Capital reserves are gains that have resulted from an increasein the value of assets and they are not freely distributable to the shareholders. Themost common capital reserves one comes across are the share premium accountarising from the issue of shares at a premium and the capital revaluation reserve, i.e.unrealized gain on the value of assets.
• Revenue Reserves - These represent profits from operations ploughed back into thecompany and not distributed as dividends to shareholders. It is important that all theprofits are not distributed as funds are required by companies to purchase new assetsto replace existing ones, for expansion and for working capital.
b) Loan FundsThe other source of funds a company has access to is borrowings. Borrowing is often preferredby companies as it is quicker, relatively easier and the rules that need to be complied with aremuch less. The loans taken by companies are either :
Secured loans - These loans are taken by a company by pledging some of its assetsor by a floating charge on some or all of its assets. The usual secured loans a companyhas are debentures and term loans.
Unsecured loans - Companies do not pledge any assets when they take unsecuredloans. The comfort a lender has is usually only the good name and credit worthiness ofthe company. The more common unsecured loans of a company are fixed deposits andshort term loans. In case a company is dissolved, unsecured lenders are usually paidafter the secured lenders have been paid. Borrowings or credits for working capitalwhich fluctuate such as bank overdrafts and trade creditors are not normally classifiedas loan funds but as current liabilities.
Fixed Assets (Net Block in XYZ’s Balance Sheet) - Fixed assets are assets that a companyowns for use in its business and to produce goods. Typically it could be machinery. They arenot for resale and comprises of land, buildings i.e. offices, warehouses and factories, vehicles,machinery, furniture, equipment and the like. Every company has some fixed assets thoughthe nature or kind of fixed assets vary from company to company. A manufacturing company’smajor fixed assets would be its factory and machinery, whereas that of a shipping companywould be its ships. Fixed assets are shown in the Balance Sheet at cost less the accumulateddepreciation. Depreciation is based on the very sound concept that an asset has a useful lifeand that after years of toil it wears down. Consequently, it attempts to measure that wear andtear and to reduce the value of the asset accordingly so that at the end of its useful life, theasset will have no value.
As depreciation is a charge on profits, at the end of its useful life, the company would have setaside from profits an amount equal to the original cost of the asset and this could be utilizedto purchase another asset. However, in the inflationary times, this is inadequate and somecompanies create an additional reserve to ensure that there are sufficient funds to replace theworn out asset. The common methods of depreciation are:
Straight line method - The cost of the asset is written off equally over its life.Consequently, at the end of its useful life, the cost will equal the accumulateddepreciation.
Reducing balance method - Under this method, depreciation is calculated on thewritten down value, i.e. cost less depreciation. Consequently, depreciation is higher inthe beginning and lower as the years progress. An asset is never fully written off asthe depreciation is always calculated on a reducing balance.
Land is the only fixed asset that is never depreciated as it normally appreciates in value.Capital work in progress - factories being constructed, etc. - are not depreciated until it is afully functional asset.
Investments
Many companies purchase investments in the form of shares or debentures to earn income orto utilize cash surpluses profitably. The normal investments a company has are:
Trade investments - Trade investments are normally shares or debentures ofcompetitors that a company holds to have access to information on their growth,profitability and other details.
Subsidiary and associate companies - These are shares held in subsidiary orassociate companies. The large business houses hold controlling interest in severalcompanies through cross holdings in subsidiary and associate companies.
Others - Companies also often hold shares or debentures of other companies forinvestment or to park surplus funds.
Investments are also classified as quoted and unquoted investments. Quoted investmentsare shares and debentures that are quoted in a recognized stock exchange and can be freelytraded. Unquoted investments are not listed or quoted in a stock exchange. Consequently,they are not liquid and are difficult to dispose of.Investments are valued and stated in the balance sheet at either the acquisition cost ormarket value, whichever is lower. This is in order to be conservative and to ensure that lossesare adequately accounted for.
Current assets - Current assets are assets owned by a company which are used in thenormal course of business or are generated by the company in the course of business such asdebtors or finished stock or cash.
The rule of thumb is that any asset that is turned into cash within twelve months is a currentasset. Current assets can be divided essentially into three categories :
Converting assets - Assets that are produced or generated in the normal course ofbusiness, such as finished goods and debtors.
Constant assets - Constant assets are those that are purchased and sold withoutany add-ons or conversions, such as liquor bought by a liquor store from a liquormanufacturer.
Cash equivalents - They can be used to repay dues or purchase other assets. Themost common cash equivalent assets are cash in hand and at the bank and loansgiven.
The current assets a company has are:
• Inventories - These are arguably the most important current assets that a companyhas as it is by the sale of its stocks that a company makes its profits. Stocks, in turn,consist of:
Raw materials - The primary purchase which is utilized to manufacture theproducts a company makes.
Work in progress - Goods that are in the process of manufacture but are yet tobe completed.
Finished goods - The finished products manufactured by the company that areready for sale.
Valuation of stocks
Stocks are valued at the lower of cost or net realizable value. This is to ensure that there willbe no loss at the time of sale as that would have been accounted for. The common methodsof valuing stocks are:
FIFO or first in first out - It is assumed under this method that stocks that come infirst would be sold first and those that come in last would be sold last.
LIFO or last in last out - The premise on which this method is based is the oppositeof FIFO. It is assumed that the goods that arrive last will be sold first. The reasoningis that customers prefer newer materials or products. It is important to ascertain themethod of valuation and the accounting principles involved as stock values can easilybe manipulated by changing the method of valuation. Debtors - Most companies do not sell their products for cash but on credit and purchasers areexpected to pay for the goods they have bought within an agreed period of time - 30 days or60 days. The period of credit would vary from customer to customer and from the companyto company and depends on the credit worthiness of the customer, market conditions andcompetition. Often customers may not pay within the agreed credit period. This may be dueto laxity in credit administration or the inability of the customers to pay. Consequently, debtsare classified as:
1. Those over six months, and2. Others
These are further subdivided into;
1. Debts considered good, and2. Debts considered bad and doubtful
If debts are likely to be bad, they must be provided for or written off. If this is not done,assets will be overstated to the extent of the bad debt. A write off is made only when there isno hope of recovery. Otherwise, a provision is made. Provisions may be specific or they maybe general. When amounts are provided on certain identified debts, the provision is termedspecific whereas if a provision amounting to a certain percentage of all debts is made, theprovision is termed general.
Prepaid Expenses - All payments are not made when due. Many payments, such as insurancepremia, rent and service costs, are made in advance for a period of time which may be 3months, 6 months, or even a year. The portion of such expenses that relates to the nextaccounting period are shown as prepaid expenses in the Balance Sheet.
Cash & Bank Balances - Cash in hand in petty cash boxes, safes and balances in bankaccounts are shown under this heading in the Balance Sheet.
Loans & Advances - These are loans that have been given to other corporations, individualsand employees and are repayable within a certain period of time. This also includes amountspaid in advance for the supply of goods, materials and services.
Other Current Assets - Other current assets are all amounts due that are recoverablewithin the next twelve months. These include claims receivable, interest due on investmentsand the like.
Current Liabilities - Current liabilities are amounts due that are payable within the nexttwelve months. These also include provisions which are amounts set aside for an expenseincurred for which the bill has not been received as yet or whose cost has not been fullyestimated. Creditors - Trade creditors are those to whom the company owes money for raw materialsand other articles used in the manufacture of its products. Companies usually purchase theseon credit - the credit period depending on the demand for the item, the standing of thecompany and market practice.
Accrued Expenses - Certain expenses such as interest on bank overdrafts, telephone costs,electricity and overtime are paid after they have been incurred. This is because they fluctuateand it is not possible to either prepay or accurately anticipate these expenses. However, theexpense has been incurred. To recognize this the expense incurred is estimated based on pasttrends and known expenses incurred and accrued on the date of the Balance Sheet.
Provisions - Provisions are amounts set aside from profits for an estimated expense orloss. Certain provisions such as depreciation and provisions for bad debts are deducted fromthe concerned asset itself. There are others, such as claims that may be payable, for whichprovisions are made. Other provisions normally seen on balance sheets are those for dividendsand taxation.
Sundry Creditors - Any other amounts due are usually clubbed under the all-embracing titleof sundry creditors. These include unclaimed dividends and dues payable to third parties.
Income Statement
The Profit and Loss account summarizes the activities of a company during an accountingperiod which may be a month, a quarter, six months, a year or longer, and the result achievedby the company. It details the income earned by the company, its cost and the resulting profitor loss. It is, in effect, the performance appraisal not only of the company but also of itsmanagement - its competence, foresight and ability to lead.
Sales - Sales include the amount received or receivable from customers arising from the salesof goods and the provision of services by a company. A sale occurs when the ownership ofgoods and the consequent risk relating to these goods are passed to the customer in returnfor consideration, usually cash. In normal circumstances the physical possession of the goodsis also transferred at the same time. A sale does not occur when a company places goods atthe shop of a dealer with the clear understanding that payment need be made only after thegoods are sold failing which they may be returned. In such a case, the ownership and risksare not transferred to the dealer nor any consideration paid.
Companies do give trade discounts and other incentive discounts to customers to enticethem to buy their products. Sales should be accounted for after deducting these discounts.However, cash discounts given for early payment are a finance expense and should be shownas an expense and not deducted from sales.
There are many companies which deduct excise duty and other levies from sales. Thereare others who show this as an expense. It is preferable to deduct these from sales sincethe sales figures would then reflect the actual mark-up made by the company on its cost ofproduction.
Other Income - Companies may also receive income from sources other than from the saleof their products or the provision of services. These are usually clubbed together under theheading, other income. The more common items that appear under this title are:
Profit from the sale of assets - Profit from the sale of investments or assets.
Dividends - Dividends earned from investments made by the company in the sharesof other companies.
Rent - Rent received from commercial buildings and apartments leased from thecompany.
Interest - Interest received on deposits made and loans given to corporate and otherbodies.
Raw Materials - The raw materials and other items used in the manufacture of a company’sproducts. It is also sometimes called the cost of goods sold.
Employee Costs - The costs of employment are accounted for under this head and wouldinclude wages, salaries, bonus, gratuity, contributions made to provident and other funds,welfare expenses, and other employee related expenditure.
Operating & Other Expenses - All other costs incurred in running a company are calledoperating and other expenses, and include.
Selling expenses - The cost of advertising, sales commissions, sales promotionexpenses and other sales related expenses.
Administration expenses - Rent of offices and factories, municipal taxes, stationery,telephone and telex costs, electricity charges, insurance, repairs, motor maintenance,and all other expenses incurred to run a company.
Others - These include costs that are not strictly administration or selling expenses,such as donations made, losses on the sale of fixed assets or investments, miscellaneousexpenditure and the like.
Interest & Finance Charges - A company has to pay interest on money it borrows. This isnormally shown separately as it is a cost distinct from the normal costs incurred in running abusiness and would vary from company to company.
The normal borrowings that a company pays interest on are:1. Bank overdrafts2. Term loans taken for the purchase of machinery or construction of a factory3. Fixed deposits from the public4. Debentures5. Inter-corporate loans Depreciation - Depreciation represents the wear and tear incurred by the fixed assets of acompany, i.e. the reduction in the value of fixed assets on account of usage. This is also shownseparately as the depreciation charge of similar companies in the same industry will differ,depending on the age of the fixed assets and the cost at which they have been bought.
Tax - Most companies are taxed on the profits that they make. It must be rememberedhowever that taxes are payable on the taxable income or profit and this can differ from theaccounting income or profit. Taxable income is what income is according to tax law, which isdifferent to what accounting standards consider income to be. Some income and expenditureitems are excluded for tax purposes (i.e. they are not assessable or not deductible) but areconsidered legitimate income or expenditure for accounting purposes.
Dividends - Dividends are profits distributed to shareholders. The total profits after tax arenot always distributed – a portion is often ploughed back into the company for its futuregrowth and expansion. Companies generally pay an interim and / or final dividend. Interimdividend usually accompanies the company’s interim financial statements. The final dividendis usually declared after the results for the period have been determined. The final dividendis proposed at the annual general meeting of the company and paid after the approval of theshareholders.
Transfer to Reserves - The transfer to reserves is the profit ploughed back into the company.This may be done to finance working capital, expansion, fixed assets or for some other purpose.These are revenue reserves and can be distributed to shareholders as dividends.
Contingent Liabilities - Contingent liabilities are liabilities that may arise up on the happeningof an event. It is uncertain however whether the event itself may happen. This is why theseare not provided for and shown as an actual liability in the balance sheet. Contingent liabilitiesare detailed in the Financial Statements as a note to inform the readers of possible futureliabilities while arriving at an opinion about the company. The contingent liabilities one normallyencounters are:
Bills discounted with banks - These may crystallize into active liabilities if the bills aredishonoured.
Gratuity to employees not provided for
Claims against a company not acknowledged or accepted
Excise claims against the company etc.
Schedules and Notes to the Accounts
The schedules and notes to the accounts are an integral part of the financial statements of acompany and it is important that they be read along with the financial statements.
Schedules - The schedules detail pertinent information about the items of Balance Sheetand Profit & Loss Account. It also details information about sales, manufacturing costs,administration costs, interest, and other income and expenses. This information is vital forthe analysis of financial statements.
The schedules enable an investor to determine which expenses increased and seek the reasonsfor this. Similarly, investors would be able to find out the reasons for the increase or decreasein sales and the products that are sales leaders. The schedules even give details of stocks andsales, particulars of capacity and productions, and much other useful information.
Notes - The notes to the accounts are even more important than the schedules because it ishere that very important information relating to the company is stated. Notes can effectivelybe divided into:
• Accounting policies - All companies follow certain accounting principles and thesemay differ from those of other entities. As a consequence, the profit earned mightdiffer. Companies have also been known to change (normally increase) their profit bychanging the accounting policies. For instance, ABC Co. Ltd.’s Annual Report statedamong other things, “There has been a change in the method of accounting relatingto interest on borrowings used for capital expenditure. While such interest was fullywritten off in the previous years, interest charges incurred during the year have beencapitalized for the period upto the date from which the assets have been put to use.Accordingly, expenditure transferred to capital account includes an amount of Rs.46.63 crores towards interest capitalized. The profit before taxes for the year afterthe consequential adjustments of depreciation of Rs. 0.12 crore is therefore higher byRs. 46.51 crores than what it would have been had the previous basis been followed”.This means that by changing an accounting policy ABC Co. Ltd. was able to increaseits income by Rs. 46 crore. There could be similar notes on other items in the financialstatements.
The accounting policies normally detailed in the notes relate to:o How sales are accounted for?o What the research and development costs are?o How the gratuity liability is expensed?o How fixed assets are valued?o How depreciation is calculated?o How stock, including finished goods, work in progress, raw materials andconsumable goods are valued?o How investments are stated in the balance sheet?o How has the foreign exchange translated?
• Contingent liabilities - As noted earlier, contingent liabilities that might crystallizeupon the happening of an uncertain event. All contingent liabilities are detailed inthe notes to the accounts and it would be wise to read these as they give valuableinsights. The more common contingent liabilities that one comes across in the financialstatements of companies are:
o Outstanding guarantees.o Outstanding letters of credit.o Outstanding bills discounted.o Claims against the company not acknowledged as debts.o Claim for taxes.o Cheques discounted.o Uncalled liability on partly paid shares and debentures.
• Others - It must be appreciated that the purpose of notes to the accounts is to informthe reader more fully. Consequently, they detail all pertinent factors which affect, orwill affect, the company and its results. Often as a consequence, adjustments mayneed to be made to the accounts to unearth the true results. The more common notesone comes across are:
o Whether provisions for known or likely losses have been made.o Estimated value of contracts outstanding.o Interest not provided for.o Arrangements agreed by the company with third parties.o Agreement with labour.
The importance of these notes cannot be overstressed. It is imperative that investors readthese carefully.
Cash Flow Statement
Complementing the balance sheet and income statement, the cash flow statement (CFS)allows investors to understand how a company’s operations are running, where its money iscoming from and how it is being spent.
The Structure of the CFS
The cash flow statement is distinct from the income statement and balance sheet because itdoes not include the amount of future incoming and outgoing cash that has been recordedon credit. Therefore, cash is not the same as net income, which, on the income statementand balance sheet, includes cash sales and sales made on credit. Cash flow is determined bylooking at three components by which cash enters and leaves a company, its core operations,investing activities and financing activities.
Cash Flow From Operations
Measuring the cash inflows and outflows caused by core business operations, theoperations component of cash flow reflects how much cash is generated froma company’s products or services. Generally, changes made in cash, accountsreceivable, depreciation, inventory and accounts payable are reflected in cash from operations.Cash flow is calculated by making certain adjustments to net income by adding or subtractingdifferences in revenue, expenses and credit transactions (appearing on the balance sheetand income statement) resulting from transactions that occur from one period to the next.These adjustments are made because non-cash items are calculated into net income (incomestatement) and total assets and liabilities (balance sheet). So, because not all transactionsinvolve actual cash items, many items have to be re-evaluated when calculating cash flowfrom operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted fromthe total value of an asset that has previously been accounted for. That is why it is added backinto net sales for calculating cash flow. The only time income from an asset is accounted forin cash flow statement calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to thenext must also be reflected in cash flow. If accounts receivable decreases, this implies thatmore cash has entered the company from customers paying off their credit accounts - theamount by which accounts receivable has decreased is then added to net sales. If accountsreceivable increases from one accounting period to the next, the amount of the increasemust be deducted from net sales because, although the amounts represented in accountsreceivable are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money topurchase more raw materials. If the inventory was paid with cash, the increase in the valueof inventory is deducted from net sales. A decrease in inventory would be added to net sales.If inventory was purchased on credit, an increase in accounts payable would occur on thebalance sheet, and the amount of the increase from one year to the other would be addedto net sales.
The same logic holds true for taxes payable, salaries payable and prepaid insurance. Ifsomething has been paid off, then the difference in the value owed from one year to thenext has to be subtracted from net income. If there is an amount that is still owed, then anydifferences will have to be added to net earnings.
Cash Flow From Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cashchanges from investing are a “cash out” item, because cash is used to buy new equipment,buildings or short-term assets such as marketable securities. However, when a companydivests of an asset, the transaction is considered “cash in” for calculating cash from investing. Cash Flow From Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cashfrom financing are “cash in” when capital is raised, and they’re “cash out” when dividends arepaid. Thus, if a company issues a bond to the public, the company receives cash financing;however, when interest is paid to bondholders, the company is reducing its cash.
A company can use a cash flow statement to predict future cash flow, which helps with mattersin budgeting. For investors, the cash flow reflects a company’s financial health: basically, themore cash available for business operations, the better. However, this is not a hard and fastrule. Sometimes a negative cash flow results from a company’s growth strategy in the formof expanding its operations.
By adjusting earnings, revenues, assets and liabilities, the investor can get a very clearpicture of what some people consider the most important aspect of a company: how muchcash it generates and particularly, how much of that cash stems from core operations.
Financial Statement Analysis and Forensic Accounting
A comprehensive financial statement analysis provides insights into a firm’s performanceand/or standing in the areas of liquidity, leverage, operating efficiency and profitability. Acomplete analysis involves both time series and cross-sectional perspectives. Time seriesanalysis examines trends using the firm’s own performance as a benchmark. Cross sectionalanalysis augments the process by using external performance benchmarks (Industry or peers)for comparison purposes.
Comparative and Common-size Financial Statements
As seen in the previous NCFM module4, we often use comparative financial statements inorder to compare different financial ratios of a firm with the industry averages and otherpeers in the industry whereas we use common-size financial statements in order to compareperformance of a firm or two firms over time. Financial ratios in isolation mean nothing. Weneed to observe them change over time or compare financial ratios of a cross section of firmsin order to make sense of them.
Financial Ratios
To find the data used in the examples in this section, please see the XYZ Technologies Limited’sfinancial statements given earlier.
Combination and Analysis of the Results
Once the three components have been calculated, they can be combined to form the ROE, asfollows:
While additional measures for prior years would provide the basis for a necessary trendanalysis, this result is not meaningful until it is compared to an industry or best practicesbenchmark. The DuPont ratio/or the Indian IT Industry is:
20*1.01 * 1.1 = 22.2%
As can be seen, strengths in XYZ are immediately evident in the comparison of DuPont valuesfor XYZ and Indian IT Industry. The company appears to be significant in profitability, whiletotal asset turnover seems to be roughly in line with the industry. The overall industry leverageis slightly higher than XYZ’Ss zero debt balance sheet. The analyst can now focus on thecompany’s profitability. A quick analysis of profitability yields the following result:
Sound financial statement analysis is an integral part of the management process for anyorganization. The DuPont ratio, while not the end in itself, is an excellent way to get a quicksnapshot view of the overall performance of a firm in three of the four critical areas ofratio analysis, profitability, operating efficiency and leverage. By identifying strengths and/orweaknesses in any of the three areas, the DuPont analysis enables the analyst to quickly focushis or her detailed study on a particular spot, making the subsequent inquiry both easier andmore meaningful. Some caveats, however, are to be noted.
The DuPont ratio consists of very general measures, drawing from the broadest values on thebalance sheets and income statements (e.g., total assets is the most broad of asset measures).A DuPont study is not a replacement for detailed, comprehensive analysis. Further, theremay be problems that the DuPont decomposition does not readily identify. For example, anaverage outcome for net profitability may mask the existence of a low gross margin combinedwith an abnormally high operating margin. Without looking at the two detailed measures,understanding of the true performance of the firm would be lost.
The DuPont ratio can also be broken into more components called ‘The Extended DuPont’,depending upon the needs of the analyst In any case, the DuPont can add value, even “on thefly,” to understand and solving a broad variety of business problems.
Extended DuPont Formula
Cash Conversion Cycle
This liquidity metric expresses the length of time (in days) that a company uses to sellinventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC)measures the number of days a company’s cash is tied up in the production and sales processof its operations and the benefit it gets from payment terms from its creditors. The shorterthis cycle, the more liquid the company’s working capital position is. The CCC is also knownas the “cash” or “operating” cycle.
DIO is computed by1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per dayfigure;2. Calculating the average inventory figure by adding the year’s beginning (previous yearendamount) and ending inventory figure (both are in the balance sheet) and dividing by 2to obtain an average amount of inventory for any given year; and3. Dividing the average inventory figure by the cost of sales per day figure.For XYZ FY 2010 (in Rs. crores), its DIO would be computed with these figures:
DIO gives a measure of the number of days it takes for the company’s inventory to turn over,i.e., to be converted to sales, either as cash or accounts receivable. Understandably, being anIT company, DIO for XYZ comes out to be zero.
DSO is computed by
1. Dividing net sales (income statement) by 365 to get a net sales per day figure;2. Calculating the average accounts receivable figure by adding the year’s beginning(previous yearend amount) and ending accounts receivable amount (both figures are inthe balance sheet) and dividing by 2 to obtain an average amount of accounts receivablefor any given year; and3. Dividing the average accounts receivable figure by the net sales per day figure.
For XYZ FY 2010 (in Rs. crores), its DSO would be computed with these figures:
DSO gives a measure of the number of days it takes a company to collect on sales that go intoaccounts receivables (credit purchases).
DPO is computed by1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per dayfigure;2. Calculating the average accounts payable figure by adding the year’s beginning (previousyearend amount) and ending accounts payable amount (both figures are in the balancesheet), and dividing by 2 to get an average accounts payable amount for any givenyear; and3. Dividing the average accounts payable figure by the cost of sales per day figure.
For XYZ FY 2010 (in Rs. crores), its DPO would be computed with these figures:
DPO gives a measure of how long it takes the company to pay its obligations to suppliers.CCC computed:
XYZ’S cash conversion cycle for FY 2005 would be computed with these numbers (rounded):
Often the components of the cash conversion cycle - DIO, DSO and DPO – are expressedin terms of turnover as a times (x) factor. For example, in the case of XYZ, its days debtorsoutstanding of 57 days would be expressed as turning over 6.4x annually (365 days ÷ 57 days= 6.4 times). However, actually counting days is more literal and easier to understand whenconsidering how fast assets turn into cash.
An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it’san indicator of the company’s efficiency in managing its important working capital assets;second, it provides a clear view of a company’s ability to pay off its current liabilities.It does this by looking at how quickly the company turns its inventory into sales, and its salesinto cash, which is then used to pay its suppliers for goods and services. Again, while the quickand current ratios are more often mentioned in financial reporting, investors would be welladvised to measure true liquidity by paying attention to a company’s cash conversion cycle.
The longer the duration of inventory on hand and of the collection of receivables, coupledwith a shorter duration for payments to a company’s suppliers, means that cash is being tiedup in inventory and receivables and used more quickly in paying off trade payables. If thiscircumstance becomes a trend, it will reduce, or squeeze, a company’s cash availabilities.Conversely, a positive trend in the cash conversion cycle will add to a company’s liquidity.
By tracking the individual components of the CCC (as well as the CCC as a whole), an investoris able to discern positive and negative trends in a company’s all-important working capitalassets and liabilities. For example, an increasing trend in DIO could mean decreasing demandfor a company’s products. Decreasing DSO could indicate an increasingly competitive product,which allows a company to tighten its buyers’ payment terms. As a whole, a shorter CCCmeans greater liquidity, which translates into less of a need to borrow, more opportunity torealize price discounts with cash purchases for raw materials, and an increased capacity tofund the expansion of the business into new product lines and markets. Conversely, a longerCCC increases a company’s cash needs and negates all the positive liquidity qualities justmentioned.
Current Ratio Vs. The CCC
The obvious limitations of the current ratio as an indicator of true liquidity clearly establish astrong case for greater recognition, and use, of the cash conversion cycle in any analysis of acompany’s working capital position.Cash Conversion cycle for XYZ over five years :
The Satyam Case and Need for Forensic Accounting
In what became India’s biggest corporate scandal till date, Mr. Ramalinga Raju, founder andchairman of Satyam Computers Ltd., one of India’s four premier IT companies, admitted of afraud through a letter addressed to the board of the company in January 2009.
The Fraud
• There was Rs. 5040 crores worth inflated cash and bank balance• Non-existent accrued interest of Rs. 376 crores• Understated liability of Rs. 1230 crores• Overstated debtor position of Rs. 490 crores• Overstated Revenues & operating profit by Rs. 588 crores
Added together, it was a discrepancy of Rs. 7724 crores in the accounts for a company havingannual revenues of Rs. 10,000 odd crores.
Satyam’s share price crashed 77% to Rs. 40.25 on the news and the great story for a seeminglysuccessful Indian IT company ended. Fingers were pointed, concerns were raised, complaintswere filed and dreams were shattered.
The government was quick to act, appointing a new board for Satyam which helped carry outbidding process for the IT giant and saved the company from extinction.The Satyam fracas is one more fraud in the long history of misappropriation of resourcesgiven in trust to individuals and institutions. What this entire episode brings to the fore, is thefollowing:
• Any control system is only as good as the people administering it• Audits are not a replacement for responsible management• Laws and regulations cannot deter persons who wish to defeat them – at least temporarily.In this context, the relevance of forensic accounting and forensic accounts has grownenormously in recent years. In the interest of organizations and numerous investors whohave direct stake in the financial well-being of the organizations, more and more forensicaccountants should be involved to ward off financial disasters.
The integration of accounting, auditing and investigative skills yields the speciality known asForensic Accounting. There is a growing need among analysts, law enforcement professionals,small business owners, and department managers to better understand basic forensicaccounting principles, how different types of frauds occur and how to investigate a fraud that isdetected in a way that maximizes the chances of successful prosecution of the perpetrator
Concept of “Time value of Money”
The concept of time value of money arises from the relative importance of an asset now vs.in future. Assets provide returns and ownership of assets provides access to these returns.For example, Rs. 100 of today’s money invested for one year and earning 5% interest willbe worth Rs. 105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100a year from now. Therefore, any wise person would chose to own Rs. 100 now than Rs. 100in future. In the first option he can earn interest on on Rs. 100 while in the second option heloses interest. This explains the ‘time value’ of money. Also, Rs. 100 paid now or Rs. 105 paidexactly one year from now both have the same value to the recipient who assumes 5% as therate of interest. Using time value of money terminology, Rs. 100 invested for one year at 5%interest has a future value of Rs. 105. The method also allows the valuation of a likely streamof income in the future, in such a way that the annual incomes are discounted and then addedtogether, thus providing a lump-sum “present value” of the entire income stream. For eg. Ifyou earn Rs. 5 each for the next two years (at 5% p.a. simple interest) on Rs. 100, you wouldreceive Rs. 110 after two years. The Rs. 110 you earn, can be discounted at 5% for two yearsto arrive at the present value of Rs. 110, i.e. Rs. 100.
Valuing future cash flows, that may arise from an asset such as stocks, is one of the cornerstonesof fundamental analysis. Cash flows from assets make them more valuable now than in thefuture and to understand the relative difference we use the concepts of interest and discountrates. Interest rates provide the rate of return of an asset over a period of time, i.e., in futureand discount rates help us determine what a future value of asset, value that would come tous in future, is currently worth.
The present value of an asset could be shown to be:
Where PV = Present Value
FV = Future Value
r = Discount Rate
t = Time
Interest Rates and Discount Factors
So, what interest rate should we use while discounting the future cash flows? Understandingwhat is called as Opportunity cost is very important here.
Opportunity Cost
Opportunity cost is the cost of any activity measured in terms of the value of the otheralternative that is not chosen (that is foregone). Put another way, it is the benefit you couldhave received by taking an alternative action; the difference in return between a choseninvestment and one that is not taken. Say you invest in a stock and it returns 6% over a year.In placing your money in the stock, you gave up the opportunity of another investment - say,a fixed deposit yielding 8%. In this situation, your opportunity costs are 2% (8% - 6%).
But do you expect only fixed deposit returns from stocks? Certainly not. You expect to earnmore than the return from fixed deposit when you invest in stocks. Otherwise you are betteroff with fixed deposits. The reason you expect higher returns from stocks is because thestocks are much riskier as compared to fixed deposits. This extra risk that you assume whenyou invest in stocks calls for additional return that you assume over other risk-free (or nearrisk-free) return.
The discount rate of cost of capital to be used in case of discounting future cash flows tocome up with their present value is termed as Weighted Average Cost of Capital (WACC).
Where D = Debt portion of the Total Capital Employed by the firm TC = Total Capital Employed by the frim (D+E+P) Kd = Cost of Debt of the Company. t = Effective tax rate of the firm E = Equity portion of the Total Capital employed by the firm P = Preferred Equity portion of the Total Capital employed by the firm Kp = Cost of Preferred Equity of the firm
The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital AssetPricing Model (CAPM)
OrWhere Rf = Risk-free rate β = Beta, the factor signifying risk of the firm Rm = Implied required rate of return for the market
So what discount factors do we use in order to come up with the present value of the futurecash flows from a company’s stock?
Risk-free Rate
The risk-free interest rate is the theoretical rate of return of an investment with zero risk,including default risk. Default risk is the risk that an individual or company would be unableto pay its debt obligations. The risk-free rate represents the interest an investor would expectfrom an absolutely risk-free investment over a given period of time.
Though a truly risk-free asset exists only in theory, in practice most professionals and academicsuse short-dated government bonds of the currency in question. For US Dollar investments,US Treasury bills are used, while a common choice for EURO investments are the Germangovernment bonds or Euribor rates. The risk-free interest rate for the Indian Rupee for Indianinvestors would be the yield on Indian government bonds denominated in Indian Rupee ofappropriate maturity. These securities are considered to be risk-free because the likelihood ofgovernments defaulting is extremely low and because the short maturity of the bills protectinvestors from interest-rate risk that is present in all fixed rate bonds (if interest rates go upsoon after a bond is purchased, the investor misses out on the this amount of interest, tillthe bond matures and the amount received on maturity can be reinvested at the new interestrate).
Though Indian government bond is a riskless security per se, a foreign investor may look atthe India’s sovereign risk which would represent some risk. As India’s sovereign rating is notthe highest (please search the internet for sovereign ratings of India and other countries)a foreign investor may consider investing in Indian government bonds as not a risk freeinvestment.
For valuing Indian equities, we will take 10-Yr Government Bond as risk-free interest rate.(Roughly 7.8% - as of this writing).
Equity Risk Premium
The notion that risk matters and that riskier investments should have higher expected returnsthan safer investments, to be considered good investments, is both central to modern finance.Thus, the expected return on any investment can be written as the sum of the risk-free rateand a risk premium to compensate for the risk. The equity risk premium reflects fundamentaljudgments we make about how much risk we see in an economy/market and what price weattach to that risk. In effect, the equity risk premium is the premium that investors demand forthe average risk investment and by extension, the discount that they apply to expected cashflows with average risk. When equity risk premia rises, investors are charging a higher pricefor risk and will therefore pay lower prices for the same set of risky expected cash flows.
Equity risk premia are a central component of every risk and return model in finance and is akey input into estimating costs of equity and capital in both corporate finance and valuation.
The Beta
The Beta is a measure of the systematic risk of a security that cannot be avoided throughdiversification. Therefore, Beta measures non-diversifiable risk. It is a relative measure of risk:the risk of an individual stock relative to the market portfolio of all stocks. Beta is a statisticalmeasurement indicating the volatility of a stock’s price relative to the price movement of theoverall market. Higher-beta stocks mean greater volatility and are therefore considered to beriskier but are in turn supposed to provide a potential for higher returns; low-beta stocks poseless risk but also lower returns.
The market itself has a beta value of 1; in other words, its movement is exactly equal to itself(a 1:1 ratio). Stocks may have a beta value of less than, equal to, or greater than one. Anasset with a beta of 0 means that its price is not at all correlated with the market; that assetis independent. A positive beta means that the asset generally tracks the market. A negativebeta shows that the asset inversely follows the market; the asset generally decreases in valueif the market goes up.
where = Beta of security with market
= Covariance between security and market= Variance of market returnsORWhere = Coefficient of Correlation between security and market returns
Consider the stock of ABC Technologies Ltd. which has a beta of 0.8. This essentially points tothe fact that based on past trading data, ABC Technologies Ltd. as a whole has been relativelyless volatile as compared to the market as a whole. Its price moves less than the marketmovement. Suppose Nifty index moves by 1% (up or down), ABC Technologies Ltd.’s pricewould move 0.80% (up or down). If ABC Technologies Ltd. has a Beta of 1.2, it is theoretically20% more volatile than the market.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potentialfor higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Thisidea has been challenged by some, claiming that data shows little relation between beta andpotential returns, or even that lower-beta stocks are both less risky and more profitable.
Beta is an extremely useful tool to consider when building a portfolio. For example, if you areconcerned about the markets and want a more conservative portfolio of stocks to ride out theexpected market decline, you’ll want to focus on stocks with low betas. On the other hand, ifyou are extremely bullish on the overall market, you’ll want to focus on high beta stocks inorder to leverage the expected strong market conditions. Beta can also considered to be anindicator of expected return on investment. Given a risk-free rate of 2%, for example, if themarket (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 shouldreturn 11% (= 2% + 1.5(8% - 2%)).
Problems with Beta
The Beta is just a tool and as is the case with any tool, is not infallible. While it may seemto be a good measure of risk, there are some problems with relying on beta scores alone fordetermining the risk of an investment.
• Beta is not a sure thing. For example, the view that a stock with a beta of less than 1 willdo better than the market during down periods may not always be true in reality. Betascores merely suggest how a stock, based on its historical price movements will behaverelative to the market. Beta looks backward and history is not always an accuratepredictor of the future.
• Beta also doesn’t account for changes that are in the works, such as new lines ofbusiness or industry shifts. Indeed, a stock’s beta may change over time though usuallythis happens gradually.
As a fundamental analyst, you should never rely exclusively on beta when picking stocks.Rather, beta is best used in conjunction with other stock-picking tools.
Risk Adjusted Return (Sharpe Ratio)
The Sharpe ratio / Sharpe index / Sharpe measure / reward-to-variability ratio, is a measureof the excess return (or risk premium) per unit of risk in an investment asset or a tradingstrategy. It is defined as:
Where, R is the asset return, Rf is the return on a benchmark asset such as the risk free rate ofreturn, [R − Rf] is the expected value of the excess of the asset return over the benchmarkreturn and σ is the standard deviation of the asset.
The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate theperformance of an asset or a portfolio. The ratio helps to make the performance of oneportfolio comparable to that of another portfolio by making an adjustment for risk. It is excessreturn generated for an asset or a portfolio for every one unit of risk. For example, if stockA generates a return of 15% while stock B generates a return of 12%, it would appear thatstock A is a better performer. However, if stock A, which produced the 15% return but hasmuch larger risks than stock B (as reflected by standard deviation of stock returns or beta),it may actually be the case that stock B has a better risk-adjusted return. To continue withthe example, say that the risk free-rate is 5%, and stock A has a standard deviation (risk) of8%, while stock B has a standard deviation of 5%. The Sharpe ratio for stock A would be 1.25while stock B’s ratio would be 1.4, which is better than stock A. Based on these calculations,stock B was able to generate a higher return on a risk-adjusted basis. A ratio of 1 or better isconsidered good, 2 and better is very good, and 3 and better is considered excellent.
There are numerous ways of taking investment decisions in the market such as fundamental and technical analysis as seen in the previous NCFM module2.
Let’s take a look at some reasons why fundamental analysis is used for stock-picking in themarkets?
Efficient Market Hypothesis (EMH)
Market efficiency refers to a condition in which current prices reflect all the publicly availableinformation about a security. The basic idea underlying market efficiency is that competitionwill drive all information into the stock price quickly. Thus EMH states that it is impossibleto ‘beat the market’ because stock market efficiency causes existing share prices to alwaysincorporate and reflect all relevant information. According to the EMH, stocks always tendto trade at their fair value on stock exchanges, making it impossible for investors to eitherconsistently purchase undervalued stocks or sell stocks at inflated prices. As such, it shouldbe impossible to outperform the overall market through expert stock selection or market timingand that the only way an investor can possibly obtain higher returns is by purchasing riskierinvestments. The EMH has three versions, depending on the level on information available:
Weak form EMH
The weak form EMH stipulates that current asset prices reflect past price and volumeinformation. The information contained in the past sequence of prices of a security is fullyreflected in the current market price of that security. The weak form of the EMH implies thatinvestors should not be able to outperform the market using something that “everybody elseknows”. Yet, many financial researchers study past stock price series and trading volume(using a technique called technical analysis) data in an attempt to generate profits.
Semi-strong form EMH
The semi-strong form of the EMH states that all publicly available information is similarlyalready incorporated into asset prices. In other words, all publicly available information isfully reflected in a security’s current market price. Public information here includes not onlypast prices but also data reported in a company’s financial statements, its announcements,economic factors and others. It also implies that no one should be able to outperform themarket using something that “everybody else knows”. The semi-strong form of the EMH thusindicates that a company’s financial statements are of no help in forecasting future pricemovements and securing high investment returns in the long-term.
2 Please see NCFM’s Investment Analysis and Portfolio Management module for details.
Strong form EMH
The strong form of the EMH stipulates that private information or insider information too isquickly incorporated in market prices and therefore cannot be used to reap abnormal tradingprofits. Thus, all information, whether public or private, is fully reflected in a security’s currentmarket price. This means no long-term gains are possible, even for the management of acompany, with access to insider information. They are not able to take the advantage to profitfrom information such as a takeover decision which may have been made a few minutesago. The rationale to support this is that the market anticipates in an unbiased manner,future developments and therefore information has been incorporated and evaluated intomarket price in a much more objective and informative way than company insiders can takeadvantage of.
Although it is a cornerstone of modern financial theory, the EMH is controversial and oftendisputed by market experts. In the years immediately following the hypothesis of marketefficiency (EMH), tests of various forms of efficiency had suggested that the markets arereasonably efficient and beating them was not possible. Over time, this led to the gradualacceptance of the efficiency of markets. Academics later pointed out a number of instancesof long-term deviations from the EMH in various asset markets which lead to argumentsthat markets are not always efficient. Behavioral economists attribute the imperfections infinancial markets to a combination of cognitive biases such as overconfidence, overreaction,representative bias, information bias and various other predictable human errors in reasoningand information processing. Other empirical studies have shown that picking low P/E stockscan increase chances of beating the markets. Speculative economic bubbles are an anomalywhen it comes to market efficiency. The market often appears to be driven by buyersoperating on irrational exuberance, who take little notice of underlying value. These bubblesare typically followed by an overreaction of frantic selling, allowing shrewd investors to buystocks at bargain prices and profiting later by beating the markets. Sudden market crashesare mysterious from the perspective of efficient markets and throw market efficiency to thewinds. Other examples are of investors, who have consistently beaten the market over longperiods of time, which by definition should not be probable according to the EMH. Anotherexample where EMH is purported to fail are anomalies like cheap stocks outperforming themarkets in the long term.
Arguments against EMH
Alternative prescriptions about the behaviour of markets are widely discussed these days.Most of these prescriptions are based on the irrationality of the markets in, either processingthe information related to an event or based on biased investor preferences. The Behavioural Aspect
Behavioural Finance is a field of finance that proposes psychology-based theories to explainstock market anomalies. Within behavioural finance, it is assumed that information structureand the characteristics of market participants systematically influence individuals’ investmentdecisions as well as market outcomes.
In a market consisting of human beings, it seems logical that explanations rooted inhuman and social psychology would hold great promise in advancing our understanding ofstock market behaviour. More recent research has attempted to explain the persistence ofanomalies by adopting a psychological perspective. Evidence in the psychology literaturereveals that individuals have limited information processing capabilities, exhibit systematicbias in processing information, are prone to making mistakes, and often tend to rely on theopinion of others.
The literature on cognitive psychology provides a promising framework for analysinginvestors’ behaviour in the stock market. By dropping the stringent assumption of rationalityin conventional models, it might be possible to explain some of the persistent anomalousfindings. For example, the observation of overreaction of the markets to news is consistentwith the finding that people, in general, tend to overreact to new information. Also, peopleoften allow their decision to be guided by irrelevant points of reference, a phenomenoncalled “anchoring and adjustment”. Experts propose an alternate model of stock prices thatrecognizes the influence of social psychology. They attribute the movements in stock pricesto social movements. Since there is no objective evidence on which to base their predictionsof stock prices, it is suggested that the final opinion of individual investors may largely reflectthe opinion of a larger group. Thus, excessive volatility in the stock market is often caused bysocial “fads” which may have very little rational or logical explanation.
There have been many studies that have documented long-term historical phenomena insecurities markets that contradict the efficient market hypothesis and cannot be capturedplausibly in models based on perfect investor rationality. Behavioural finance attempts to fillthat void.
Regulatory Hindrances
In the real world, many a times there are regulatory distortions on the trading activity of thestocks such as restrictions on short-selling or on the foreign ownership of a stock etc. causinginefficiencies in the fair price discovery mechanism. Such restrictions hinder the process offair price discovery in the markets and thus represent deviation from the fair value of thestock. Then there may be some restrictions on the price movement itself (such as price bandsand circuit filters which prevent prices of stocks moving more than a certain percentageduring the day) that may prevent or delay the efficient price discovery mechanism. Also,many institutional investors and strategic investors hold stocks despite deviation from the fairvalue due to lack of trading interest in the stock in the short term and that may cause someinefficiencies in the price discovery mechanism of the market.
So, does fundamental analysis work?
In the EMH, investors have a long-term perspective and return on investment is determinedby a rational calculation based on changes in the long-run income flows. However, in themarkets, investors may have shorter horizons and returns also represent changes in short-runprice fluctuations. Recent years have witnessed a new wave of researchers who have providedthought provoking, theoretical arguments and provided supporting empirical evidence to showthat security prices could deviate from their equilibrium values due to psychological factors,fads, and noise trading. That’s where investors through fundamental analysis and a soundinvestment objective can achieve excess returns and beat the market.
Steps in Fundamental Analysis
Fundamental analysis is the cornerstone of investing. In fact all types of investing comprisestudying some fundamentals. The subject of fundamental analysis is also very vast. However,the most important part of fundamental analysis involves delving into the financial statements.This involves looking at revenue, expenses, assets, liabilities and all the other financialaspects of a company. Fundamental analysts look at these information to gain an insight intoa company’s future performance.
Fundamental analysis consists of a systemtatic series of steps to examine the investmentenvironment of a company and then identify opportunities. Some of these are:
• Macroeconomic analysis - which involves analysing capital flows, interest rate cycles,currencies, commodities, indices etc.
• Industry analysis - which involves the analysis of industry and the companies that area part of the sector
• Situational analysis of a company
• Financial analysis of the company
• Valuation
The previous NCFM module3 focused on macroeconomic and industry analysis, we wouldexamine company analysis (financials) and valuation in this module.
3 Please see NCFM’s Investment Analysis and Portfolio Management module for details.
What is fundamental analysis?
Fundamental analysis is a stock valuation methodology that uses financial and economicanalysis to envisage the movement of stock prices. The fundamental data that is analysedcould include a company’s financial reports and non-financial information such as estimates ofits growth, demand for products sold by the company, industry comparisons, economy-widechanges, changes in government policies etc.
The outcome of fundamental analysis is a value (or a range of values) of the stock of thecompany called its ‘intrinsic value’ (often called ‘price target’ in fundamental analysts’ parlance).To a fundamental investor, the market price of a stock tends to revert towards its intrinsicvalue. If the intrinsic value of a stock is above the current market price, the investor wouldpurchase the stock because he believes that the stock price would rise and move towards itsintrinsic value. If the intrinsic value of a stock is below the market price, the investor wouldsell the stock because he believes that the stock price is going to fall and come closer to itsintrinsic value.
To find the intrinsic value of a company, the fundamental analyst initially takes a top-downview of the economic environment; the current and future overall health of the economy asa whole. After the analysis of the macro-economy, the next step is to analyse the industryenvironment which the firm is operating in. One should analyse all the factors that givethe firm a competitive advantage in its sector, such as, management experience, historyof performance, growth potential, low cost of production, brand name etc. This step of theanalysis entails finding out as much as possible about the industry and the inter-relationshipsof the companies operating in the industry as we have seen in the previous NCFM module1.The next step is to study the company and its products.
Some of the questions that should be asked while taking up fundamental analysis of a companywould include:
1. What is the general economic environment in which the company is operating? Is it conducive or obstructive to the growth of the company and the industry in which the company is operating?
For companies operating in emerging markets like India, the economic environmentis one of growth, growing incomes, high business confidence etc. As opposed to this acompany may be operating in a developed but saturated market with stagnant incomes,high competition and lower relative expectations of incremental growth.
1 Please see NCFM’s Investment Analysis and Portfolio Management module for details. 2. How is the political environment of the countries/markets in which the company is operating or based?
A stable political environment, supported by law and order in society leads to companiesbeing able to operate without threats such as frequent changes to laws, politicaldisturbances, terrorism, nationalization etc. Stable political environment also means thatthe government can carry on with progressive policies which would make doing businessin the country easy and profitable.
3. Does the company have any core competency that puts it ahead of all the other competing firms?
Some companies have patented technologies or leadership position in a particularsegment of the business that puts them ahead of the industry in general. For example,Reliance Industries’ core competency is its low-cost production model whereas Apple’scompetency is its design and engineering capabilities adaptable to music players, mobilephones, tablets, computers etc.
4. What advantage do they have over their competing firms?
Some companies have strong brands; some have assured raw material supplies whileothers get government subsidies. All of these may help firms gain a competitive advantageover others by making their businesses more attractive in comparison to competitors.For example, a steel company that has its own captive mines (of iron ore, coal) isless dependent and affected by the raw material price fluctuations in the marketplace.Similarly, a power generation company that has entered into power purchase agreementsis assured of the sale of the power that it produces and has the advantage of beingperceived as a less risky business.
5. Does the company have a strong market presence and market share? Or does it constantly have to employ a large part of its profits and resources in marketing and finding new customers and fighting for market share?
Competition generally makes companies spend large amounts on advertising, engagein price wars by reducing prices to increase market shares which may in turn erodemargins and profitability in general. The Indian telecom industry is an example of cutthroat competition eating into companies’ profitability and a vigorous fight for marketshare. On the other hand there are very large, established companies which have aleadership position on account of established, large market share. Some of them havenear-monopoly power which lets them set prices leading to constant profitability
Moving averages "smooth" price data by creating a single flowing line. The line represents the average rate over a period of time. Which moving average the trader chooses to use is limited by the time frame in which he or she trades. For investors and long-term trend members, the 200-day, 100-day, and 50-day simple moving average are common choices.
There are several ways to appropriate the moving average. The first is to look at the angle of the moving average. If it is mostly moving horizontally for an extended amount of time, then the price isn't trending, it is ranging. If the moving average line is angled up, an uptrend is underway. Moving averages don't predict though; they simply show whatever the price is doing, on average, over a period of time.
Crossovers are a different way to employ moving averages. By plotting a 200-day and 50-day moving average on your chart, a buy signal occurs when the 50-day crosses above the 200-day. A sell signal occurs when the 50-day drops below the 200-day. The time frames can be altered to suit your individual trading time frame. When the price crosses above a moving average, it can also be used as a buy signal, and when the price crosses below a moving average, it can be used as a sell signal. Since price is more volatile than the moving average, this method is prone to more false signals.
The MACD is an oscillating indicator, fluctuating above and below zero. It is both a trend-following and impulse indicator.
One primary MACD approach is to look at which side of zero the MACD lines are on in the histogram below the graph. Zero for a sustained period of time, and the trend is likely up; below zero for a sustained period of time, and the trend is likely down. Inherent buy signals occur when the MACD moves above zero, and potential sell signals when it overpasses below zero.
Signal line crossovers provide additional buy and sell signals. A MACD has two lines – a fast line and a slow line. A buy signal occurs when the fast line crosses through and above the slow line. A sell signal occurs when the fast line crosses through and below the slow line.
The RSI is another oscillator, but because its movement is contained between zero and 100, it provides some different information than the MACD.
The whole way to interpret the RSI is by viewing the price as "overbought" – and due for a change – when the indicator in the histogram is above 70, and viewing the price as oversold – and quite for a bounce – when the indicator is underneath 30. In a steady uptrend, the price will often reach 70 and beyond for sustained periods, and downtrends can linger at 30 or below for a long time. While general overbought and oversold levels can be accurate occasionally, they may not implement the various timely signals for trend traders.
An alternative is to buy near oversold conditions when the trend is up and place a short trade near an overbought condition in a downtrend.
Say the long-term trend of a stock is up. A buy signal occurs when the RSI moves below 50 and then back above it. Essentially, this means a pullback in price has occurred, and the trader is buying once the pullback appears to have ended (according to the RSI) and the trend is returning. The 50 levels are used because the RSI doesn't typically reach 30 in an uptrend except a dormant reversal is underway. A short-trade signal occurs when the trend is down and the RSI crosses above 50 and then back below it. Trend lines or a moving average can help establish the trend direction and in which direction to take trade signals.
The volume itself is an important indicator, and OBV demands a quantity of volume information and compiles it into a single one-line indicator. The indicator contains cumulative buying/selling pressure by adding the volume on up days and withholding volume on down days.
Ideally, the volume should reinforce trends. A mounting price should be conducted by a rising OBV; a declining price should be accompanied by a falling OBV. Since OBV didn't drop below its trendline, it was a good indication that the price was likely to continue trending higher after the pullbacks. If OBV is rising and the price isn't, price is likely to follow the OBV and start rising. If the price is rising and OBV is flat-lining or falling, the price may be near a top. If the price is falling and OBV is flat-lining or rising, the price could be nearing a bottom.
What is Technical Analysis?
Technical Analysis can be defined as an art and science of forecasting future prices based on an examination of the past price movements. Technical analysis is not astrology for predicting prices. Technical analysis is based on analyzing the current demand-supply of commodities, stocks, indices, futures or any tradable instrument. Technical analysis involves putting stock information like prices, volumes and open interest on a chart and applying various patterns and indicators to it in order to assess the future price movements. The time frame in which technical analysis is applied may range from intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data for many years. There are essentially two methods of analyzing investment opportunities in the security market viz fundamental analysis and technical analysis. You can use fundamental information like financial and non-financial aspects of the company or technical information which ignores fundamentals and focuses on actual price movements. The basis of Technical Analysis What makes Technical Analysis an effective tool to analyze price behavior is explained by following theories are given by Charles Dow: • Price discounts everything • Price movements are not totally random • What is more important than why
Price discounts everything
“Each price represents a momentary consensus of value of all market participants – large commercial interests and small speculators, fundamental researchers, technicians and gamblers- at the moment of transaction” – Dr. Alexander Elder 10 Technical analysts believe that the current price fully reflects all the possible material the information which could affect the price. The market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts, and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis looks at the price and what it has done in the past and assumes it will perform similarly in the future under similar circumstances. Technical analysis looks at the price and assumes that it will perform in the same way as done in the past under similar circumstances in the future.
Price movements are not totally random
Technical analysis is a trend following system. Most technicians acknowledge that hundred of years of price, charts have shown us one basic truth – prices move in trends. If prices were always random, it would be extremely difficult to make money using technical analysis. A the technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends. “What” is more important than “Why” It is said that “A technical analyst knows the price of everything, but the value of nothing”. Technical analysts are mainly concerned with two things: 1. The current price 2. The history of the price movement All of you will agree that the value of any asset is only what someone is willing to pay for it. Who needs to know why? By focusing just on price and nothing else, technical analysis represents a direct approach. The price is the final result of the fight between the forces of supply and demand for any tradable instrument. The objective of the analysis is to forecast the the direction of the future price. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). The principles of technical analysis are universally applicable. The principles of support, resistance, trend, trading range and other aspects can be applied to any chart. Technical analysis can be used for any time horizon; for any marketable instrument like stocks, futures and commodities, fixed-income securities, forex, etc Top-down Technical Analysis
Technical analysis uses a top-down approach to investing. For each stock, an investor would analyze long-term and short-term charts. First of all, you will consider the overall market, most probably the index. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of vector charts. Those sectors that show the most promise would be selected for individual stock analysis. Once the sector list is narrowed to 3-5 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-5 most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find 3-4 best amongst the rest in the lot.
Technical Analysis: The basic assumptions
The field of technical analysis is based on three assumptions: 1. The market discounts everything. 2. Price moves in trends. 3. History tends to repeat itself.
1. The market discounts everything
Technical analysis is criticized for considering only prices and ignoring the fundamental analysis of the company, economy, etc. Technical analysis assumes that at any given time, a stock’s price reflects everything that has or could affect the company - including fundamental factors. The market is driven by mass psychology and pulses with the flow of human emotions. Emotions may respond rapidly to extreme events, but normally change gradually over time. It is believed that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.
2. Price moves in trends
“Trade with the trend” is the basic logic behind the technical analysis. Once a trend has been established, the future price movement is more likely to be in the same direction as the trend then to be against it. Technical analysts frame strategies based on this assumption only.
3. History tends to repeat itself
People have been using charts and patterns for several decades to demonstrate patterns in price movements that often repeat themselves. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends.
Importance of Technical Analysis
Not Just for stocks
Technical analysis has universal applicability. It can be applied to any fi financial instrument - stocks, futures, and commodities, fixed-income securities, forex, etc
Focus on price
Fundamental developments are followed by price movements. By focusing only on price action, technicians focus on the future. The price pattern is considered as a leading indicator and generally leads the economy by 6 to 9 months. To track the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden unexpected reactions, hints usually develop before significant movements. You should refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Supply, demand, and price action
Technicians make use of high, low and closing prices to analyze the price action of a stock. A good analysis can be made only when all the above information is present Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.
Support and resistance
Charting is a technique used in the analysis of support and resistance level. These are trading range in which the prices move for an extended period of time, saying that forces of demand and supply is deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Pictorial price history
A price chart offers the most valuable information that facilitates reading historical account of a security’s price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following: • Market reactions before and after important events • Past and present volatility • Historical volume or trading levels • The relative strength of the stock versus the index.
Assist with an entry point
Technical analysis helps in tracking a proper entry point. Fundamental analysis is used to decide what to buy and technical analysis is used to decide when to buy. Timings in this context plays a very important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Checking out for a breakout above resistance or buying near support, levels can improve returns. First of all, you should analyze the stock’s price history. If a stock selected by you were great for the last three years has traded flat for those three years, it would appear that market has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
Weaknesses of Technical Analysis
Analyst bias
Technical analysis is not hardcore science. It is subjective in nature and your personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled eternal bear, then the analysis will probably have a bearish tilt.
Open to interpretation
Technical analysis is a combination of science and art and is always open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. Is the cup half-empty or half-full? It is in the eye of the beholder.
Too late
You can criticize the technical analysis for being too late. By the time the trend is identified, the substantial move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory. Always another level
Technical analysts always wait for another new level. Even after a new trend has been identified, there is always another “important” level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.
Trader’s remorse
An array of pattern and indicators arises while studying technical analysis. Not all the signals work. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for Infosys, but a 70-day moving average may work better for Reliance. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.
TA is also useful in controlling risk
It is Technical Analysis only that can provide you the discipline to get out when you’re on the wrong side of a trade. The easiest thing in the world to do is to get on the wrong side of a trade and to get stubborn. That is also potentially the worst thing you can do. You think that if you ride it out you’ll be okay. However, there will also be occasions when you won’t be okay. The stock will move against you in ways and to an extent that you previously found virtually unimaginable.
It is more important to control risk than to maximize profit!
There is an asymmetry between zero and infinity. What does that mean? Most of us have very finite capital but infinite opportunities because of thousands of stocks. If we lose an opportunity, we will have thousands more tomorrow. If we lose our capital, will we get thousands more tomorrow? It is likely that we will not. We will also lose our opportunities. Our capital holds more worth to us than our opportunities because we must have capital in order to take advantage of tomorrow’s opportunities. It is more important to control risk than to maximize profits! Technical Analysis, if practiced with discipline, gives you specific parameters for managing risk. It’s simply supply and demand. Waste what’s plentiful, preserve what’s scarce. Preserve your capital because your capital is your opportunity. You can be right a thousand times, become very wealthy and then get wiped out completely if you manage your risk poorly just once. One last time: That is why it is more important to control risk than to maximize profits! How to know what to look for? How to organize your thinking in a market of thousands of stock trading millions of shares per day? How to learn your way around? Technical Analysis answers all these questions.
Conclusions
Technical analysis works on the Pareto principle. It considers the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going? Even though some principles and rules of technical analysis are universally applicable, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.
What is the chart?
Charts are the working tools of technical analysts. They use charts to plot the price movements of a stock over specific time frames. It’s a graphical method of showing where stock prices have been in the past. A chart gives us a complete picture of a stock’s price history over a period of an hour, day, week, month or many years. It has an x-axis (horizontal) and a y-axis (vertical). Typically, the x-axis represents time; the y-axis represents price. By plotting a stock’s price over a period of time, we end up with a pictorial representation of any stock’s trading history. A chart can also depict the history of the volume of trading in a stock. That is, a chart can illustrate the number of shares that change hands over a certain time period.
Types of price charts:
1. Line charts
“Line charts” are formed by connecting the closing prices of a specific stock or market over a given period of time. The line chart is particularly useful for providing a clear visual illustration of the trend of a stock’s price or a market’s movement. It is an extremely valuable analytical a tool which has been used by traders for the past many years.
2. Bar chart
A bar chart is the most popular method traders use to see price action in a stock over a given period of time. Such visual
representation of price activity helps in spotting trends and patterns. Although
daily bar charts are best known, bar charts can be created for any time period -
weekly and monthly, for example. A bar shows the high price for the period at the
top and the lowest price at the bottom of the bar. Small lines on either side of
the vertical bar serve to mark the opening and closing prices. The opening price
is marked by a small tick to the left of the bar; the closing price is shown by a
similar tick to the right of the bar. Many investors work with bar charts created
over a matter of minutes during a day’s trading.
3. Candlesticks
Formation
Candlestick charts provide visual insight into current market psychology. A candlestick displays the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a the manner that extenuates the relationship between the opening and closing prices. Candlesticks don’t involve any calculations. Each candlestick represents one period (e.g., day) of data. The the figure given below displays the elements of a candle.
A candlestick chart can be created using the data of high, low, open and closing
prices for each time period that you want to display. The hollow or filled portion
of the candlestick is called “the body” (also referred to as “the real body”). The
long thin lines above and below the body represent the high/low range and are called
“shadows” (also referred to as “wicks” and “tails”). The high is marked by the top
of the upper shadow and the low by the bottom of the lower shadow.
If the stock closes higher than its opening price, a hollow candlestick
is drawn with the bottom of the body representing the opening price and the top of
the body representing the closing price.
If the stock closes lower than its opening price, a filled candlestick is
drawn with the top of the body representing the opening price and the bottom of the
body representing the closing price. Each candlestick provides an easy-to-decipher
picture of price action. Immediately a trader can see and compare the relationship
between the open and close as well as the high and low. The relationship between
the open and close is considered vital information and forms the essence of candlesticks.
Hollow candlesticks, where the close is greater than the open, indicate buying pressure.
Filled candlesticks, where the close is less than the open, indicate selling pressure.
Thus, compared to traditional bar charts, many traders consider candlestick charts
more visually appealing and easier to interpret.
Why candlestick charts?
What does candlestick charting offer that typical Western high-low bar charts do not? Instead of the vertical line having horizontal ticks to identify open and close, candlesticks represent two dimensional bodies to depict open to close range and shadows to mark day’s high and low. For several years, the Japanese traders have been using candlestick charts to track market activity. Eastern analysts have identified a number of patterns to determine the continuation and reversal of a trend. These patterns are the basis for Japanese candlestick chart analysis. This places candlesticks rightly as a part of technical analysis. Japanese candlesticks offer a quick picture into the psychology of short term trading, studying the effect, not the cause. Applying candlesticks means that for short-term, an investor can make confident decisions about buying, selling, or holding an investment.
Candlestick analysis
One cannot ignore that investor’s psychologically driven forces of fear; greed and hope greatly influence stock prices. The overall market psychology can be tracked through candlestick analysis. More than just a method of pattern recognition, candlestick analysis shows the interaction between buyers and sellers. A white candlestick indicates the opening price of the the session is below the closing price, and a black candlestick shows the opening price of the the session being above the closing price. The shadow at top and bottom indicates the high and low for the session. Japanese candlesticks offer a quick picture into the psychology of short term trading, studying the effect, not the cause. Therefore if you combine candlestick analysis with other technical analysis tools, candlestick pattern analysis can be a very useful way to select entry and exit points.
One candle patterns
In the terminology of Japanese candlesticks, one candle patterns are known as “Umbrella lines”. There are two types of umbrella lines - the hanging man and the hammer. They have long lower shadows and small real bodies that are at top of the trading range for the session. They are the simplest lines because they do not necessarily have to be spotted in combination with other candles to have some validity. Hammer and Hanging Man Hammer Hanging Man Candlesticks
Hammer
Hammer is a one candle pattern that occurs in a downtrend when bulls make a start to step into the rally. It is so named because it hammers out the bottom. The lower shadow of hammer is a minimum of twice the length of the body. Although, the color of the body is not of much significance but a white candle shows slightly more bullish implications than the black body. A positive day i.e. a white candle is required the next day to confirm this signal. Criteria 1. The lower shadow should be at least two times the length of the body. 2. There should be no upper shadow or a very small upper shadow. 3. The real body is at the upper end of the trading range. The color of the body is not important although a white body should have slightly more bullish implications. 4. The following day needs to confirm the Hammer signal with a strong bullish day.
Signal enhancements
1. The longer the lower shadow, the higher the potential of a reversal occurring. 2. Large volume on the Hammer day increases the chances that a blow off day has occurred. 3. A gap down from the previous day’s close sets up for a stronger reversal move provided the day after the Hammer signal opens higher. Pattern psychology The market has been in a downtrend, so there is an air of bearishness. The price opens and starts to trade lower. However, the sell-off is abated and market returns to high for the day as the bulls have stepped in. They start bringing the price back up towards the top of the trading range. This creates a small body with a large lower shadow. This represents that the bears could not maintain control. The long lower shadow now has the bears questioning whether the decline is still intact. Confirmation would be a higher open with yet a still higher close on the next trading day.
Hanging man
The hanging man appears during an uptrend, and its real body can be either black
or white. While it signifies a potential top reversal, it requires confirmation during
the next trading session. The hanging man usually has little or no upper shadow.
Soybean Oil-December, 1990, Daily (Hanging Man and Hammer) Dow Jones Industrials-1990,
Daily (Hanging Man and Hammer) Shooting star and inverted hammer Other candles similar
to the hanging man and hammer are the “shooting star,” and the “inverted hammer.”
Both have small real bodies and can be either black or white but they both have long
upper shadows and have very little or no lower shadows.
Inverted Hammer
Description
The inverted hammer is one candle pattern with a shadow at least two times greater than the body. This pattern is identified by the small body. They are found at the bottom of the decline which is evidence that bulls are stepping in but still selling is going on. The color of the small the body is not important but the white body has more bullish indications than a black body. A a positive day is required the following day to confirm this signal. Signal enhancements 1. The longer the upper shadow, the higher the potential of a reversal occurring. 2. A gap down from the previous day’s close sets up for a stronger reversal move. 3. Large volume on the day of the inverted hammer signal increases the chances that a blow off day has occurred 4. The day after the inverted hammer signal opens higher. Pattern psychology After a downtrend has been in effect, the atmosphere is bearish. The price opens and starts to trade higher. The Bulls have stepped in, but they cannot maintain the strength. The existing sellers knock the price back down to the lower end of the trading range. The Bears are still in control. But the next day, the Bulls step in and take the price back up without major resistance from the Bears. If the price maintains strong after the Inverted Hammer day, the signal is confirmed. Stars A small real body that gaps away from the large real body preceding it is known as a star. It’s still a star as long as the small real body does not overlap the preceding real body. The color of the star is not important. Stars can occur at tops or bottoms.
Shooting star
Description
The Shooting Star is a single line pattern that indicates an end to the uptrend. It is easily identified by the presence of a small body with a shadow at least two times greater than the body. It is found at the top of an uptrend. The Japanese named this pattern because it looks like a shooting star falling from the sky with the tail trailing it. Criteria 1. The upper shadow should be at least two times the length of the body. 2. Prices gap open after an uptrend. 3. A small real body is formed near the lower part of the price range. The color of the body is not important although a black body should have slightly more bearish implications. 4. The lower shadow is virtually non-existent. 5. The following day needs to confirm the Shooting Star signal with a black candle or better yet, a gap down with a lower close. Signal enhancements 1. The longer the upper shadow, the higher the potential of a reversal occurring. 2. A gap up from the previous day’s close sets up for a stronger reversal move provided. 3. The day after the Shooting Star signal opens lower. 4. Large volume on the Shooting Star day increases the chances that a blow-off day has occurred although it is not a necessity. Pattern psychology During an uptrend, the market gaps open and rallies to a new high. The price opens and trades higher. The bulls are in control. But before the close of the day, the bears step in and take the price back down to the lower end of the trading range, creating a small body for the day.
This could indicate that the bulls still have control if analyzing a Western bar chart. However, the long upper shadow represents that sellers had started stepping in at these levels. Even though the bulls may have been able to keep the price positive by the end of the day, the evidence of the selling was apparent. A lower open or a black candle the next day reinforces the fact that selling is going on.
Two Candle Pattern and Three Candle Pattern
Two candles pattern
Bullish engulfing
A “bullish engulfing pattern” consists of a large white real body that engulfs a small black real body during a downtrend. It signifies that the buyers are overwhelming the sellers Engulfing
Bullish engulfing
Description
The Engulfing pattern is a major reversal pattern comprised of two opposite colored bodies. This Bullish Pattern is formed after a downtrend. It is formed when a small black candlestick is followed by a large white candlestick that completely eclipses the previous day candlestick. It opens lower than the previous day’s close and closes higher than the previous day’s open. Criteria 1. The candlestick body of the previous day is completely overshadowed by the next day’s candlestick. 2. Prices have been declining definitely, even if it has been in the short term. 3. The color of the first candle is similar to that of the previous one and the body of the the second candle is opposite in color to that first candle. The only exception being an engulfed the body which is a doji.
Signal enhancements
1. A small body is covered by the larger one. The previous day shows the trend was running out of steam. The large body shows that the new direction has started with good force. 2. Large volume on the engulfing day increases the chances that a blow off day has occurred. 3. The engulfing body engulfs absorbs the body and the shadows of the previous day; the the reversal has a greater probability of working. 4. The probability of a strong reversal increases as the open gaps between them previous and the current day increases.
Pattern psychology
After a decline has taken place, the price opens at a lower level than its previous day closing price. Before the close of the day, the buyers have taken over and have led to an increase in the price above the opening price of the previous day. The emotional psychology of the trend has now been altered. When investors are learning the stock market they should utilize the information that has worked with high probability in the past. Bullish Engulfing signal if used after proper training and at proper locations can lead to highly profitable trades and consistent results. This pattern allows an investor to improve their probabilities of being in a correct trade. The common sense elements conveyed in candlestick signals make for a clear and concise trading technique for beginning investors as well as experienced traders.
Bearish engulfing
A “bearish engulfing pattern,” on the other hand, occurs when the sellers are overwhelming the buyers. This pattern consists of a small white candlestick with short shadows or tails followed by a large black candlestick that eclipses or “engulfs” the small white one. Piercing
The bullish counterpart to the dark cloud cover is the “piercing pattern.” The first thing to look for is to spot the piercing pattern in an existing downtrend, which consists of a long black candlestick followed by a gap lower open during the next session, but which closes at least halfway into the prior black candlestick’s real body.
Description
The Piercing Pattern is composed of a two-candle formation in a down trending market. With daily candles, the piercing pattern will often end a minor downtrend (a downtrend that lasts between six and fifteen trading days). The day before the piercing candle appears, the the daily candle should have a fairly large dark real body, signifying a strong down day. Criteria
1. The downtrend has been evident for a good period. 2. The body of the first candle is black; the body of the second candle is white. 3. A long black candle occurs at the end of the trend. 4. The white candle closes more than halfway up the black candle. 5. The second day opens lower than the trading of the prior day.
Signal enhancements
1. The reversal will be more pronounced if the gap down the previous day close is more. 2. The longer the black candle and the white candle, the more forceful the reversal. 3. The higher the white candle closes into the black candle, the stronger the reversal. 4. Large volume during these two trading days is a significant confirmation.
Pattern psychology
The atmosphere becomes bearish once a strong downtrend has been in effect. The price goes down. Bears may move the price even further but before the day ends the bulls enters and bring a dramatic change in price in the opposite direction. They finish near the high of the day. The move has almost negated the price decline of the previous day. This now has the bears concerned. More buying the next day will confirm the move. Being able to utilize information that has been used successfully in the past is a much more viable investment strategy than taking shots in the dark. Keep in mind, when you are given privileged information about stock market tips, where you are in the food chain. Are you one of those privileged few that get top-notch pertinent information in a timely manner, or are you one of the masses that feed into a frenzy and allow the smart money to make the profits? Harami
Bearish Harami
In uptrends, the harami consists of a large white candle followed by a small white or black candle (usually black) that is within the previous session’s large real body.
Description
Bearish Harami is a two-candlestick pattern composed of small black real body contained within a prior relatively long white real body. The body of the first candle is the same color as that of the current trend. The open and the close occur inside the open and the close of the previous day. Its presence indicates that the trend is over. Criteria 1. The first candle is white in color; the body of the second candle is black. 2. The second day opens lower than the close of the previous day and closes higher than the open of the prior day. 3. For a reversal signal, confirmation is needed. The next day should show weakness. 4. The uptrend has been apparent. A long white candle occurs at the end of the trend. Signal enhancements 1. The reversal will be more forceful if the white and the black candle are longer. 2. The lower the black candle closes down on the white candle, the more convincing that a the reversal has occurred, despite the size of the black candle. Pattern psychology The bears open the price lower than the previous close, after a strong uptrend has been in effect and after a long white candle day. The longs get concerned and start profit taking. The price for the day ends at a lower level. The bulls are now concerned as the price closes lower. It is becoming evident that the trend has been violated. A weak day after that would convince everybody that the trend was reversing. Volume increases due to the profit taking and the addition of short sales. Bullish Harami
A candlestick chart pattern in which a large candlestick is followed by a smaller candlestick whose body is located within the vertical range of the larger body. In downtrends, the harami consists of a large black candle followed by a small white or black candle (usually white) that is within the previous session’s large real body. This pattern signifies that the immediately the preceding trend may be concluding, and that the bulls and bears have called a truce.
Description
The Harami is a commonly observed phenomenon. The pattern is composed of two candle formation in a down-trending market. The color first candle is the same as that of current trend. The first body in the pattern is longer than the second one. The open and the close occur inside the open and the close of the previous day. Its presence indicates that the trend is over.
The Harami (meaning “pregnant” in Japanese) Candlestick Pattern is a reversal pattern. The the pattern consists of two Candlesticks. The first candle is black in color and a continuation of the existing trend. The second candle, the little belly sticking out, is usually white in color but that is not always the case. The magnitude of the reversal is affected by the location and size of the candles.
Criteria 1. The first candle is black in the body; the body of the second candle is white. 2. The downtrend has been evident for a good period. A long black candle occurs at the end of the trend. 3. The second day opens higher than the close of the previous day and closes lower than the open of the prior day. 4. Unlike the Western “Inside Day”, just the body needs to remain in the previous day’s body, whereas the “Inside Day” requires both the body and the shadows to remain inside the previous day’s body. 5. For a reversal signal, further confirmation is required to indicate that the trend is now moving up.
Signal enhancements 1. The reversal will be more forceful if the black candle and the white candle are longer. 2. If the white candle closes up on the black candle then the reversal has occurred in a convincing manner despite the size of the white candle.
Pattern psychology
After a strong downtrend has been in effect and after a selling day, the bulls open at a price higher than the previous close. The short’s get concerned and start covering. The price for the day finishes at a higher level. This gives enough notice to the short sellers that trend has been violated. A strong day i.e. the next day would convince everybody that the trend was reversing. Usually, the volume is above the recent norm due to the unwinding of short positions. When the second candle is a doji, which is a candle with an almost non-existent real body, these patterns are called “harami crosses.” They are however less reliable as reversal patterns as more indecision is indicated. Three candle pattern
Evening star
The Evening Star is a top reversal pattern that occurs at the top of an uptrend. It is formed by a tall white body candle, a second candle with a small real body that gaps above the first real body to form a “star” and a third black candle that closes well into the first session’s white real body.
Description
The Evening Star pattern is a bearish reversal signal. Like the planet Venus, the evening star represents that darkness is about to set or prices are going to decline. An uptrend has been in a place which is assisted by a long white candlestick. The following day gaps up, yet the trading range remain small for the day. Again, this is the star of the formation. The third day is a black candle day and represents the fact that the bears have now seized control. That candle should consist of a closing that is at least halfway down the white candle of two days prior. The optimal Evening Star signal would have a gap before and after the start day.
Criteria
1. The uptrend should be apparent. 2. The body of the first candle is white, continuing the current trend. The second candle has small trading range showing indecision formation. 3. The third day shows evidence that the bears have stepped in. That candle should close at least halfway down the white candle.
Signal enhancements
1. The long length of the white candle and the black candle indicates more forceful reversal. 2. The more indecision the middle day portrays, the better the probabilities that a reversal will occur. 3. A gap between the first day and the second day adds to the probability of occurrence of reversal. 4. A gap before and after the star day is even more desirable. The magnitude, that the the third day comes down into the white candle of the first day, indicates the strength of the reversal.
Pattern psychology
The psychology behind this pattern is that a strong uptrend has been in effect. Buyers have been piling up the stock. However, it is the level where sellers start taking profits or think the price is fairly valued. The next day all the buying is being met with the selling, causing for a small trading range. The bulls get concerned and the bears start taking over. The third day is a large sell-off day. If there is a big volume during these days, it shows that the ownership has dramatically changed hands. The change of direction is immediately seen in the color of the bodies. Morning star
Morning star is the reverse of the evening star. It is a bullish reversal pattern formed by a tall black body candle, a second candle with a small real body that gaps below the first real body to form a star and a third white candle that closes well into the first session’s black real body. Its name indicates that it foresees higher prices.
Description
The Morning Star is a bottom reversal signal. Like the planet Mercury, the morning star, signifies brighter things – that is sunrise is about to occur, or the prices are going to go higher. A downtrend has been in place which is assisted by a long black candlestick. There is little about the downtrend continuing with this type of action. The next day prices gap lower on the open, trade within a small range and close near their open. This small body shows the beginning of indecision. The next day prices gap higher on the open and then close much higher. A significant reversal of trend has occurred. The makeup of the star, an indecision formation, can consist of a number of candle formations. The important factor is to witness the confirmation of the bulls taking over the next day. That the candle should consist of a closing that is at least halfway up the black candle of two days prior.
Criteria 1. Downtrend should be there. 2. The body of the first candle is black, continuing the current trend. The second candle is an indecision formation. 3. The third day is the opposite color of the first day. It shows evidence that the bulls have stepped in. That candle should close at least halfway up the black candle. Signal enhancements 1. The long length of the black candle and the white candle indicates more forceful reversal. 2. The more indecision that the star day illustrates, the better probabilities that a reversal will occur. 3. A Gap between the first day and the second day adds to the probability of occurrence of reversal. 4. A gap before and after the star day is even more desirable. 5. The magnitude, that the third day comes up into the black candle of the first day indicates the strength of the reversal.
Pattern psychology
While a strong downtrend has been in effect, there is a large sell-off day. The selling continues and bulls continue to step in at low prices. Big volume on this day shows that the ownership has dramatically changed. The second day does not have a large trading range. The third day, the bears start to lose conviction as the bull increase their buying. When the price starts moving back into the trading range of the first day, the sellers diminish and the buyers seize control. Doji
Doji lines are patterns with the same open and close price. It’s a significant reversal indicator.
The perfect doji session has the same opening and closing price, yet there is some flexibility to this rule. If the opening and closing price are within a few ticks of each other, the line could still, be viewed as a doji. How do you decide whether a near-doji day (that is, where the open and close are very close, but not exact) should be considered a doji? This is subjective and there are no rigid rules but one way is to look at a near-doji day in relation to recent action. If there are a series of very small real bodies, the near-doji day would not be viewed as significant since so many other recent periods had small real bodies. One technique is based on recent market activity. If the the market is at an important market junction or is at the mature part of a bull or bear move, or there are other technical signals sending out an alert, the appearance of a near-doji is treated as a doji. The philosophy is that a doji can be a significant warning and that it is better to attend to a false warning than to ignore a real one. To ignore a doji, with all its inherent implications could be dangerous. The doji is a distinct trend change signal. However, the likelihood of a reversal increases if subsequent candlesticks confi rm the doji’s reversal potential. Doji sessions are important only in markets where there are not many doji. If there are many doji on a particular chart, one should not view the emergence of a new doji in that particular market as a meaningful development. That is why candlestick analysis usually should not use intra-day charts of less then 30 minutes. Less than 30 minutes and many of the candlestick lines become doji or near doji
Doji at tops
A Doji star at the top is a warning that the uptrend is about to change. This is especially true after a long white candlestick in an uptrend. The reason for the doji’s negative implications in the uptrend is because of a doji represents indecision. Indecision among bulls will not maintain the uptrend. It takes the conviction of buyers to sustain a rally. If the market has had an extended the rally, or is overbought, then the formation of a doji could mean the scaffolding of buyers’ support will give way. Doji is also valued for their ability to show reversal potential in downtrends. The reason may be that a doji reflects a balance between buying and selling forces. With ambivalent market participants, the market could fall due to its own weight. Thus, an uptrend should reverse but a falling market may continue its descent. Because of this, doji need more confirmation to signal a bottom than they do a top. New Terms
Bull: An investor who thinks the market, a specific security or an industry will rise. Bear: An investor who believes that a particular security or market is headed downward is indicative of a bearish trend. Bears attempt to profit from a decline in prices. Bears are generally pessimistic about the state of a given market. Bull market: A financial market of a group of securities in which prices are rising or are expected to rise. The term “bull market” is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities. Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. It’s difficult to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market. Bear Market A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market, selling continues, which then creates further pessimism. This is not to be confused with a correction which is a short-term trend that has duration shorter than two months. While corrections are often a great place for a value investor to find an entry point, bear markets rarely provide great entry points as timing the bottom is very difficult to do. Fighting back can be extremely dangerous because it is quite difficult for an investor to make stellar gains during a bear market unless he or she is a short seller. Fundamental Analysis: A method of evaluating securities by analyzing statistics generated by market activity such as past prices and volume is defined as ‘Fundamental Analysis’. Technical analysts do not attempt to measure a security’s intrinsic value, but instead, use charts and other tools to identify patterns that can suggest future activity. Morning star : A bullish candlestick pattern that consists of three candles that have demonstrated the following characteristics: • The first bar is a large black candlestick located within a defined downtrend. • The second bar is a small-bodied candle (either black or white) that closes below the first black bar. • The last bar is a large white candle that opens above the middle candle and closes near the center of the first bar’s body. This pattern is used by traders as an early indication that the downtrend is about to reverse. Technical Analysis: This is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity
What are the support and resistance lines?
Support and resistance represent key junctures where the forces of supply and demand meet. These lines appear as thresholds to price patterns. They are the respective lines which stop the prices from decreasing or increasing. A support line refers to that level beyond which a stock’s price will not fall. It denotes that the price level at which there is a sufficient amount of demand to stop and possibly, for a time, turn a downtrend higher. Similarly, a resistance line refers to that line beyond which a stock’s the price will not increase. It indicates that the price level at which a sufficient supply of stock is available to stop and possibly, for a time, head of an uptrend in prices. Trend lines are often referred to as support and resistance lines on an angle.
Support
Support is a horizontal floor where interest in buying a commodity is strong enough to overcome the pressure to sell. A support level is the price level at which sufficient demand exists to, at least temporarily, halt a downward movement in prices. Logically as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support. Support does not always hold true and a break below support signals that the bulls have lost over the bears. A fall below support level indicates more willingness to sell and a lack of willingness to buy. A break in the levels of support indicates that the expectations of sellers are reducing and they are ready to sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level
ACC chart showing the the support level at 720 Resistance
Resistance is a horizontal ceiling where the pressure to sell is greater than the pressure to buy. Thus a Resistance level is a price at which sufficient supply exists to; at least temporarily, halt an upward movement. Logically as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance. Resistance does not always hold true and a break above resistance signals that the bears have lost over the bulls. A break in the resistance level shows more willingness to buy or lack of incentive to sell. Resistance breaks and new highs indicate that buyer’s expectations have increased and are ready to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level. Euro showing resistance around 1.4930 and then 1.5896
Why do support and resistance lines occur?
A stock’s price is determined by supply and demand. Bulls buy when the stock’s are prices are too low and bears sell when the price reaches its maximum. Bulls increase the prices by increasing the demand and bears decrease it by increasing the supply. The market reaches a balance when bulls and bears agree on a price. When prices are increasing upward, there exists a point at which the bears become more aggressive the bulls begin to pull back - the market balances along with the resistance line. When prices are going downwards, the market balances along the support line. As prices starts to decline toward the support line, buyers become more inclined to buy and sellers start holding on to their stocks. The support line marks the point where demand takes precedence oversupply and prices will not decrease below that support line. The reverse holds true for a resistance line. Prices of ten break through support and resistance lines. A break through a resistance line shows that the buyers have won out over the sellers. The price of the stock is bid higher than the previous levels by the Bulls. Once the resistance line is broken, another will be created at a higher level. The reverse holds true for a support line.
Support and resistance zones
Support and resistance is of ten thought of as a price level. For example, analysts and traders might discuss support for Nifty futures contract is at 4850. As a trader, if you are looking for a place to go long would you wait for the market to actually trade at 4850 before taking a position? Should you buy one, two or maybe five ticks above the low and stop yourselfout one tick through the low to manage your risk in the long position. If you wait for a test of support, you could miss a trading opportunity. The problem is thinking about support and resistance as a precise price level and this is where most traders err. It is very common for most people to think of support and resistance levels in terms of absolute price levels. For instance, if they are looking at Rs 50 as a resistance level, they mean exactly Rs 50. In reality, support and resistance levels are not exact prices, but rather price zones. So, if the resistance level is Rs50, then it is actually the zone around that 50 level that is the resistance. The stock may hit only 49.87 or it may hit 50.25 and still hold the Rs 50 as price resistance. One solution is to use price zones for support and resistance instead of price levels. Support and resistance zones give you a better trading opportunity. A risk-taking an investor may buy at top of support zone whereas a cautious investor may want to wait till the bottom of support zone. The main factor in determining exactly how much the exact prices are tested by is how quickly or slowly the prices move into that resistance zone. For instance, if the zone hits very quickly on a large momentum surge, then it is more likely to hit that 50.25 level. This is also the case if the stock is a rather volatile one with a wide price range intraday. If the security spikes higher and does not quite hit the price resistance, such as a spike into 49.70, then it may round of finto 50 with slightly higher highs and never exactly touch the Rs 50 price resistance zone before turning over due to the slowdown in momentum into that resistance. The larger the time frame, the greater the price zone is as well. A resistance zone at 50 on a weekly time the frame may have a range of 1 Rs on each side of 50. Where traders tend to run into trouble is in thinking that because the stock has traded over 50, therefore, the Rs 50 resistance has been broken, so we of ten hear of people “buying the highs” or “shorting the lows” in the case of support. Resistance levels can transform into support levels and vice versa. After prices breakthrough a support level, investors may try to limit their losses by selling the stock, pushing prices back up to the line which now becomes a resistance level.
Change of support to resistance and vice versa
Another principle of technical analysis stipulates that support can turn into resistance and visa-versa. Once the price penetrates below the support level, the earlier or the broken support the level can turn into resistance. The break of support level signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, it is likely to be an increase in supply, and hence resistance Wipro chart showing change of support around 440 to resistance Another aspect of technical analysis is resistance turning into support. As the price increases above resistance, it signals changes in demand and supply. The breakout above resistance proves that the forces of demand have overcome the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support can be established at this point Crude oil chart showing change of resistance to support around 100$
Why are the support and resistance lines important?
Technical analysts of ten say that the market has a memory. Support and resistance lines are a key component of that memory. Investors “tend” to remember previous area levels and thus make them important. When a price of a stock is changing rapidly each day the buying and selling will be done at a divergent level and there will not exist any unanimity or pattern in price changing. But when prices trade within a narrow range for a period of time an area is formed and investors begin to remember that specific price. If the prices stay in an area for a longer period than the volume of that spot increases and that the level becomes more important because investors remember it exceptionally well. Therefore, that level becomes more significant for the technical analyst. According to experts, previous support and resistance levels can be used as “target” or “limit” prices when the market has traded away from them. Assume that a year ago a rally ended with a top price of 120. That price of 120 then becomes a resistance level for the rally occurring in today’s market.
The head and shoulders pattern can be either head and shoulders, top or head and shoulders bottom. The Charts are a picture of a head and shoulders movement, which portrays three successive rallies and reactions with the second one making the highest/lowest point. Head and Shoulders (Top reversal)
A Head and Shoulders (Top) is a reversal pattern which occurs following an extended uptrend forms and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline As its name implies, the head and shoulders reversal pattern is made up of a left shoulder, head, right shoulder, and neckline. Other parts playing a role in the pattern are volume, the breakout, price target, and support turned resistance. Let's look at each part individually, and then put them together with some example
1. Prior trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be ahead and shoulders reversal pattern, or any reversal pattern for that matter.
2. Left shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. It is formed usually at the end of an extensive advance during which volume is quite heavy. At the end of the left shoulder, there is usually a dip or recession which typically occurs on low volume.
3. Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. At this point, in order to conform to proper form, prices must come down somewhere near the low of the left shoulder –somewhat lower perhaps or somewhat higher but in any case, below the top of the left shoulder.
4. Right shoulder: The right shoulder is formed when the low of the head advances again. The peak of the right shoulder is almost equal in height to that of the left shoulder but lower then the head. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.
5. Neckline: A neckline can be drawn across the bottoms of the left shoulder, the head and the right shoulder. Breaking of this neckline on a decline from the right the shoulder is the final confirmation and completes the head and shoulder formation.
6. Volume: As the head and shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left the shoulder should be higher than during the advance of the head. These decreases in volume along with new highs that form the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder.
7. Neckline break: The head and shoulders pattern is said to be complete only when the neckline support is broken. Ideally, this should also occur in a convincing manner with an expansion in volume.
8. Support turned resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and of fer a second chance to sell.
9. Price target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. Price target is calculated by subtracting the above distance from the neckline. Any price target should serve as a rough guide and other factors such as previous support levels should be considered as well.
ABHISHEK IND chart showing the Head and Shoulders pattern
Potato futures (MCX) showing H&S Pattern Signals generated by head and shoulder pattern
• The support line is based on points B and C. • The resistance line. After giving in at point D, the market may retest the neckline at point E. • The price direction. If the neckline holds the buying pressure at point E, then the formation provides information regarding the price direction: diametrically opposed to the direction of the head-and-shoulders (bearish). • The price target D to F. This is provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume). This is equal to the range from top of the head to the neckline.
Volume study Some important points to remember
• The head and shoulders pattern is one of the most common reversal formations. It occurs after an uptrend and usually marks a major trend reversal when complete. • It is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. • Volume support and neckline support identification are considered to be the most critical factors. The support break indicates a new willingness to sell at lower prices. There is an increase in supply combined with lower prices and increasing volume.The combination can be lethal, and sometimes, there is no second chance return to the support break. • Measuring the expected length of the decline after the breakout can be helpful, but it is not always a necessary target. As the pattern unfolds over time, other aspects of the the technical picture is likely to take precedence.
Inverted head and shoulders
The head and shoulders bottom is the inverse of the H&S Top. In the chart below, after a period, the downward trend reaches a climax, which is followed by a rally that tends to carry the share back approximately to the neckline. After a decline below the previous low followed by a rally, the head is formed. This is followed by the third decline which fails to reach the previous low. The advance from this point continues across the neckline and constitutes the breakthrough. The main difference between this and the Head and Shoulders Top is in the volume pattern associated with the share price movements. The volume should increase with the increase in the price from the bottom of the head and then it should start increasing even more on the rally which is followed by the right shoulder. If the neckline is broken but volume is low, you should be skeptical about the validity of the formation. As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its completion marks a change in trend. The pattern contains three troughs in successive manner with the two outside troughs namely the right and the shoulder being lower in height than the middle trough (head) which is the deepest. Ideally, the two shoulders i.e. the right and the left the shoulder should be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance or a neckline.
Head and shoulders bottom
The price action remains roughly the same for both the head and shoulders top and bottom, but in a reversed manner. The biggest difference between the two is played by the volume. While an increase in volume on the neckline breakout for a head and shoulders top is welcomed, it is absolutely required for a bottom. Let's look at each part of the pattern individually, keeping volume in mind:
1. Prior trend: For this to be a reversal pattern it is important to establish the existence of a prior downtrend for this to be a reversal pattern. There cannot be ahead and shoulders the bottom formation, without a prior downtrend to reverse.
2. Left shoulder: It is formed after an extensive increase in price, usually supported by high volume. While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder. The high of the decline usually remains below any longer the trend line, thus keeping the downtrend intact.
3. Head: After the formation of the left shoulder, a decline begins that exceeds the previous low and forms a point at an even lower point. After making a bottom, the high of the subsequent advance forms the second point of the neckline.
4. Right shoulder: Right shoulder is formed when the high of the head begins to decline. The height of the right shoulder is always less than the head and is usually in line with the left shoulder, though it can be narrower or wider. When the advance from the low of the right shoulder breaks the neckline, the head and shoulders reversal is complete.
5. Neckline: The neckline is drawn through the highest points of the two intervening troughs and may slope upward or downward. The neckline forms by connecting two reaction highs. The first reaction marks the end of the left shoulder and the beginning of the head. The second reaction marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern’s degree of bullishness: an upward slope is more bullish than the downward slope.
6. Volume: Volume plays a very important role in head and shoulders bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing the absolute levels associated with each peak and trough. Volume levels during the second halfof the pattern are more important than the first half. The decline of the volume of the left shoulder is usually heavy and selling pressure is also very intense. The selling continues to be intense even during the decline that forms the low of the head. After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances. The advance from the low of the head should be accompanied by an increase in volume and/or better indicator readings (e.g. CMF> 0 or strength in OBV). After the formation of the second neckline point by the reaction high, there should be a decline in the right shoulder accompanied with light volume. It is normal to experience prof it-taking after an advance. Volume analysis helps distinguish between normal prof it-taking and heavy selling pressure. With light volume on the pullback, indicators like CMFand OBV should remain strong. The a most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid there needs to be an expansion of volume on the advance and during the breakout.
1. Neckline break: The head and shoulders pattern is said to be complete only when neckline resistance is broken. For a head and shoulders bottom, this must occur in a convincing the manner with an expansion of volume.
2. Resistance turned support: The same resistance the level can turn into support if the resistance is broken. The price will return to the resistance break and provide a second chance to buy.
3. Price target: Once the neckline resistance is broken, the projected advance is calculated by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages.
CNX IT INDEX Chart Showing Inverse Head and Shoulders Pattern
Once the neckline breaches the prices of index starts rising
Once the resistance is broken at point D the price target will be equal to the bottom of the head from the neckline. It may test the line again at point E, therefore, the stop should be below the neckline.
Some important points to remember:
• Head and shoulder bottom is one of the most common and reliable reversal formations. They occur after a downtrend and usually mark a major trend reversal when complete. • It is preferable but not a necessary requirement that the left and right shoulders be symmetrical. Shoulders can be of different widths as well as different heights. If you are looking for the perfect pattern, then it will take a long time to come. • The major focus of the analysis of the head and shoulders bottom should be the correct identification of neckline resistance and volume patterns. These are two of the most important aspects of a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force and the price is being affected. • As seen from the examples, traders do not always have to choose a stock after the neckline breakout. Many times, the price will return to this new support level and of fer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but it is not always necessary to achieve the final target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedent.
Double tops and bottoms
These are considered to be among the most familiar of all chart patterns and of ten signal turning points, or reversals. The double top resembles the letter “M”. Conversely, the double bottom resembles a “W” formation; in reverse of the double top. Double top
It is a term used in technical analysis to describe the rise of a stock, a drop and another rise roughly of the same level as the previous top and finally followed by another drop. A double top is a reversal pattern which occurs following an extended uptrend. This name is given to the pair of peaks which is formed when the price is unable to reach a new high. It is desirable to sell when the price breaks below the reaction low that is formed between the two peaks.
Context: The double top must be followed by an extended price rise or uptrend. The two peaks formed need not be equal in price but should be the same in the area with a minor reaction low between them. This is a reliable indicator of a potential reversal to the downside.
Appearance: Price moves higher and forms a new high. This is followed by a downside retracement, which forms a reaction low before one final low-volume assault is made on the area of the recent high. In some cases the previous high is never reached, and sometimes it is briefly but does not hold. This pattern is said to be complete once the price makes the second peak and then penetrates the lowest point between the highs, called the reaction low. The sell indication from this topping pattern occurs when price breaks the reaction low to the downside.
Breakout expectation: When the reaction low is penetrated to the downside, accompanied by expanding the volume of the double top pattern becomes of ficial. Downside price target is calculated by subtracting the distance from the reaction low to the peak from the reaction low. Of ten times a double top will mark a lasting top and lead to a significant decline which exceeds the price target to the downside. Although there can be variations if the trend is from bullish to bearish, the classic double the top will mark at least an intermediate change, if not long-term change. Many potential double tops can form along the way up, but until key support is broken, a reversal cannot be confirmed. Let’s look at the key points in the formation.
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double top, a significant uptrend of several months should be in place.
2. First peak: The first peak marks the highest point of the current trend.
3. Trough: Once the first peak is reached, a decline takes place that typically ranges from 10-20%. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand.
4. Second peak: The advance of fthe lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected and after the resistance is met, only the possibility of a double top exists. The pattern still needs to be confirmed. The time period between peaks can vary from a few weeks to many months, with the norm being 1-3 months. While exact peaks are preferable, there is some leeway. Usually, a peak within 3% of the previous high is adequate.
5. The decline from peak: Decline in the second peak is witnessed by an expanding volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that the forces of supply are stronger than the forces of demand and a support test is imminent.
6. Support break: The double top and trend reversal are not complete even when the trading till the support is done. The double top pattern is said to be complete when the support breaks from the lowest point between the peaks. This too should occur with an increase in volume and/or an accelerated descent. 7. Support turned resistance: Broken support becomes potential resistance and there is sometimes a test of this newfound resistance level with a reaction rally
8. Price target: Price target is calculated by subtracting the distance from the support break to peak from the support break. The larger the potential decline the bigger will be the formation.
ALEMBIC LTD Chart Showing Double Top
BHEL Chart showing Double Top
• This stock formed a double top after a big price advance. But it fails to breach the resistance and results in price falls.
Points to be kept in mind:
• Technicians should take proper steps to avoid deceptive double tops. The peaks should be separated by a time period of at least a month. If the peaks are too close, they could just represent normal resistance rather than a lasting change in the supply/demand picture. Ensure that the low between the peaks declines at least 10%. Declines less than 10% may not be indicative of a significant increase in selling pressure. After the decline, analyze the trough for clues on the strength of demand. If the trough drags on a bit and has trouble moving back up, demand could be drying up. When the security does advance, look for a contraction in volume as a further indication of weakening demand. • The most important aspect of a double top is to avoid jumping the gun. The support should be broken in a convincing manner and with an expansion of volume. A price or time filter can be applied to differentiate between valid and false support breaks. A price filter might require a 3% support break before validation. A time filter might require the support break to hold for 3 days before considering it valid. The trend is in force until proven otherwise. This applies to the double top as well. Until support is broken in a convincing manner, the the trend remains up.
Double bottom
Double bottom is a charting technique used in technical analysis. It is used to describe a drop in the value of a stock (index), bounces back and then another drop to the similar level as the previous low and fi nally rebounds again. A double bottom is a reversal pattern which occurs following an extended downtrend. The buy signal is when price breaks above the reaction high which is formed between the two lows.
Context: The double bottom must be followed by an extended decline in prices. The two lows formed have to be equal in areas with a minor reaction high between them, though they need not to be equal in price. This is a reliable indicator of a potential reversal to the upside.
Appearance: Price reduces further to form a new low. This is followed by upside retracement or minor bounce, which forms a reaction high before one fi nal low-volume downward push is made to the area of the recent low. In some cases the previous low is never reached, while in others it is briefl y penetrated to the downside, but price does not remain below it. This pattern is considered complete once price makes the second low and then penetrates the highest point between the lows, called the reaction high. The buy indication from this bottom pattern occurs when price breaks the reaction high to the upside.
Breakout expectation: A double bottom pattern becomes of fi cial when the reaction high is penetrated to the upside, ideally accompanied by expanding volume. Upside price target is calculated adding the distance from the reaction high to the low to that of reaction high. Of ten times a double bottom will mark a lasting low and lead to a significant price advance which exceeds the price target to the upside. There can be many variations that can occur in the double bottom, but the classic double the bottom usually marks an intermediate or a long-term change in trend. Many potential double bottoms can be formed along the way down, but a reversal cannot be confirmed until key resistance is broken. The key points in the formation are as follows:
1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double bottom, a significant downtrend of several months should be in place.
2. First trough: It marks the lowest point of the current trend. Though it is fairly normal in appearance and the downtrend remains firmly in place.
3. Peak: After the first trough is reached, an advance ranging from 10-20% usually takes place. An increase in the volume from the first trough signals an early accumulation. The peaks high is sometimes rounded or drawn out a bit because of the hesitation in going back. This hesitation is an indication of an increase in demand, but this increase is not strong enough for a breakout.
4. Second trough: The decline of fthe reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a double bottom exists, it still needs to be confirmed. The time period between troughs can vary from a few weeks to many months, with the norm being 1-3 months. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid.
5. Advance from trough: Volume gains more importance in the double bottom than in the double top. The advance of the second trough should be clearly evidenced by the increasing volume and buying pressure. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment. 6. Resistance break: The double top and trend reversal are considered incomplete, even after they trade up to resistance. Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/ or an accelerated ascent.
7. Resistance turned support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the fi rst correction. Such a test can of fer a second chance to close a short position or initiate a long.
8. Price target: Target is estimated by adding the distance from the resistance breakout to trough lows on top of the resistance break. This would imply that the bigger the formation is, the larger the potential advance.
Crude oil chart showing Double Bottom
Points to be kept In Mind
• The double bottom is an intermediate to long-term reversal pattern that will not form in a few days. Though it can be formed in a time span of few weeks, but it is preferable to have at least a time of 4 weeks between the two lows. Bottoms usually take more time than the top. This pattern should be given proper time to develop. • The advance of fof the fi rst trough should be 10-20%. The second trough should form a low within 3% of the previous low and volume on the ensuing advance should increase. Signs of buying pressure can be checked by the volume indicators such as Chaikin Money Flow, OBV and Accumulation/Distribution. The formation is not complete until the previous reaction high is taken out.
Rounded top and bottom
Another shape which a top and bottom can take is one in which the reversal is “rounded”. The rounded bottom formation forms when the market gradually yet steadily shifts from a bearish to bullish outlook while in the case of a rounded top, from bullish to bearish. The Rounded Top formation consists of a gradual change in trend from up to down. The Rounded Bottom formation consists of a gradual change in trend from down to up. This formation is the exact opposite of a Rounded Top Formation. The prices take on a bowl shaped pattern as the market slowly and casually changes from an upward to a downward trend
OMAXE Chart showing Rounded Top
It is very (remove) considered very dif fi cult to separate a rounded bottom, where the price continues to decrease from a consolidation pattern and where price stays at a level, but the clue, as always, is in volume. In a true Rounded Bottom, the volume decreases as the price decreases, this signifies a decrease in the selling pressure. A very little trading activity can be seen when the price movement becomes neutral and goes sideways and the volumes are also low. Then, as prices start to increase, the volume increases.
Gap theory
A gap is an area on a price chart in which there were no trades. Normally this occurs after the close of the market on one day and the next day’s open. Lot’s of things can cause this, such as an earnings report coming out after the stock market had closed for the day. If the earnings were significantly higher than expected, this could result in the price opening higher than the previous day’s close. If the trading that day continues to trade above that point, a gap will exist in the price chart. Gaps can of fer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. Gaps appear more frequently on daily charts, where every day is an opportunity to create an opening gap. Gaps can be subdivided into four basic categories: • Common gap • Breakaway gap • Runaway/ Continuation gap • Exhaustion gap Common gaps
Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful. This gap occurs characteristically in nervous markets and is generally closed within few days. In fact, they can be caused by a stock going ex-dividend when the trading volume is low. Getting closed means that the price action at a later time (few days to a few weeks) usually retraces to at the least the last day before the gap. This is also known as fi lling the gap. A common gap usually appears in a trading range or congestion area and reinforces the apparent lack of interest in the stock at that time. Many times this is further exacerbated by low trading volume. Being aware of these types of gaps is good, but doubtful that they will produce trading opportunities.
Breakaway gaps
Breakaway gaps are the exciting ones. They occur when the price action is breaking out of their trading range or congestion area. To understand gaps, one has to understand the nature of congestion areas in the market. A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so. The area near the top of the congestion area is usually resistance when approached from below. Likewise, the area near the bottom of the congestion area is support when approached from above. To break out of these areas requires market enthusiasm and either many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts. Volume will (should) pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the volume does not happen until the gap occurs. This means that the new change in market direction has a chance of continuing. The point of breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout). Don’t fall into the trap of thinking this type of gap, if associated with good volume, will be fi lled soon. It might take a long time. Go with the fact that a new trend in the direction of the stock has taken place and trade accordingly. A good confirmation for trading gaps is if they are associated with classic chart patterns. For example, if an ascending triangle all of a sudden has a breakout gap to the upside, this can be a much better trade than a breakaway gap without a good chart pattern associated with it.
Runaway gaps
Runaway gaps are also called measuring gaps and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden and the price gaps above the previous day’s close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by signifying news events that cause new interest in the stock. Runaway gaps can also happen in down trends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell, but sell to whom? The price has to continue to drop and gap down to fi nd buyers. Not a good situation. The futures market at times will have runaway gaps that are caused by trading limits imposed by the exchanges. Getting caught on the wrong side of the trend when you have these limit moves in futures can be horrifying. The good news is that you can also be on the right side of them. These are not common occurrences in the futures market despite all the wrong information being touted by those who do not understand it and are only repeating something they read from an uninformed reporter.
Exhaustion gaps
Exhaustion gaps are those that happen near the end of a good up or down trend. They are many times the fi rst signal of the end of that move. They are identified by high volume and the large price difference between the previous day’s close and the new opening price. They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume. It is almost a state of panic if during a long down move pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly fi lled as prices reverse their trend. Likewise if they happen during a bull move, some bullish euphoria overcomes trades and they cannot get enough of that stock. The prices gap up with huge volume, then there is great profit taking and the demand for the stock totally dries up. Prices drop and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. In the chart, notice that there was one more day of trading to the upside before the stock plunged. The high volume was the giveaway that this was going to be either an exhaustion gap or a runaway gap. Because of the size of the gap and an almost doubling of volume, an exhaustion gap was in the making here.
Island cluster
Island clusters are identified by an exhaustion gap followed by a breakaway gap in opposite direction. They are powerful reversal signals
Conclusion
There is an old saying that the market abhors a vacuum and all gaps will eventually be fi lled. While this may have some merit for common and exhaustion gaps, holding positions waiting for breakout or runaway gaps to be fi lled can be devastating to your portfolio. Likewise if waiting to get on board a trend by waiting for prices to fi ll a gap just might mean you never participate in the move. Gaps are significant technical development in price action and in chart analysis, and should not be ignored. Japanese candlestick analysis is fi lled with patterns that rely on gaps to fulfi ll their objectives.
What Does a Technical indicator of fer?
Technical analysts use indicators to look into a dif ferent perspective from which stock prices can be analyzed. Technical indicators provide unique outlook on the strength and direction of the underlying price action for a given timeframe.
Why use indicators?
Technical Indicators broadly serve three functions: to alert, to confi rm and to predict. Indicator acts as an alert to study price action, sometimes it also gives a signal to watch for a break of support. A large positive divergence can act as an alert to watch for a resistance breakout. Indicators can be used to confi rm other technical analysis tools. Some investors and traders use indicators to predict the direction of future prices.
Tips for using indicators
There are a large number of Technical Indicators that can be used to assist you in selection of stocks and in tracking the right entry and exit points. In short, indicators indicate. But it doesn’t mean that traders should ignore the price action of a stock and focus solely on the indicator. Indicators just fi lter price action with formulas. As such, they are derivatives and not direct refl ections of the price action. While applying the indicators, the analyst should consider: What is the indicator saying about the price action of a security? Is the price action getting stronger? Is it getting weaker? The buy and sell signals generated by the indicators, should be read in context with other technical analysis tools like candlesticks, trends, patterns etc. For example, an indicator may fl ash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal. An indicator should be selected with due care and attention. It would be a futile exercise to cover more than fi ve indicators. It is best to focus on two or three indicators and learn their intricacies inside and out. One should always choose indicators that complement each other, instead of those that move in unison and generate the same signals. For example, it would be redundant to use two indicators that are good for showing overbought and oversold levels, such as Stochastic and RSI. Both of these indicators measure momentum and both have overbought/oversold levels.
Types of indicators
Indicators can broadly be divided into two types “LEADING” and “LAGGING”.
Leading indicators
Leading indicators are designed to lead price movements. Benefi ts of leading indicators are early signaling for entry and exit, generating more signals and allow more opportunities to trade. They represent a form of price momentum over a fi xed look-back period, which is the number of periods used to calculate the indicator. Some of the wellmore popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Lagging Indicators
Lagging Indicators are the indicators that would follow a trend rather then predicting a reversal. A lagging indicator follows an event. These indicators work well when prices move in relatively long trends. They don’t warn you of upcoming changes in prices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly. These trend following indicators makes you buy and sell late and, in exchange for missing the early opportunities, they greatly reduce your risk by keeping you on the right side of the market. Moving averages and the MACD are examples of trend following, or “lagging,” indicators.
Moving averages
One of the most common and familiar trend-following indicators is the moving averages. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays. The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are described in more detail below.
Simple moving average (SMA)
A simple moving average is formed by computing the average (mean) price of a security over a specified number of periods. It places equal value on every price for the time span selected. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.
The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curving line - the moving average line. Continuing our example, if the next closing price in the average is 15, then this new period would be added and the oldest day, which is 10, would be dropped.
The new 5-day simple moving average would be calculated as follows:
Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will be subtracted and the moving average will continue to move over time.
Exponential moving average (EMA)
Exponential moving average also called as exponentially weighted moving average is calculated by applying more weight to recent prices relative to older prices. In order to reduce the lag in simple moving averages, technicians of ten use exponential moving averages. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA’s period, weight is applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% while a 20-period EMA weighs the most recent price 9.52%. As we’ll see, the calculating and EMA is much harder than calculating an SMA. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average. Here’s the calculation formula.
Exponential moving average calculation
Exponential Moving Averages can be specified in two ways - as a percent-based EMA or as a period-based EMA. A percent-based EMA has a percentage as its single parameter while a period-based EMA has a parameter that represents the duration of the EMA. The formula for an exponential moving average is:
EMA (current) = ((Price (current) - EMA (prev)) x (Multiplier) + EMA (prev)
For a percentage-based EMA, “Multiplier” is equal to the EMA’s specified percentage. For a period-based EMA, “Multiplier” is equal to 2 / (1 + N) where N is the specified number of periods.
For example, a 10-period EMA’s Multiplier is calculated like this:
This means that a 10-period EMA is equivalent to an 18.18% EMA.
The 10-period simple moving average is used for the fi rst calculation only. After that the previous period’s EMA is used.
Note that, in exponential moving average, every previous closing price in the data set is used in the calculation. The impact of the older data never disappears though it diminishes over a period of time. This is true regardless of the EMA’s specified period. The effects of older data diminish rapidly for shorter EMA’s than for longer ones but, again, they never completely disappear.
Simple versus exponential
Generally you will fi nd very little dif ference between an exponential moving average and a simple moving average. Consider this example which uses only 21 trading days, the dif ference is minimal but a dif ference nonetheless. The exponential moving average is consistently closer to the actual price. On average, the EMA is 3/8 of a point closer to the actual price than the SMA.
Which is better?
A question about moving averages that seems to weigh heavily on traders’ minds is whether to use the “simple” or “exponential” moving average. Regardless of the type you choose, the basic principle is that if there is more buying pressure than selling pressure, prices will move above the average and the market will be in an uptrend. On the other hand heavy selling pressure will make the prices drop below the moving average, indicating a downtrend.
The choice of moving average depends on various factors like your trading frequency, investing style and the stock which has been traded by you. The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks. Some traders prefer to use exponential moving averages for shorter time periods to capture changes quicker. Some investors prefer simple moving averages over long time periods to identif y long-term trend changes. In addition, much will depend on the individual security in question. A 50- day SMA might work great for identif ying support levels in INFOSYS but a 100-day EMA may work better for the ACC. Moving average type and length of time will depend greatly on the individual security and how it has reacted in the past.
The dilemma of an investor whether to select exponential moving average or simple moving average can be solved only by obtaining an optimum trade of fbetween sensitivity and reliability. The more sensitive an indicator is the more signals that will be given. Although these signals may prove timely, but they are highly sensitive and may generate false signals. The less sensitive an indicator is the fewer signals that will be given by it. However, less sensitivity leads to fewer and more reliable signals. Sometimes these signals can be late as well.
Shorter moving averages are very sensitive and generate more signals. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. But along with it numbers of false signals are also high. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. Thus it requires every investor to experiment on dif ferent moving averages –lengths and their types to examine the trade-of fbetween sensitivity and signal reliability.
Trend-following indicator
Moving averages are used to determine the direction of trend and are basis of many trendfollowing systems. Moving averages smooth out a data series and make it easier to identif y the direction of the trend. Instead of predicting a change in trend, moving averages follow behind the current trend because past price data is used to form moving averages, they are considered lagging or trend following. Therefore, you can use moving averages for trend identification and trend following purposes, not for prediction.
When to use?
Because moving average is a trend following indicator, you should use it when a security is trending. Application of moving averages would be ineffective when a security moves in a trading range. With this in mind, investors and traders should fi rst identif y securities that display some trending characteristics before attempting to analyze with moving averages. With a simple visual assessment of the price chart you can determine if a security exhibits characteristics of trend.
Using price chart you can analyse whether a stock is trending up, trending down or trading in a range. When a security forms a series of higher highs and higher lows it is said to be in uptrend. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.
It is sometimes dif fi cult to determine when a trend will stop and a trading range will begin or when a trading range will stop and a trend will begin. The basic rules for trends and trading ranges laid out above can be applied.
Moving average settings
Once the security exhibiting the above characteristics is selected the next task is to select the number of moving average periods and type of moving average. The number of periods in a moving average will depend upon the security’s volatility, trend and personal preferences. Shorter length moving averages are more sensitive and identif y new trends earlier, but also give more false alarms. Longer moving averages are more reliable but less responsive, only picking up the big trends. There is no predetermined or fi xed length of moving averages, but some of the more popular lengths include 21, 50, 89, 150 and 200 days as well as 10, 30 and 40 weeks. Short-term traders may look for evidence of 2-3 week trends with a 21-day moving average, while longer-term investors may look for evidence of 3-4 month trends with a 40-week moving average. You should examine how the moving average fi ts with the price data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If the moving average is slow to react, shorten the moving average to increase its sensitivity. In addition, you may want to try using both simple and exponential moving averages. Exponential moving averages are usually best for short-term situations that require a responsive moving average. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity.
Uses of moving averages
There are many uses for moving averages, but three basic uses stand out: • Trend identification/confirmation • Support and resistance level identification/confirmation • Trading systems
Trend identification/ Confirmation
Moving averages are helpful in keeping you in line with the price trend by providing buy signals shortly after the market bottoms out and sell signals shortly after it tops, rather than trying to catch the exact bottom or top.
There are three ways to identif y the trend with moving averages: direction, location and crossovers.
The fi rst trend identification technique uses the direction of the moving average to determine the trend. The trend is considered up when moving average is continuously rising. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.
The second technique for trend identification is price location. The basic trend can be determined through location of the price relative to the moving average. If the price is located below the moving average then there is a downward trend in place and visa versa for the price being located above the moving average.
The third technique for trend identification is the location of the shorter moving average relative to the longer moving average. The trend will go up is going up if the shorter moving average is above the longer moving average. If the shorter moving average is below the longer moving average, the trend is considered down.
Moving averages - key points
The Moving Average (MA) is the simplest and most widely used technical analysis tool. The MA attempts to tone down the fl uctuations of market prices to a smoothed trend, so that distortions are reduced to a minimum. MAs help in tracking trends and signaling reversals. The most important merit of moving average system is that you will always be on “right” side of the market.
Interpretation
Signals to buy or sell are generated when the price crosses the MA or when one MA crosses another, in the case of multiple MAs. Buy when prices move above the moving average line on the chart and sell when prices drop below the moving average line
Another method used by technical analysts is using the two moving averages on the same chart with dif ferent time periods. Since the MA is a lagging indicator, a crossover will usually signal a trend reversal well after a new trend has begun and is used largely for confirmation. Generally speaking, the longer the time span covered by an MA, the greater the significance of a crossover signal. For example, the crossover of a 100 or 200-day MA is significantly more important then the crossover of a 20-day MA.
Moving averages dif fer according to the weight assigned to the most recent data. Simple moving averages apply equal weight to all prices. More weight is applied to recent prices in the case of exponential and weighted averages. Variable moving averages change the weighting based on the volatility of prices.
When prices fl uctuate up and down in a broad sideways pattern for an extended period (trading-range market), longer term MAs are slow to react to reversals in trend, and when prices move sideways in a narrow range shorter term MAs of ten produce false signals. Flat and confl icting MAs generally indicate a trading-range market and one to avoid, unless there is pronounced rounding that suggests a possible new trend.
A variable moving average is an exponential moving average that automatically adjusts the smoothing percentage based on the volatility of the data series. Such moving average compensates for trading-range versus trending markets. This MA automatically adjusts the smoothing constant to adjust its sensitivity, of ten allowing it to outperform the other moving averages in these dif fi cult markets.
Because of the potential for false signals MAs should always be used in conjunction with the other indicators. For example Bollinger bands adjust in distance from a moving average based on volatility, using standard deviation above and below the moving average rather than percentages.
Indicators which are especially well-suited for being used with moving averages include MACD, Price ROC, Momentum, and Stochastic. A moving average of another moving average is also common.
Signals - moving average price crossover
A price break upwards through an MA is generally a buy signal, and a price break downwards through an MA is generally a sell signal. As we have seen, the longer the time span or period covered by an MA, the greater the significance of a crossover signal.
If the MA is fl at or has already changed direction, its violation is fairly conclusive proof that the previous trend has reversed.
False signals can be avoided by using a fi ltering mechanism. Many traders, for example, recommend waiting for one period - that is one day for daily data and one week for weekly data.
Whenever possible try to use a combination of signals. MA crossovers that take place at the same time as trend line violations or price pattern signals of ten provide strong confirmation.
Signals - multiple moving averages
It is usually advantageous to employ more than one moving average. Double and triple MAs of ten provide useful signals.
With two MAs the double crossover is used. When the short term moving average crosses the long term moving average to the downside, then a sell signal would be triggered and visa versa. For example, two popular combinations are the 5 and 20-day averages and the 20 and 100-day averages. The technique of using two averages together lags the market a bit more than a single moving average but produces fewer whipsaws.
Many investors use the triple moving average crossover system to buy and sell stock. The most widely used triple crossover system is the popular 4-9-18-day MA combination. A buy signal is generated when the shortest (and most sensitive) average - the 4 day - crosses fi rst the 9-day and then the 18-day averages, each crossover confi rming the change in trend.
Additional points
• The 200-day MA (or 40-week MA), should be carefully watched as a pivotal level of support or resistance for the long-term trend. Many people watch carefully when the 200-day MA is approached by the price. The relationship between the price and its 200- day MA can of ten provide excellent buy or sell signals.
• The 200-day MA is also particularly significant for the various indexes, such as the Nif ty, Sensex or NASDAQ. A crossover of this MA has of ten signaled a correction or period of consolidation.
• Moving averages can also be calculated and plotted for other indicators, not just the price. A continued upward movement by the indicator is signified by the indicator rising above its moving average. A continued downward movement is signified by the indicator falling below its moving average.
Trend-following indicator
Moving averages are used to determine the direction of trend and are basis of many trendfollowing systems. Moving averages smooth out a data series and make it easier to identif y the direction of the trend. Instead of predicting a change in trend, moving averages follow behind the current trend because past price data is used to form moving averages, they are considered lagging or trend following. Therefore, you can use moving averages for trend identification and trend following purposes, not for prediction.
When to use?
Because moving average is a trend following indicator, you should use it when a security is trending. Application of moving averages would be ineffective when a security moves in a trading range. With this in mind, investors and traders should fi rst identif y securities that display some trending characteristics before attempting to analyze with moving averages. With a simple visual assessment of the price chart you can determine if a security exhibits characteristics of trend.
Using price chart you can analyse whether a stock is trending up, trending down or trading in a range. When a security forms a series of higher highs and higher lows it is said to be in uptrend. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.
It is sometimes dif fi cult to determine when a trend will stop and a trading range will begin or when a trading range will stop and a trend will begin. The basic rules for trends and trading ranges laid out above can be applied.
Moving average settings
Once the security exhibiting the above characteristics is selected the next task is to select the number of moving average periods and type of moving average. The number of periods in a moving average will depend upon the security’s volatility, trend and personal preferences. Shorter length moving averages are more sensitive and identif y new trends earlier, but also give more false alarms. Longer moving averages are more reliable but less responsive, only picking up the big trends. There is no predetermined or fi xed length of moving averages, but some of the more popular lengths include 21, 50, 89, 150 and 200 days as well as 10, 30 and 40 weeks. Short-term traders may look for evidence of 2-3 week trends with a 21-day moving average, while longer-term investors may look for evidence of 3-4 month trends with a 40-week moving average. You should examine how the moving average fi ts with the price data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If the moving average is slow to react, shorten the moving average to increase its sensitivity. In addition, you may want to try using both simple and exponential moving averages. Exponential moving averages are usually best for short-term situations that require a responsive moving average. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity.
Uses of moving averages
There are many uses for moving averages, but three basic uses stand out: • Trend identification/confirmation • Support and resistance level identification/confirmation • Trading systems
Trend identification/ Confirmation
Moving averages are helpful in keeping you in line with the price trend by providing buy signals shortly after the market bottoms out and sell signals shortly after it tops, rather than trying to catch the exact bottom or top.
There are three ways to identif y the trend with moving averages: direction, location and crossovers.
The fi rst trend identification technique uses the direction of the moving average to determine the trend. The trend is considered up when moving average is continuously rising. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.
The second technique for trend identification is price location. The basic trend can be determined through location of the price relative to the moving average. If the price is located below the moving average then there is a downward trend in place and visa versa for the price being located above the moving average.
The third technique for trend identification is the location of the shorter moving average relative to the longer moving average. The trend will go up is going up if the shorter moving average is above the longer moving average. If the shorter moving average is below the longer moving average, the trend is considered down.
Moving averages - key points
The Moving Average (MA) is the simplest and most widely used technical analysis tool. The MA attempts to tone down the fl uctuations of market prices to a smoothed trend, so that distortions are reduced to a minimum. MAs help in tracking trends and signaling reversals. The most important merit of moving average system is that you will always be on “right” side of the market.
Interpretation
Signals to buy or sell are generated when the price crosses the MA or when one MA crosses another, in the case of multiple MAs. Buy when prices move above the moving average line on the chart and sell when prices drop below the moving average line
Another method used by technical analysts is using the two moving averages on the same chart with dif ferent time periods. Since the MA is a lagging indicator, a crossover will usually signal a trend reversal well after a new trend has begun and is used largely for confirmation. Generally speaking, the longer the time span covered by an MA, the greater the significance of a crossover signal. For example, the crossover of a 100 or 200-day MA is significantly more important then the crossover of a 20-day MA.
Moving averages dif fer according to the weight assigned to the most recent data. Simple moving averages apply equal weight to all prices. More weight is applied to recent prices in the case of exponential and weighted averages. Variable moving averages change the weighting based on the volatility of prices.
When prices fl uctuate up and down in a broad sideways pattern for an extended period (trading-range market), longer term MAs are slow to react to reversals in trend, and when prices move sideways in a narrow range shorter term MAs of ten produce false signals. Flat and confl icting MAs generally indicate a trading-range market and one to avoid, unless there is pronounced rounding that suggests a possible new trend.
A variable moving average is an exponential moving average that automatically adjusts the smoothing percentage based on the volatility of the data series. Such moving average compensates for trading-range versus trending markets. This MA automatically adjusts the smoothing constant to adjust its sensitivity, of ten allowing it to outperform the other moving averages in these dif fi cult markets.
Because of the potential for false signals MAs should always be used in conjunction with the other indicators. For example Bollinger bands adjust in distance from a moving average based on volatility, using standard deviation above and below the moving average rather than percentages.
Indicators which are especially well-suited for being used with moving averages include MACD, Price ROC, Momentum, and Stochastic. A moving average of another moving average is also common.
Signals - moving average price crossover
A price break upwards through an MA is generally a buy signal, and a price break downwards through an MA is generally a sell signal. As we have seen, the longer the time span or period covered by an MA, the greater the significance of a crossover signal.
If the MA is fl at or has already changed direction, its violation is fairly conclusive proof that the previous trend has reversed.
False signals can be avoided by using a fi ltering mechanism. Many traders, for example, recommend waiting for one period - that is one day for daily data and one week for weekly data.
Whenever possible try to use a combination of signals. MA crossovers that take place at the same time as trend line violations or price pattern signals of ten provide strong confirmation.
Signals - multiple moving averages
It is usually advantageous to employ more than one moving average. Double and triple MAs of ten provide useful signals.
With two MAs the double crossover is used. When the short term moving average crosses the long term moving average to the downside, then a sell signal would be triggered and visa versa. For example, two popular combinations are the 5 and 20-day averages and the 20 and 100-day averages. The technique of using two averages together lags the market a bit more than a single moving average but produces fewer whipsaws.
Many investors use the triple moving average crossover system to buy and sell stock. The most widely used triple crossover system is the popular 4-9-18-day MA combination. A buy signal is generated when the shortest (and most sensitive) average - the 4 day - crosses fi rst the 9-day and then the 18-day averages, each crossover confi rming the change in trend.
Additional points
• The 200-day MA (or 40-week MA), should be carefully watched as a pivotal level of support or resistance for the long-term trend. Many people watch carefully when the 200-day MA is approached by the price. The relationship between the price and its 200- day MA can of ten provide excellent buy or sell signals.
• The 200-day MA is also particularly significant for the various indexes, such as the Nif ty, Sensex or NASDAQ. A crossover of this MA has of ten signaled a correction or period of consolidation.
• Moving averages can also be calculated and plotted for other indicators, not just the price. A continued upward movement by the indicator is signified by the indicator rising above its moving average. A continued downward movement is signified by the indicator falling below its moving average.
Oscillator
Relative Strength Index (RSI)
The RSI is part of a class of indicators called momentum oscillators.
There are a number of indicators that fall in this category, the most common being Relative Strength Index, Stochastic, Rate of Change, Williams %R. Although these indicators are all calculated dif ferently, there are a number of common elements to their use which shall be discussed in the context of the RSI.
What is momentum?
Momentum is simply the rate of change – the speed or slope at which a stock or commodity ascends or declines. Measuring speed is a useful gage of impending change. For example, assume that you were riding in a friends’ car, not looking at what was happening ahead but instead just at the speedometer. You can see when the car starts to slow down and if it continues to do so you can reasonably assume it’s going to stop very shortly. You may not know the reason for it coming to a stop…it could be the end of the journey, approaching and intersection or because the road is a little rougher ahead. In this manner watching the speed provides a guide for what may happen in the future.
An oscillator is an indicator that moves back and forth across a reference line or between prescribed upper and lower limits. When an oscillator reaches a new high, it shows that an uptrend is gaining speed and is likely to continue. When an oscillator traces a lower peak, it means that the trend has stopped accelerating and a reversal can be expected from there, much like a car slowing down to make a U-Turn.
In the same way watching a stock for impending momentum change can provide a glimpse of what may happen in the future – momentum oscillators, such as RSI are referred to as trend leading indicators. The chart below illustrates the typical construction of the RSI which oscillates between 0% and 100%. You will notice there is a pair of horizontal reference lines: 70% ‘overbought’ and 30% ‘oversold’ lines. The overbought region refers to the case where the RSI oscillator has moved into a region of significant buying pressure relative to the recent past and is of ten an indication that an upward trend is about to end. Similarly the oversold region refers to the lower part of the momentum oscillator where there is a significant amount of selling pressure relative to the recent past and is indicative of an end to a down swing.
Nif ty Chart with RSI
Application of RSI
RSI is a momentum oscillator generally used in sideways or ranging markets where the price moves between support and resistance levels. It is one of the most useful technical tool employed by many traders to measure the velocity of directional price movement.
Overbought and Oversold
The RSI is a price-following oscillator that ranges between 0 and 100. Generally, technical analysts use 30% oversold and 70% overbought lines to generate the buy and sell signals.
• Go long when the indicator moves from below to above the oversold line.
• Go short when the indicator moves from above to below the overbought line.
Note here that the direction of crossing is important; the indicator needs to fi rst go past the overbought/oversold lines and then cross back through them.
Silver Chart showing buy and sell points and also the failure in trending market
Divergence
The other means of using RSI is to look at divergences between price peaks/troughs and indicator peaks/ troughs.
If the price makes a new higher peak but the momentum does not make a corresponding higher peak this indicates there is less power driving the new price high. Since there is less power or support for the new higher price a reversal could be expected.
Similarly if the price makes a new lower trough but the momentum indicator does not make a corresponding lower trough, then it can be surmised that the downward movement is running out of strength and a reversal upward could soon be expected. This is illustrated in the chart below. A bullish divergence represents upward price pressure and a bearish divergence represents downward price pressure.
Wipro Chart showing Negative and Positive Divergence • The fi rst divergence shows a new lower trough forming at point ‘A’ but the RSI oscillator does not reach a new lower trough. This indicates the downward movement is exhausting and an upward move is imminent.
• The second and third are a bearish divergence with a new sharply higher peak formed at ‘B’ but it is not supported by at least an equal high in the RSI, hence a downward move is expected.
Natural Gas Chart showing Strong Bullish Divergence
Stochastic
The Stochastic indicator was developed by George Lane. It compares where a security’s price closes over a selected number of period. The most commonly 14 periods stochastic is used.
The Stochastic indicator is designated by “%K” which is just a mathematical representation of a ratio.
%K=(today’s Close)-(Lowest low over a selected period)/(Highest over a selected period)- (Lowest low over a selected period)
For example, if today’s close is 50 and high and low over last 14 days is 40 and 55 respectively then,
%K= 50-40 / 55-40 = 0.666
Finally these values are multiplied by 100 to change decimal value into percentage for better scaling.
This 0.666 signifies that today’s close was at 66.6% level relative to its trading range over last 14 days.
A moving average of %K is then calculated which is designated by %D. The most commonly 3 period’s %D is used.
The stochastic indicator always moves between zero and hundred, hence it is also known as stochastic oscillator. The value of stochastic oscillator near to zero signifies that today’s close is near to lowest price security traded over a selected period and similarly value of stochastic oscillator near to hundred signifies that today’s close is near to highest price security traded over a selected period.
Interpretation of Stochastic Indicator
Most popularly stochastic indicator is used in three ways
a. To defi ne overbought and oversold zone- Generally stochastic oscillator reading above 80 is considered overbought and stochastic oscillator reading below 20 is considered oversold. It basically suggests that
• One should book profit in buy side positions and should avoid new buy side positions in an overbought zone.
• One should book profit in sell side positions and should avoid new sell side positions in an oversold zone
This would be clearer from figure
Figure illustrates overbought and oversold zones for spot Nif ty. It is clearly visible that in most of the cases prices have corrected from overbought zone and similarly prices have rallied from oversold zone.
b. Buy when %K line crosses % D line(dotted line) to the upside in oversold zone and sell when %K line crosses % D line(dotted line) to the downside in overbought zone-
This would be clearer from fi gure below
Figure illustrates buying signals being generated by %K upside crossover in an oversold zone and selling signals being generated by %K downside crossover in an overbought zone on a Nif ty spot price chart.
c. Look for Divergences- Divergences are of two types i.e. positive and negative. Positive Divergence-are formed when price makes new low, but stochastic oscillator fails to make new low. This divergence suggests a reversal of trend from down to up. This would be clearer from fi gure below.
Figure illustrates Nif ty spot making new lows whereas stochastic oscillator fails to make new low, fi nally Nif ty trend reversed from down to up.
Negative Divergence-are formed when price makes new high, but stochastic oscillator fails to make new high. This divergence suggests a reversal of trend from up to down. This would be clearer from fi gure below.
Figure illustrates Nif ty spot making new highs whereas stochastic oscillator fails to make new high, fi nally Nif ty trend reversed from up to down.
William %R
The William %R indicator was developed by Larry Williams. This is almost similar to stochastic oscillator except for a negative scale. The William %R indicator always moves between zero and minus hundred (-100)
Interpretation of William %R Indicator
Most popularly stochastic indicator is used in two ways
a. To defi ne overbought and oversold zone- Generally William % R reading between 0 and -20 are considered overbought and William % R reading between -80 to -100 are considered oversold. It basically suggests that
• One should book profit in buy side positions and should avoid new buy side positions in an overbought zone.
• One should book profit in sell side positions and should avoid new sell side positions in an oversold zone
This would be clearer from fi gure 138 below.
Figure illustrates overbought and oversold zones for spot Nif ty. It is clearly visible that in most of the cases prices have corrected from overbought zone and similarly prices have rallied from oversold zone.
b. Look for Divergences- Divergences are of two types i.e. positive and negative. Positive Divergence-are formed when price makes new low, but William % R fails to make new low. This divergence suggests a reversal of trend from down to up. This would be clearer from fi gure below.
Figure illustrates Nif ty spot making new lows whereas William % R fails to make new low, fi nally Nif ty trend reversed from down to up.
Negative Divergence-are formed when price makes new high, but William % R fails to make new high. This divergence suggests a reversal of trend from up to down. This would be clearer from fi gure below.
Figure illustrates Nif ty spot making new highs whereas William % R fails to make new high, fi nally Nif ty trend reversed from up to down.
To Summarize
The RSI belong to a class of indicators called trend leading indicators. These are usually used in ranging markets and are not suitable for trending markets. We have discussed the basic concept of momentum, being a measure of speed of price movement. The RSI has oversold and overbought lines or zones at a predefi ned level. For the RSI, oversold and overbought levels are defi ned by lines that pass through the significant peaks and troughs of the indicator.
There are two basic methods of using these oscillators in ranging markets; using the overbought/oversold regions and divergence between the price and oscillator.
When the indicator fi rst moves into the overbought zone and then crosses back through the overbought line this is a signal to go short. Similarly when the indicator moves into the oversold region and then crosses back across the oversold line this is a signal to go long.
There are two main types of divergence, a strong and moderate divergence. A strong divergence occurs when the price makes a new higher peak but the momentum indicator makes a corresponding lower peak indicating a loss of momentum in the current up trend. When this occurs it is a signal to go short. Lower price troughs and higher momentum troughs indicate a bullish move and is a signal to go long.
Real-lif e Problems in use of RSI
• RSI in overbought levels does not always signif y an overbought Market.
• RSI in oversold levels does not always signif y an oversold Market.
• The RSI can remain in overbought / oversold zones for long periods of time.
• A bullish divergence may not always lead to a rally.
• A bearish divergence may not always lead to a decline.
Advanced Concepts
In Bull Markets the level is 70 and 40.
Gold Chart in Uptrend showing RSI Oversold levels below 40
IN Bear Markets the level is 60 and 30.
Infosys in Downtrend showing Overbought level above 60
RSI moves into overbought and oversold zones
• Overbought and oversold levels cannot be used to buy and sell under all circumstances. When the RSI goes above 70, we say that it is overbought. This leads to the erroneous conclusion that we should be selling the security. IF the RSI goes below 30, we say that it is oversold. This leads to the erroneous conclusion that we should be buying the security.
• We should consider the upper and lower boundaries of 70 and 30 as ‘extreme zones’. When the RSI moves inside an extreme zone, we receive an alert that the security may be ready for a buy or sell trade. But, the trade may or may not actually happen. Low risk trades when RSI is in extreme zones
• The level of extreme zones changes in bull and bear markets. In general, in a bull market, the extreme zones are located at 70 and 40. In a bear market, the extreme zones are located at 60 and 30.
• A zone shif t in an indication of a change in trend. When the RSI shif ts zones, this is one of the fi rst indications that a change in trend is taking place.
• In a bear market, the RSI moves up during periods of bear allies. It usually fi nds resistance around 60. Now, in one such rally, the RSI crosses 60 and fi nds resistance around 70. A zone shif t has taken place. This is one of the fi rst signs that the market may be shif ting from a bearish to bullish environment.
In a bear market, look for these signs
• The RSI moves up during periods of bear rallies. It usually fi nds resistance around 60. Now, in one such rally, the RSI crosses 60 and fi nds resistance around 70. A zone shif t has taken place. This is one of the fi rst signs that the market may be shif ting from a bearish to bullish environment.
• The RSI falls and fi nds support between 20 to 30. During a decline, the RSI falls but fi nds support around 40. This may be a sign that the market is changing from bearish to bullish. This is also an example of zone shif t.
Shif t from Bear to Bull
Reliance Chart showing Upward Shif t in RSI
In a bull market, look for these signs
• The RSI moves down during periods of declines decline. It usually fi nds support around 40. Now, in one such decline, the RSI crosses 40 and fi nds support around 30. A zone shif t has taken place. This is one of the fi rst signs that the market may be shif ting from a bullish to bearish environment.
• The RSI rallies and fi nds resistance around 70. During a rally, the RSI rises but fi nds resistance around 60. This may be a sign that the market is changing from bullish to bearish. This is also an example of zone shif t.
Shif t from bull to bear
When a zone shif t is detected, look for a signal to trade in the direction of the new trend. If possible, step down to a lower time frame to take the trade.
If a zone shif t from Up to Down is detected on a daily chart, move to a 60-minute chart. Sell when the trend indicators on this 60 minute chart give a sell signal.
• Use the ADX to determine a strong trend. When the ADX is above 30 and rising, assume that a strong trend is in place. The direction of the trend, up or down should be available by simple chart examination. When the market is trending use the extreme levels to identif y trades only in the direction of the trend.
IF the market is in an up trend, then a dip to 40 should be considered as an opportunity to buy. But a rally to 70 is NOT an opportunity to short sell.
Moving Average Convergence/Divergence (MACD)
MACD stands for Moving Average Convergence / Divergence. It is a technical analysis indicator created by Gerald Appel in the late 1970s. The MACD indicator is basically a refi nement of the two moving averages system and measures the distance between the two moving average lines.
What is the MACD and how is it calculated?
The MACD does not completely fall into either the trend-leading indicator or trend following indicator; it is in fact a hybrid with elements of both. The MACD comprises two lines, the fast line and the slow or signal line. These are easy to identif y as the slow line will be the smoother of the two.
NIF TY chart below illustrates the basic MACD lines
The procedure for calculating the MACD lines is as follows: Step1. Calculate a 12 period exponential moving average of the close price. Step2. Calculate a 26 period exponential moving average of the close price. Step3. Subtract the 26 period moving average from the 12 period moving average. This is the fast MACD line. Step4. Calculate a 9 period exponential moving average of the fast MACD line calculated above. This is the slow or signal MACD line.
MACD benefits
The importance of MACD lies in the fact that it takes into account the aspects of both momentum and trend in one indicator. As a trend-following indicator, it will not be wrong for very long. The use of moving averages ensures that the indicator will eventually follow the movements of the underlying security. By using exponential moving averages, as opposed to simple moving averages, some of the lag has been taken out. As a momentum indicator, MACD has the ability to foreshadow moves in the underlying security. MACD divergences can be key factors in predicting a trend change. A negative divergence signals that bullish momentum is going to end and there could be a potential change in trend from bullish to bearish. This can serve as an alert for traders to take some profits in long positions, or for aggressive traders to consider initiating a short position.
MACD can be applied to daily, weekly or monthly charts. The MACD indicator is basically a refi nement of the two moving averages system and measures the distance between the two moving average. The standard setting for MACD is the dif ference between the 12 and 26- period EMA. However, any combination of moving averages can be used. The set of moving averages used in MACD can be tailored for each individual security. For weekly charts, a faster set of moving averages may be appropriate. For volatile stocks, slower moving averages may be needed to help smooth the data. No matter what the characteristics of the underlying security, each individual can set MACD to suit his or her own trading style, objectives and risk tolerance.
Use of MACD lines
MACD generates signals from three main sources: • Moving average crossover
• Centerline crossover
• Divergence
Crossover of fast and slow lines
The MACD proves most effective in wide-swinging trading markets. We will fi rst consider the use of the two MACD lines. The signals to go long or short are provided by a crossing of the fast and slow lines. The basic MACD trading rules are as follows:
• Go long when the fast line crosses above the slow line. • Go short when the fast line crosses below the slow line.
These signals are best when they occur some distance above or below the reference line. If the lines remain near the reference line for an extended period as usually occurs in a sideways market, then the signals should be ignored.
INFOSYS chart showing MACD crossovers Center line crossover
A bullish centerline crossover occurs when MACD moves above the zero line and into positive territory. This is a clear indication that momentum has changed from negative to positive or from bearish to bullish. After a positive divergence and bullish moving average crossover, the centerline crossover can act as a confirmation signal. Of the three signals, moving average crossover are probably the second most common signals.
A bearish centerline crossover occurs when MACD moves below zero and into negative territory. This is a clear indication that momentum has changed from positive to negative or from bullish to bearish. The centerline crossover can act as an independent signal, or confi rm a prior signal such as a moving average crossover or negative divergence. Once MACD crosses into negative territory, momentum, at least for the short term, has turned bearish.
Tata Steel Chart showing Centerline crossover
Divergence
An indication that an end to the current trend may be near occurs when the MACD diverges from the security. A positive divergence occurs when MACD begins to advance and the security is still in a downtrend and makes a lower reaction low. MACD can either form as a series of higher lows or a second low that is higher than the previous low. Positive divergences are probably the least common of the three signals, but are usually the most reliable and lead to the biggest moves.
A negative divergence forms when the security advances or moves sideways and MACD declines. The negative divergence in MACD can take the form of either a lower high or a straight decline. Negative divergences are probably the least common of the three signals, but are usually the most reliable and can warn of an impending peak.
INFOSYS chart showing MACD Positive Divergence
NIF TY chart showing MACD Negative Divergence
To Summarize
• The MACD is a hybrid trend following and trend leading indicator.
• The MACD consists of two lines; a fast line and a slow ‘signal’ line
. • A long position is indicated by a cross of the fast line from below to above the slow line.
• A short position is indicated by a cross of the fast line from above to below the slow line.
• MACD should be avoided in trading markets
• The MACD is useful for determining the presence of divergences with the price data.
Money Flow Index
Money fl ow index takes into account volume action and on the basis of volume action; it attempts to measure the strength of money fl owing in and out the security which now a days is also known as smart money fl ow indicator.
To understand calculation aspect of MFI, one should fi rst understand positive money fl ow and negative money fl ow which is the basis of MFI. When day’s average price is greater than previous day’s average price, it’s said to be positive money fl ow and similarly when day’s average price is less than previous day’s average price; it’s said to be negative money fl ow. Money fl ow for a specific day is calculated by multiplying the average price by the volume. Positive money fl ow is calculated by summing the positive money fl ow over a specified number of periods. Negative money fl ow is calculated by summing the negative money fl ow over a specified number of periods.
When one divides positive money fl ow by negative money fl ow, one gets money ratio.
Finally MFI = 100-100/(1+money ratio)
Interpretation of MFI
Most popularly MFI indicator is used in two ways
a. To defi ne overbought and oversold zone- Generally MFI reading above 80 is considered overbought and MFI reading below 20 is considered oversold. It basically suggests that
• One should book profit in buy side positions and should avoid new buy side positions in an overbought zone.
• One should book profit in sell side positions and should avoid new sell side positions in an oversold zone
This would be clearer from fi gure below.
Figure illustrates overbought and oversold zones for spot Nif ty. It is clearly visible that in most of the cases prices have corrected from overbought zone and similarly prices have rallied from oversold zone.
b. Look for Divergences- Divergences are of two types i.e. positive and negative. Positive Divergence-are formed when price is making new lows, but MFI fails to break previous lows. This divergence suggests a reversal of trend from down to up.
Figure illustrates Nif ty making new lows, where as MFI fails to break previous lows.
Figure illustrates Nifty making new lows whereas MFI fails to make new low, fi nally Nifty trend reversed from down to up.
Negative Divergence-are formed when price is making new highs, but MFI fails to make new high. This divergence suggests a reversal of trend from up to down.
Figure below illustrates Nifty making new highs, where as MFI fails to make new high.
Figure illustrates Nifty making new highs whereas MFI fails to make new high, fi nally Nifty Future trend reversed from up to down.
Bollinger Bands
Bollinger bands are trading bands developed by John Bollinger.
It consists of a 20 period simple moving average with upper and lower bands. The upper band is 2 standard deviation above the moving average and similarly lower band is 2 standard deviation below the moving average. This makes these bands more dynamic and adaptive to volatility.
This would be clearer from fi gure below
Figure illustrates Bollinger band plotted on Nifty price chart.
Interpretation of Bollinger Bands
Mr. John Bollinger described following important interpretation of Bollinger bands in projecting price trends.
1. Big move in price is witnessed on either side when bands tightens/contracts as volatility lessens.
2. The upper band act as area of resistance and lower band act as area of support.
3. When prices move outside the band, it signifies breakout, hence continuation of the trend.
4. Bottoms and tops made outside the band, followed by tops and bottoms made inside the band suggests reversal of the trend.
Price-sensitive techniques
Moving Averages — Gives the general trend of price based on its recent be havior and tells when the trend has been broken.
Relative Strength — Measures the strength left in a price trend by comparing number of up and down days over a recent timeframe.
Percentage R — This compares a day’s closing price to a recent range of prices to determine if a market is overbought or oversold.
Oscillators — Measure the momentum of a price trend based on recent price behavior.
Stochastic — Combines indicators like moving average and relative strength to measure overbought and oversold tendencies.
Point-and-Figure/ kagi — Plots trends and reversals in price movement and then gives buy/ sell signals based on recognizable patterns.
Basic Charting — Techniques for recognizing common price movement pat terns and gauging market movements.
Swing Charting — Provides rigid entry and exit signals based on recent price history.
Volume-sensitive techniques
Tic Volume — This is similar to On-Balance Volume, but looks at the volume and directions of individual trades.
On-Balance Volume — Discovers “smart money’s” moves by balancing the volume of days with rising prices against falling days.
Composite methods
Elliott Waive — Uses rules of cyclic market behavior and pattern formations to predict future price levels, trends, and reversal points.
How to use the tool kit of trading techniques
Price-sensitive techniques
Moving Averages — Gives very good signals in a trending market, but can reduce profits in a trading market.
Relative Strength — This confi rms other methods in trading markets. Users have to keep adjusting the scale in trending markets.
Oscillators — Can confi rm other techniques and indicate whether market is overbought or oversold and should be sold or bought.
Stochastic — Accurate for predicting trading market lows and highs.
Point-and-Figure — Gives acceptable results most of the time, but can be un reliable in strongly trending markers.
Basic Charting — Gives general framework for interpreting most other tech niques. Volume analysis is an of fshoot of basic charting.
Swing Charting — Works in trending markets. Combine longer and shorter period charts to avoid choppiness in trading markets.
Volume-sensitive techniques
Tic Volume — Same observations apply as for On-Balance Volume. Does not work well in a market with no big players.
On-Balance Volume — Gives good advance warning of when the market will move of fthe bottom, but is late on tops.
Composite techniques
Elliott Wave — Predicts major market moves. Use other techniques to confi rm the times and price levels.
Trading market tool kit application
1) Moving Averages — Fade breakouts
2) RSI, and Oscillators — Sell overbought, buy oversold
3) Stochastic — Sell crossovers to downside and buy crossovers to upside
4) On-Balance Volume and Tic Volume — Useless as forecasting indicators but can be viable as confi rming indicators
5) Elliott Wave — Verifies the existence of trading market via fl at-type cor rections classification and shows possible end of trading range
Bull market tool kit application
1) Moving Averages — Buy the upside crossovers
2) RSI, and Oscillators—Buy oversold indicators and ignore the over bought indicators
3) Stochastics—Buy the crossovers to the upside; do not sell crossovers to the downside
4) On-Balance Volume and Tic Volume—Useless as forecasting indicators, but viable as confi rming indicators, since OBV curves would continual ly display new breakout highs
5) Elliott Wave — Buy breakouts of previous highs
Bear market toolkit application
1) Moving Averages — Sell the downside crossovers
2) RSI, and Oscillators—Sell the overbought indicators and ignore the oversold indicators
3) Stochastics — Sell the crossovers to the downside; do not buy crossovers to the upside
4) On-Balance Volume and Tic Volume — Too late for forecasting, and non- effective as confirming indicators
5) Elliott Wave — Sell the breakdowns of previous lows
Trading market changing to bull market toolkit application
1) Moving Averages — If traders are fading the false breakouts in the trading market, one trade will fi nally go against them for a greater than normal loss (short in a bull market). This will signal to them that the markets are about to change.
2) RSI, and Oscillators — If traders have been selling overbought and buying oversold, they will fi nd a trade which will show a loss even though they sold the overbought signal (short in bull market). This will signal to them that the markets are changing.
3) Stochastics — Traders must buy all crossovers from the oversold condi tions and not execute trades on overbought signals.
4) On-Balance Volume and Tic Volume — Accumulation can be observed and hence eventual upside price breakouts can be forecasted with high ac curacy.
5) Elliott Wave — The theory will show a possible breakout to the upside. Cautiously buy at the trading range for an impending move and ag gressively buy when the price breaks into new highs moving above the trading range high.
Trading market changing to bear market toolkit application
1) Moving Averages — If traders had been fading the false breakouts to the upside and false breakdowns to the downside in a trading market, they would fi nd their last trade to be a disproportionate loss (long in a bear market). There really isn’t much chance to recoup this loss because the breakdown is fast and severe. It is best not to fade the markets on the buy side using moving averages after the markets have had a severe run up going into a trading range market.
2) RSI, %R and Oscillators — If traders had been selling overbought and buying oversold indicators in a trading market, they would suffer a large loss on the last trade. Traders would also fi nd a growing number of oversold indicators and a diminishing number of overbought signals using standard parameters. This signals an impending change in the state of the market condition.
3) Stochastic — Crossovers from the overbought side to the downside are more valid than crossovers to the upside from the oversold level.
4) On-Balance Volume and Tic Volume — These two indicators are unreliable for forewarning traders of impending weakness. The best that traders can expect from these indicators is a fl attening of the OBV pattern, im plying a possible, but not certain, breakdown. The prices would drop dramatically and then the volume indicators would indicate a breakdown.
5) Elliott Wave — In Elliott Wave corrections, traders have a one-in-two chance that the correction could possibly turn into a bear market sell-of f(a zigzag instead of a flat correction). However, in the formation of this correction traders cannot tell until they approach the forecasted event that the correction could turn into a bear market correction instead of a fl at correction. If the market turns into a bear market correction they only have to sell into new lows and maintain a short position to profit from the move downwards. If , however, it turns into a fl at correction, they will fi nd themselves selling the bottom. Elliott Wave analysis does of fer inkling about what type of correction traders can expect, based on the existence of alternative patterns prior to the one currently under examination.
Bull market changing to trading market toolkit application
1) Moving Averages — Price fi nally crosses the moving averages to the downside after leading the averages from above. If traders didn’t buy the price breakout to the upside, traders mustn’t do it now but, instead, start to fade the upside breakouts carefully and fade the downside breakdowns.
2) RSI, and Oscillators — After a solid series of bad overbought signals in the bull market, traders fi nally fi nd more oversold indicators appear ing. As the trading market continues, oversold and overbought in dicators become equal in number. The fact that the numbers even out indicates the complexion of the market is changing from uptrend to trading.
3) Stochastics — In the bull trend, the crossovers from overbought were more of ten than not false signals and the crossovers from over sold, if they did happen, were valid buy signals. Now, as the market fl at tens out, traders will fi nd the crossovers from either side to be valid and can also initiate positions with profitability.
4) On-Balance Volume and Tic Volume — This technique fails when you try to use it to forecast imminent price breakdowns. These cumulative volume indicators would not begin to signal distribution until price deterioration was well underway. The best signal that could be emitted would be a flattening of the price trend signal.
5) Elliott Wave — According to strict Elliott Wave tenets, this application does not exist per se: A bull market turns to a bear market upon its completion. Elliott Wave would not consider the existence of trading to bear market designation, but bull to bear immediately. Yet, traders can observe that the two types of corrective markets alternate with each other: if a previous correction was one of two types (fl at or zigzag) then the second of the set will be the alternate type to the fi rst. In this way, traders can predict something about the nature of this market phase.
Bear market changing to trading market tool kit application
1) Moving Averages — When the market changes to a trading market from a bear market the moving averages will no longer lag as far behind the actual price or shorter moving average as was the case in the preceding bear market. Traders can now expect a fl attening out of the moving average curve to correspond with the fl attening of market prices. If they continued to sell the breakdowns and defer from buying as before, they would be continually whipsawed (instead, they should sell the breakouts and buy the breakdowns).
2) RSI, and Oscillators — In the bear down trend traders would have an overwhelming number of oversold signals and a dearth of over bought signals. They could have adjusted the overbought parameter to the downside to give themselves, in effect, “overbought” signals to in itiate short positions on. At the changing point, the number of oversold and overbought signals begins to equal each other in numbers. They could sell the overbought and buy the oversold with confi dence at this point.
3) Stochastics — During the bear market, crossovers from the oversold side were less valid as buy signals than crossovers from the overbought side were as sell signals. They will now appear equally valid as the trading market appears.
4) On-Balance Volume and Tic Volume — The OBV curve and Tic Volume flatten out after the bottom price is made, thereby giving traders an after-the-fact confirmation of the end of the down move, but not a reliable anticipatory signal.
5) Elliott Wave — The ‘bear move down’ would have been an impulse wave down and the trading market would have been a corrective wave to this. Once traders have determined which of the three impulse waves (1,3, or 5 of an impulse 1-2-3-4-5, or even in a larger dimension or of an a-bc correction) they were in the process of completing they would have a better idea of what type of correction was beginning
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