Is God in the technicals?

It is an exciting time on the bourses. Based on Thursday’s close of 19,289.83, the Sensex was up 44.89% on last year’s close of 13,786.91. And many market observers remain bullish despite the recent sharp spurt, although they also predict more volatility in the coming days. It is not easy to figure out what to buy and sell in such a market—for instance, you may have sold out completely, when the pundits were predicting a sharp downslide in August. Or, maybe you sold out when the Sensex was at 18,000, thinking it couldn’t go up any further so quickly. But what indicators were you going by?

Now that the Sensex has hit 20,000 (and then retreated), you must be regretting any hasty decision. After all, at the time, analysts who believed stocks were overvalued, and trading much above their actual value, affirmed the lack of conviction among investors. But if you had gone by the predictions of technical analysts, you would have probably stayed put in the market until now. Unlike fundamental analysts, who meet company management, scrutinize balance sheets and profit and loss accounts, and predict stock prices based on the future prospects of a company, technical analysts use mathematical tools to study the past price behaviour of a stock or an index and predict future performance.

On 29 October, when the Sensex reached the 20,000 milestone, Mint’s columnist Vipul Verma, an independent investment advisor, mentioned the inevitability of the market continuing to rise in his column Ahead of the Ticker. “Purely technically, the rally is not likely to stop at 20,000 points and may gain further,” he wrote. Milind Karandikar, an independent technical analyst, was the first to predict in an article in a newspaper column on 8 January that the Bombay Stock Exchange’s benchmark index would reach 20,000 in 2007. Karandikar used the Elliot Wave Theory, a complex calculation, framed by accountant Ralph Nelson Elliot, which is based on the premise that market prices unfold in patterns that are specific. “Those who cannot overcome the general feeling of nervousness would miss a lifetime investment opportunity that the year 2007 presents,” Karandikar wrote.

The study of price trends is relevant because the recent rally has been driven largely by funds from foreign institutional investors. “Based on the fundamental reasons, one should have sold in this kind of a market,” says Mahesh Bhagwat, head of equities at MAPE ADMISI Securities Pvt. Ltd, a Mumbai-based broking firm. “Therefore, in times like this, it’s the study of price trends which gives an indication of the future trend in the stock.” Often, a study of price trends can also be a precursor to a fundamental change in the company.

To give an example, Reliance Natural Resources Ltd (RNRL) was at Rs25-30 until February. The stock started moving up, despite lack of clarity over gas pricing with Reliance Industries Ltd (RIL). If you tracked the stock based on the moving average using a 30-day period, it has been giving a buy signal since June. In September, the stock saw huge breakout from an accumulation pattern (which was easily identifiable) along with large volumes. It’s now trading at Rs150.95.

A primer on technical indicators

There are complex tools for most technical analysis. Some can be figured out just by using a simple spreadsheet but, for the complicated ones, you would need to consult your broker or use the software designed for specific metrics.

Moving Averages

Tells you whether the stock is following an upward, downward or sideways trend and helps you confirm whether you are in line with it. It’s calculated by averaging out the stock price for a number of trading days for which moving average is required. For a 10-day moving average, the stock price over the 10 trading days is added and divided by 10.

If the moving average is above the current price, it signals a downward trend and the other way round. In addition, if the shorter duration average is higher than longer duration average, it signals an upward trend. If the longer duration average is above the shorter duration one, it signals a downward trend.

Moving Average Convergence/Divergence (MACD)

If the value of the 26-day moving average is deducted from the 12-day moving average, it yields the MACD and helps to gauge the momentum of the stock. MACD is plotted against the 9-day moving average. So if the MACD moves above the 9-day average, it’s a buy signal and if it falls below the latter, it’s a sell sign. Also if the price of the stock diverges significantly from MACD, then the current trend is going to end soon.

Relative Strength Index (RSI)

Helps you compare the rate of change in the stock price when it falls and rises. RSI is calculated by taking the ratio of the total gains made by the stock to the total losses during a specific period. The number calculated is then converted into an index with the help of mathematical formulae. The index value can range between 0 and 100. If it approaches 70 or is more than 70, it’s a sign that the stock is overbought and is bound to come down. If the index value is below 30, or approaches 30, it’s an indication that the stock is oversold and is bound to see an upward correction.

Tip # 1: Revisit your stop loss frequently

Analysts suggest that in this kind of rising market, investors should keep increasing their stop loss targets as the price targets are met quickly. “If you are sure that the rising trend of the stock price will continue, then keep increasing the stop loss until you see any reversal in the upward trend,” says Gurudatta Dhanokar, technical analyst and derivative strategist at Almondz Global Securities.

Tip # 2: Use indicators that suit your style

If you are among those who want to enter the market in the morning and exit by evening, then a 30-day or 200-day moving average will be of no use to you. The thumb rule is that if you are investing for 100 days, you use an indicator which covers price trend over 25 and 50 days.

“When we see our next door neighbour making more bucks, we tend to become a short-term investor or even a day trader,” says C.K. Narayan, head of derivatives at ICICI Securities Ltd. “So the indicators, which you used in the beginning, may not give you the right direction once you start trading shorter-term cycles.”

Tip # 3: All technical tools are not for all seasons

Some indicators give best results when used in a rising market, and some in a range-bound market. Complex tools such as Elliot Wave theory, which assumes that stock price charts follow a wave-pattern, are best used for determining the long-term trends.

Tip # 4: A little knowledge can be a dangerous thing

“Often people tend to analyze indicators in different pieces rather than in aggregate form. For instance, the ratio of advancing stocks to declining stock has no meaning in itself if it’s not seen along with the aggregate volumes of advancing and declining stocks” says Vipul Verma, a ‘Mint’ columnist and an independent investment adviser.

Narayan adds that some technical indicators are simple to understand but if one doesn’t know how to apply the results, then one may end up entering or exiting the stock prematurely.

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