I have combined posts together to give you the framework I use to analyze the market. As I had said earlier, everything was already mentioned in the threads and it was just a matter of how to organize it. Once you go through what is given below, you will be able to trade on your own with practice. Broadly, whenever I look at the market, I look at 6 things.
1) Basic Analysis of Broader Market
2) Basic Analysis of Global Market
3) Psychological Makeup for Current Scenario
4) Selecting Correct stocks to Trade
5) Setting appropriate Stop losses based on underlying volatility
6) Final Price analysis before deciding when to initiate the trade
Following is explained below. Hopefully, this will give you a very good idea of how to analyze the markets.
Tc
1. How I analyze main Index/Stock periodically. Below is a case study when I called the top on the markets in January 2010
I feel markets are headed down in the shorter term. And here's why.
1. Ascending Triangle 1 - Markets had formed an ascending triangle from June to September and eventually broke out from it to rally to new intermediate highs. During this formation, the momentum and strength of the market was extremely strong (refer to Momentum indicator and the RSI). However, when the market broke out of the triangle, the momentum and strength of the market weakened as compared to the July-August levels. Market made a new high and there was evidence of divergence visible.
2. Ascending Triangle 2 - Markets have agained formed an ascending triangle between November and December and have broken out from it yesterday. However, there are quite number of things to be noted here. Firstly, the momentum and strength of the market is now weakest when compared to July - August and ascending triangle 1. The divergence has now extended from Mid August to present. Secondly, historically it is quite known that triangles have a 50-50 chance of succeeding and failing. It is also very rare that two triangles have been formed back to back with no failures in between. The odds of two successive triangles giving valid signals is very rare. Lastly, look at the breakout carefully. Triangle one broke out with NIFTY notching up 2.2% gain on that day. Whereas triangle 2 breakout has been accompanied with double DOJI and a probable EVENING STAR (Major reversal pattern, have marked it with a circle).
3. Price Projections - If you take the bottom B and project the price upwards, then the current level falls exactly between the 50 -61.8% retracement. Today the markets rejected this level and fell down to 5282. The probability of price projections have to be weighed in with the uncertainties ahead (interest rates, budget, global market correction, quarterly results).
4. Cyclic Analysis - If you take the two major top's Z and B, then the current time frame lies exactly in between 50 -61.8% retracement cycle. Which means even time wise we are due for a correction. Again all the uncertainties mentioned above should be factored in.
5. Trendline - If you visualize a trend line from point A to C, then the chances of trendline being broken looks good if the markets start to correct. I have purposely not drawn the trend line as I did not want to clutter the charts with too much information.
It is indeed very rare when Price patterns, Price projections, Cyclic analysis and the surrounding uncertainties fail together. If they indeed do, then that's the beauty of STOCK MARKET guys.
Tc.
2. How I analyze Global Markets in Conjunction with Nifty. Below is a case study when I called the top in market in April - May 2010
Another important day for the market came to a fitting end. As I had mentioned yesterday, the market tried and built a base to signal that it is not going to fall further. Though many would suggest that today was a hammer sort of a formation, I would still not read too much into it. The reason is simple, A hammer is only valid when it occurs near a strong base or a previous support level. There was no such significant level which I could find around today's low. Also, most of the significant action today happened below yesterday's low. So technically, we were still trading weak today especially after witnessing an outside bar engulfing yesterday. This week's action led to Nifty breaking its important trendline which extended right from March 2009 (See the figure below).
When we try and combine the global picture with what is happening in India, we find that there is a lot of uncertainty that is lurking around. Hanseng Index has recently turned around from the complex head and shoulder neckline it had formed (See the figure). China Index has been forming a symmetrical triangle since september 2009. China is going to have an Important meeting regarding it's currency valuation and interest rates scenario. Isn't it ironical that symmetrical triangle being formed is precisely reflecting this (the uncertainty)? I could not find anything bearish in the US index accept from the fact that S&P is hovering around a major trendline support and if it violates that things could look different for the short term.
(Update: S&P has formed a classic Evening start pattern on friday. From here on the high of 1214 remains a formidable resistance. World over we are witnessing reversal signals. Such insync signals always lead to deeper corrections)
What we can conclude at this juncture is that globally there are uncertainties present but still we must still see how things will shape up. One thing is for sure, that in which ever direction the breakout occurs (or the price moves), the move could be significant and one should be alert and ruthless enough to switch position. Volatility cycle at least suggests so. Let's have a nice weekend and let the market play its course.
HangSeng
China
India
3. This is my psychological make up when I trade. I keep getting in and keep getting out till I am right
Has it ever happened to you that as a trader you chase a stock and it continues to give you whipsaws. You finally make up your mind to give up on that stock and ironically find it rallying on the very next move. I guess, this has happened to each one of us in our trading career. Therefore, as traders what can we do to counter this? Before we touch upon this topic in detail, I'll assume that everyone reading this has a distinct advantage over the markets in form of systems or methodology. By distinctive advantage, I mean a system which does not depend on specific market conditions to work. So, let's begin !
Well, if you think about this issue in detail, this is more of a psychological issue than a system issue. As soon as we get a couple of loss making trades, we begin to look at our P&L statement. Furthermore, we begin to extrapolate the P&L "if" we were to loose a few more trades. Believe me, if you want to be successful, then
don't do this ! We all go through phases where the stocks just don't move and eventually when they do move, we are ultimately out of it. Most of you who follow this thread, must have noted on many occasions that I keep reversing my trades till I find that stock in my favor. Currently, I am doing the same with India Bulls Real estate. I will keep reversing my positions till that stock fits my scaling in and profit booking criteria. It's psychologically tough, but who told that markets rewards one for taking easy decisions?
When we are wrong, we want to make sure our losses are small and when we are right, we need to make sure our profits are relatively large.
There are few things in trading which are not documented well enough. Out of those, the topic of getting out and getting in is one. Folks, as far as our system has a positive expectancy, we should not be bothered with the whipsaws and the draw downs. To be successful in this, never ever forget the 2% risk management rule. If you don't let one trade take more than 2% of your portfolio, believe me you'll be soon taking your account in the whole new direction. That is, towards profits.
If you intend to become a good trader, you have to incorporate this in your trading plan. Be relentless, don't think about potential losses, let them show up and then apply the risk management rules.
Don't trade what you think, trade what you see.
Tc
4. How I select the right kind of Stock to Swing Trade
Essentially, Swing trading is a way of trading where we try to capture some percentage movement of a stock in either direction in order to profit. However, it is essential we try and pick the right kind of stocks in order to capture some percentage move. If we don't identify the correct stocks, we are essentially increasing the cost of trading by paying commissions for stocks which are not destined to move. As trader's we certainly don't want to be in this scenario. In this post, I'll just highlight some methods to swing trade the right kind of stocks. So, lets begin !
Every stock has a different inherent character. This is precisely we need to research in depth to find out which stocks have the typical characteristics which suit Swing trading. Before moving forward, lets us predetermine what we require in swing trading. For a Swing trade to be successful, we would require such stocks which tend to move more frequently in either direction. Basically those stock which exhibit significant volatility. Taking this concept in mind, we can then build a system around this and swing trade profitably.
There are essentially two ways in which one can determine which stocks to trade profitably. The first way is the
Beta methodology and I will discuss this method in this post. In future, I'll write about the second technique.
Beta methodology is essentially filtering out those set of stocks which move more than the underlying index in terms of volatility. For example, a stock with Beta rating 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market.Hence, if a stock's beta is 1.5, it's 50% more volatile than the market. As swing trader's we want to be in stocks which exhibit Beta ratings of over 1.5. For our market, such stocks would typically be a DLF, Unitech, Rel Capital, Hindalco, JSW, IBrealest etc. However, please bear in mind that trading high beta stocks is a double edged sword. If stock begins to go against you, then the loss could be more than what you would undertake in a low beta stock. Hence make sure to keep tight stop losses.
How to incorporate this in your trading
I hope by now, you understand why it is almost quintessential to select the right kind of stock. Going forward, you would need to adopt this in your trading plan. The best way to do is to weekly review which stocks in the index are exhibiting the highest beta rating. Be sure to calculate the Beta figures on at least 100 days of trading record. I would however encourage you to calculate beta over a period of 6 - 12 months of data. Remember, if the stock does not move, your account will certainly not move.
Tc
5. This is how I set my stop losses
Historical Volatility
Historical Volatility is a measure of price fluctuation over time. It uses historical price data to empirically measure the volatility of a market or instrument in the past. In other words, it is also known as statistical volatility, which is also the standard deviation of day to day price change expressed as annual percentage. In terms of practical implementation in trading, Historical volatility is essentially used to know how a stock has fluctuated in the past and how much likely it is to fluctuate in the future.
Calculation
HV = StandardDeviation(Ln(close/yesterday'sclose), days) *100*Sqrt(number of trading days in year)
where, Days = Length of days (10,20,30,40 .... )
Ln = Natural Logarithm
For e.g A 50 Day HV with 252 trading days in an year would be calculated like this,
HV(50) = Stdev(Ln(Close/Yesterday's close), 50)*100*Sqrt(252)
Use in Setting Stop Losses
Suppose the 50 day HV of stock which trades at 100 is 20%. Now, if we assume that prices are normally distributed, we can with 66% certainty say that prices for this stock will fluctuate between 80 - 120 one year from now. Hence any stop set on this stock should be kept with this fact in mind. If you don't use this concept, then you are going to get stopped out more often than you should.
One more thing that has to be analysed is that every stock of same price range has different volatility and hence stop loss technique cannot be same for both. Hence, depending on the stocks volatility, stop price is set.
For Investment trades, try and use HV calculated across 40 -60 days and use it on the daily frame only.
Caution
Some times you will find that the volatility band is just too wide and hence stop losses will be set 10 -15% away from the current price. In this case, you can do two things.
1) Either use ATR in this case as I had explained earlier.
2) Find stocks which offer better risk to reward in terms of stop losses set on HV parameters.
Don't expect to get hang of this concept immediately. It took me almost 6 months to refine and use this properly and hence be patient with it. One easy way would be for me to share my entire research here. But, that will limit your growth as a trader. Believe me, I have given a lot of lead here. You just have to put in a little more effort.
At first this concept seems very intimidating, but as you research more, you will know how to use this better. Once you can do this, your Investments and Options understanding will reach the next level. Hence, research more and don't expect any easy answers from the market.
6. Final Price Analysis
I have attached two images below. The first one is a chart legend. Understand this before reading the chart. Since I have explained the entire 2010 year for Sterlite, the chart might seem confusing. Hence, its absolutely essential to understand the chart legend first (which is self explanatory).
Now, since the legend is clear, we will come back to Sterlite chart. In my opinion, this stock should never have been bought in the first case. For a stock to remain in an upmove, stock should exhibit significant strength. By strength we mean, a stock should not retrace more than 38.2%. Here are some guidelines.
Extremely Bullish - Retraces less than or equal to 38.2% of previous move.
Weakly Bullish - Retraces more than 38.2% but less than 50%
Neutral - Retraces more than 50% but less than 61.8% but remains sideways
Weakly Bearish - Retraces more than 61.8% but less than 100%
Extremely Bearish - Retraces more than 100% move.
Lets review the sterlite chart now. I have marked points 1-5 depicting the entire upmoves. Not even once has this stock stabilized at some level. The above framework that I have given classifies Sterlite as an Extremely bearish stock since starting of 2010. Hence the
line of least resistance has always been on the downside. Any trade taken on the upside is just
fighting the trend.
I hope this helps SM bro. I don't emphasize too much on patterns or indicators, hence I have not discussed any indicators here. Price is sufficient if looked at from all angles.
http://img824.imageshack.us/img824/774/chartlegend.png
http://img80.imageshack.us/img80/1859/sterlite.png
Tc
