You could probably guess what happen next. It was a good idea probably for me to become a trader than a professional basketball player. But you know, sport is not all that different from the stock market. They both have a winner and loser. We also have different companies ...
You could probably guess what happen next. It was a good idea probably for me to become a trader than a professional basketball player. But you know, sport is not all that different from the stock market. They both have a winner and loser. We also have different companies like you have different teams and different players. Very often, I’m sure you’ve noticed, that a team will go through a high performance level and the media calls this a ‘hot streak’. What’s interesting is, that how do you know the difference between a hot streak or just a random fluke. Perhaps the idea is in the duration of the streak. Imagine two scenarios:
Scenario A – a mediocre football team seemingly out of nowhere wins 53 matches in a row over a span of many months.
Scenario B – an average player has one incredible game and scored 6 goals during a football match.
Now, both are laudable achievements, but if you had to pick one, wouldn’t you say the team that won 53 matches in a row accomplished a more impressive feat? You see the reason is simple; in fact you can sum it up in one word – consistency. The first occurred over a long sustained period of time and the second was just a onetime event. Now, refer to this idea back in lesson 1, but I’ll say it again, Technical Analysis is about price, about indicators, patterns and trends. In this lesson we’re going to introduce you to the concepts of Trends.
Alright, so let’s see couple of charts to see how trends can be applied to the stock market.
This is a chart of Sun Pharmaceuticals,
India’s largest pharmaceutical company by market capitalization and India’s 8th largest company overall. The chart shows its price from 2011 all the way to 2015, the stock appreciated by 370% and that is the chart of ITC,
India’s 4th largest company overall. It is a one month long chart, during which time it is fallen about 20%.
Now both Sun Pharma and ITC are huge companies. Sun Pharma is on, what we call, an upward trend for the past five years. ITC on the other hand has been on a downward trend for the past month. Notice that in both instances, there is a clear trend on the price charts. In the example of Sun Pharma, there seems to be no reason not to buy the stock. Why is that? Because it’s been consistently going up in price for the past five years. You can’t get a prettier looking job than that. But what about ITC? The price chart seems to indicate that it’s on a downward trend. Since it’s on a downtrend, wouldn’t it make sense to sell? After all, that’s what we talked about in Lesson 1: Identify a pattern/trend and then follow it.
Now this is where most technical analysts will mess up. Remember the Big Three from Lesson 1 – the third tenet was that ‘the fundamentals of a company always matter’. And since it’s important, I will say it again that Fundamentals and Technicals complement each other and the best way to show you this is through a chart of ITC for 5 years.
Now isn’t that remarkable? And you’re now left with more questions than answers; making that decision to sell is not quite so simple now, is it? Many traders would actually look to buy ITC in that situation.
Now, I understand that it seems intuitive – it seems right to be able to short a stock when you see a downtrend. However, remember that the in long term charts, a higher time frame will always matter and reflect what the fundamentals of the companies are. Let me explain, if you look at a higher time frame like the monthly or weekly charts and a long span, you will get a consensus of what the biggest investors believe in. In this example of ITC, you will notice that investors actually trust the company’s fundamentals; therefore it’s in the long term uptrend. Fundamentals of the company always matter.
Sun Pharma and ITC are both in long term uptrend in the five year charts.
The 3 kinds of trends are:
2. Downtrends, and
3. Sideways Trends
Now, I’m sure you’re wondering, why does a trend actually form? How do we get a long term uptrend or a long term downtrend? Why does that actually happen? You see, there is a connection between the macroeconomics of a country, such as India and its stock market. We all know, India’s GDP is growing. Let’s look at this graph of India’s GDP.
You will notice that the GDP plummeted in 2008 – the same year, the Sensex fell 50%. Interesting! Now let’s take a step back and think about what happens when India’s economy is not doing well. When India’s GDP is not doing well, it’s a result of poor performance of the companies that make up the stock market. Take 2008, for instance, the GDP stalled therefore the Sensex fell by 50%. The biggest participants in the stock market are not investors like you or I; the retails investors don’t cut it. Institutions are the biggest players in the stock market and they’re more fondly known as the FIIs and the DIIs.
FII stands for Foreign Institutional Investors – think Goldman Sachs, JP Morgan. They’re located abroad but they pinpoint our country and companies which are growing well. The DIIs on the other hand are called the Domestic Institutional Investors. Think about LIC India or any Mutual Fund located in the country. Now FIIs and DIIs, these institutions, they manage billions of dollars and they need to make an informed decision. They follow the money. Now what does it mean? When the GDP shrinks due to poor performance, the Net Profit of these companies, let’s say the Nifty, shrinks as well.
Now think about it, what do you think is going to happen when an institution sees companies’ profits shrinking – they will not be interested to buy. As a result the company’s stock may fall. Just the opposite is true when the GDP rises, the Net Profit of the companies rises as well. The FIIs and DIIs now are interested to invest in these healthy growing companies.
Now, knowing that little tidbit of information, let’s add a column to the same graph that shows the net amount of money of FIIs invested during those years.
Notice a correlation that when India’s economy dwindled in 2008, FIIs took money out of the country. This supply, this selling causes the markets to fall. This is where trends come into the picture. If you made a monthly chart of FII activity from 2007 all the way to 2009 this is what you would see.
Notice that in early 2008, Institutions already started taking money out. Savvy investors would have recognized that and when the correct moment struck, they would have sold. Technical analysts would have been able to leverage the power of trends and short the Nifty. This is the price chart of Nifty.
In the method that you will soon learn in this course, this is the point where you would have shorted. This is where the downtrend actually begins; the price continues to fall. Now almost near January 2009, FIIs would have a net positive equity investment and at this point the uptrend begun, the money is reflected on price charts.
THAT is the power of technical analysis. So when someone says you can only make money when the markets go up, here the person is probably at a disadvantage. Technical analysis can help us stay with the trend even when the markets are trending down.
What did the weighted coin teach us? It taught us – no matter how many times you flip the weighted coin, you will get heads more than tales, much like a trend. If you are buying or going long in an uptrend, the odds are in your favor and if you’re shorting or selling when the markets are going down in a downtrend, the odds are in your favor again. What do you think is going to happen when a good company keeps posting profit after profit every single month, quarter, and year? Investors and traders, even institutions will buy the stock and you will get a long term uptrend and that uptrend is likely to continue in that direction.
Now, we are going to teach you a method with an entry and exit so you can begin investing right away but before you do that you need to know about charting and that’s exactly what the next lesson is going to talk about – bar charts and candlestick charts.