Chapter 5

Portfolio Management: Stock Market Investing

Introduction
Discussions with people of various age groups, with different educational backgrounds, engaged
in different types of activities, belonging to different income groups often reveals a general
perception that stock market investing is risky, akin to gambling, always loss-making, highly
speculative and can have severe adverse financial implications. This chapter intends to update the
participants about the nature of the stock market, introduce them to the established tools and
techniques of stock market investing, hand hold them for informed decision making, at the same
time highlighting the riskiness of random decision making on the basis of hearsay. It is an
awareness exercise aimed at dispelling certain myths associated with this market, at the same time
providing readers with the tools for trading in this market. Many of us may not be aware that even
if we directly stay away from the stock market, our savings are deployed in this market by
insurance companies and mutual funds. Yes, it is true, that these financial institutions are manned
by experts in this area. However, it is our savings that they are using and it is our responsibility to
understand the basics of this market.

Stock markets are dynamic in nature. This dynamism stems from changing fundamentals of
companies, changes in the macro-economy – both domestic and international, and changes in
market sentiment, something that cannot be explained and which at times has no rational basis.
The stock market, like any other market, has buyers and sellers and there are goods (shares of
companies) that are exchanged for a price. However, the goods are not demanded for their own
sake, but are a means to increase wealth to enhance future consumption. It has attracted hordes
of individuals, across all sections of society, with various degrees of knowledge and education,
whose only objective is to make money, quickly and lots of it. There is an inherent greed factor
in this market, and overall it makes it very difficult to predict market movements. In spite of
this, academicians and market analysts have tried to make sense of this market, and they have
provided some analytical structures of analysis. It is only that very few market players have
paid serious attention to this literature, or are unable to understand it, that has created a certain
perception of this market as unpredictable and volatile.

There are various magazines, journals, websites and television channels that make an honest
attempt in providing an understanding of the market, even on a daily basis. They, however
provide short term, at times instantaneous, views on market movements, lacking analytical
clarity. Brokers of repute provide valuable insight into market movements and also warn
investors of market pitfalls and the dangers. But they also probably have failed to provide
education that is so badly needed. It is possible that the frenzy of money making in the stock
market does not require education. People like to look at it as a gamble, the outcome of which
is known with a certain probability, and which cannot be reduced with education.

The Indian stock market has attracted the attention of domestic players and international
players and is considered to be one of the active markets in the world. The growth rate of the
economy is one of the highest in the world and its future potential has made it an attractive
destination for foreign investors. However, it is also true that the varied domestic clientele in
this market neither has the inclination nor the ability to understand the various facets of this
market, they being guided singularly by the motive of making money, fast. The purpose of this
chapter is to weave together movements in the Indian stock market with the existing techniques
available in the literature. It will show that there is logic to price movements in this market, and
one should be aware of these elements. This, I hope, will act as a guide to those who believe in
informed investing.

There are four sets of players in the stock market: investors who have a medium to long-run
perspective, day traders, arbitrageurs and speculators. However hard we try, we will not be able
to wish any of them away. For a household who is contemplating entry into this market, it is
important to understand in which segment he or she belongs and the risk-return trade-off.

What is a stock?

A share or stock of a company represents the ownership right of a company. Any company has
to start its operations having a certain owners’ capital when it is registered with the authorities.
This indicates who owns the company. The ownership pattern of a company is reflected in its
shareholding pattern. Thus, any individual who buys a share of a company is the partial owner
of the company till the shares are with the individual. Once they sell it, they cease to be
owners. Stocks or shares are bought and sold in the market and ownership pattern keeps
changing. It is a product, which has a market, and it is forces of demand and supply that
determine its price. Although shares represent ownership, a large part of trading in shares
happen, every day, for returns from price appreciation. Owning a stock entitles a person to the
dividends that are declared on the stock. However, to receive the dividend, the individual has to
hold the shares on that date.

Why do stock prices move?

As mentioned above, stock prices are determined by the forces of demand and supply. If prices
are rising, it must be that there are more buyers than sellers - there is demand pressure. If prices
are falling, there must be more sellers than buyers - there is selling pressure.

What is a tick? What is open, close, high and low?

In any chart on stock prices, a tick looks this.

The highest point of the line is the day’s highest price, the lowest point is the day’s lowest
price, the left horizontal line is the opening price for the day, and the right horizontal line is the
day’s close price. For example, on 22.3.2011, for NIFTY, the High was 5428, the Low was
5376, the Open was 5391, and the Close was 5414. The TICK thus has 4 dimensions, and these
keep changing every day. Some of the shapes that it can take are
 A B C D E F

In A, the high, open and the close are the same. In B, the low, open and close are the same. In
C, the open is near the low and the high is near the high. In D, the open is equal to the low and
the close is equal to the high. In E, the open is equal to the high and the close is equal to the
low. In F, the open and close are the same.

One can think of an infinite number of combinations and each has a different meaning and
implication with respect to daily price behavior. One can draw their own lessons from the
shape of the tick at the end of the day, and also regarding daily movement in ticks. For
example, D is bullish as it says that the market closed at a high. E is bearish as the market
closed at a low from where it opened. There was loss of interest in the market during the day.
A shows stagnant interest as the market only went down during the day and recovered ground.
F shows consolidation and rethinking as the market closed at the open and tasted high and low.
It also can reflect uncertainty.

The length of the tick shows intraday volatility. If the tick is long as in K, the market was
volatile. If the tick is short like L, the market was not volatile. It was relatively stagnant. This
means that there was not much buying and selling interest during the day.

K L

On two successive days if we have the ticks like M, then this means that the market has turned
bullish. This is because the lengths of the ticks have remained the same, today’s open is higher
than yesterday’s open, today’s close is higher than yesterday’s close, today’s low is higher than
yesterday’s low and today’s high is higher than yesterday’s high.

Two successive ticks like N shows declining interest in the market.

For a concrete live example let us look at the chart of Pantaloons Retail Ltd. in Figure 1.

Figure 1

Source: Metastock
From 11.3.2011 to 16.3.2011, the closes were lower than the open indicating that prices would
fall further. On the 18th, volatility increased as the range was higher and the high was higher
than the previous day’s high. Some interest can be observed. On the 22 nd the trend got reversed
and the close became higher than the low. This signaled a reversal, and on the 23 rd. the stock
saw prices going up. So, a close observation of ticks can provide some insight into future price
movement, for 1 or 2 days.

In Figure 2, for Nifty, from the close being higher than the open on 16.3.2011, on the 17 th the
close became lower than the open. This indicated a reversal and this is what happened. The
Nifty fell on the 18th and also on the 21st. On the 22nd, the close became higher than the open
indicating again a reversal. The Nifty rose on the 23rd.

Figure 2

Source: Metastock

How to calculate returns from a stock?

If Pt is the price of a stock in period t and Pt-1 is the price in the previous period, then returns
from a stock during the period is defined as

Rt = (Pt – Pt-1)/Pt-1
If the stock pays dividend Dt during the period, then returns is defined as

Rt = (Pt – Pt-1 + Dt)/Pt-1

How to calculate the risk of a stock?

Risk of holding a stock is the standard deviation of returns from the stock during the period.
Variance is a yearly concept, and hence the risk of the holding period has to be adjusted to
make it per annum.

Consider prices of a stock for a period of 100 days. Then we can calculate daily returns and we
will have 99 observations of returns. If we draw the frequency distribution of the returns, then
the standard deviation of the returns is the risk from holding the stock for the period. If we
impose the condition of normality on the distribution of returns, then students familiar with
statistics would know the probability of returns falling in between (returns +/- 2s). That is,
based on past data, it is possible to have some idea about the extent to which returns can fall.

What is portfolio risk?

A portfolio of stocks is a collection of stocks held by an individual. For simplicity, let there be
two stocks in the portfolio and let their share be w1 and w2. Then, portfolio risk is defined as

sp = Square Root of (w12s12 + w22s22 + 2w1w2ρs1s2)

where sp is portfolio risk, s1 and s2 are the standard deviations of returns from the two stocks,
and ρ is the correlation of returns from the two stocks. Clearly, if the returns from the two
stocks are positively correlated, then the portfolio risk will be more than the sum of holding the
two stocks and hence it is not rational to hold these two stocks in the portfolio. On the other
hand, if the returns from the stocks are negatively correlated, then portfolio risk would be
lower than the sum of the individual risks. The purpose of portfolio diversification is to hold
assets whose returns are not positively correlated. This is another way of saying not to put all
eggs in one basket.
Difference between large-cap, mid-cap and small-cap firms

The difference between large cap, mid cap and small cap firms is in terms of market
capitalization. The market capitalization of a share is defined by the total paid up shares of a
company multiplied by the current price. As prices keep changing, market capitalization keeps
changing. Large-cap companies tend to be large in terms of their operations and some
examples will be ABB Limited, ICICI Bank Ltd., and Maruti Suzuki Ltd. Examples of mid-cap
companies would include MRF, Havells India, Berger Paints and Castrol. Some names of
small-cap companies are Graphite India, KEC International, La Opala and Century Plyboard.
The Sensex is a 30 company index of market capitalization; turnover etc. and these are 30 large
companies which are traded on the Bombay Stock Exchange (BSE). Along with NIFTY, the
index of the National Stock Exchange (NSE), the Sensex is an index of stock market sentiment.
There are also various indices available like the Mid Cap Index, FMCG index etc.

Figure 3 gives the movement of the three indices over time. The Sensex, which consists of 30
large companies, is shown in blue, the BSE Mid Cap index is shown in pink, and the BSE
Small Cap Index is shown in red. In common parlance, some large companies are termed as
blue-chip companies. Small-cap companies tend to be speculative stocks. The figure shows that
there have been periods when the indices have converged, which is something investors need
to be wary of.
Figure 3

Source: Drawn from Metastock

The relation between domestic and international indices

One of the effects of globalization has been the financial integration of economies around the
world. With advances in computing and communication technology, billions of dollars move
across the globe at lightning speed every day. Besides direct investment, funds move into stock
and debt markets, whenever there is an opportunity for gain. Portfolio formation has moved
beyond financial assets, but into countries. Large fund houses diversify across countries, and
then across financial assets. Thus, holding China or India in the portfolio is equally talked
about, as having TCS and Hero Motoco shares in the portfolio. Fund houses not only look at
company or asset class exposure, but also at country exposure. This has led to financial co-
integration of stock markets and also led to volatility transmission. Figure 3 gives the
movement of various stock market indices across the world, along with India.

Observe that prior to the 2008 sub-prime crisis, all the indices worldwide converged. After the
crisis, all the indices fell simultaneously indicating the integration and spillovers. Lately, there
has also been some convergence, with the exception of Shanghai Composite (green). Note the
fast convergence of Borsa Istanbul (brown) with the rest. Indian Sensex (blue) has been up
there together with the rest. These co-movements also provide some insight into the perception
of fund houses of these economies and the expected returns and risk.
Figure 4

Source: Drawn from Metastock

Movement of gold prices, crude oil prices, and foreign exchange
There is considerable interest both in the press and in political debates in India, about the sharp
increase in the rupee price of the US dollar (R/$), the increase in the price of gold and also the
increasing deficit in the Current Account Deficit (CAD). As India’s import of crude oil is the
largest component of its total import bill, an increase in its price causes the gap in the CAD to
widen and raise the demand for dollars. If there is no commensurate increase in the supply of
dollars, this causes R/$ to rise. While the source of demand for dollars is imports of goods and
services, the source of supply of dollars is both export of goods and services in the current
account and also inflow of dollars through the capital account by way of FII net inflows and
also Indian companies borrowing from abroad.

Gold, on the other hand, is a financial asset. In India there is considerable demand for it in the
form of jewelry – but the underlying principle is financial security for the girl child. The other
major players in the gold market are the central banks of various countries. Whenever there is
some economic or political uncertainty in the world market, there is a tendency of gold prices
to rise as it is considered to be the safest asset.

The movement in prices of gold (black), price of crude oil (blue), the exchange rate (green),
and NIFTY (red) in India is shown in Figure 5. In spite of an increase in the price of crude oil,
of late, the exchange rate has not appreciated. This indicates that there is now renewed faith in
the Indian economy and $ inflow has not decreased. Further, pricing of gasoline, kerosene etc.
has been deregulated and much of the increase in crude can be now passed to the consumer. In
petrol and diesel, we have now dynamic pricing in India. For the confidence factor, the price of
gold has not increased.
Figure 5

Source: Drawn from Metastock

P/E Ratio

The P/E ratio of a company is defined as the price of a share of a company divided by the
earnings per share (EPS). It is commonly referred to as a multiple. EPS is a yearly figure and
represents what a single share earns during a year. The inverse of the multiple i.e. EPS/P
represents returns from a single share. Thus, if the P/E ratio is 15, then buying the share will
give a return around 6.5%.

P/E can rise if P rises or EPS falls – or when P is rising faster than rising EPS. P/E can fall if P
falls or EPS rises – or when P is falling faster than falling EPS. The various combinations can
be shown by way of a two-way table.

EPS rises EPS falls

P rises P/E can rise or fall P/E rises
P falls P/E falls P/E can rise or fall
The following provides an explanation as to which are the situations that are plausible and
under what market situation. It is followed up with examples of movement in PE ratio of
certain specific companies.

 When the market is extremely bullish implying people are not behaving in a rational
fashion or in near bubble situation – we can have P rising along with EPS falling.
Normally P should not rise with EPS falling.
 When the market is quite bearish, we can have P falling with EPS rising. That is there is
nothing wrong with the fundamentals of the company – only overall market sentiment
is depressed.
 P rising at a faster rate than EPS – i.e. P/E rising – is plausible. People are bullish about
this stock and the market will discount the future growth potential of the company.
 P falling at a faster rate than EPS is also plausible. i.e. PE falling.
 P is rising at a slower rate than EPS – i.e. P/E falling is also plausible for companies
whose prices have reached a level whereby there is no opportunity for price discovery.
There is no further cream left.
 P falling slower than falling EPS i.e. PE rising – this we feel is not plausible for a
considerable period of time. It can happen due to short-term market adjustments.

P/BVPS

Price of a share P is the market price of a share, and it is continuously changing with the
change in demand and supply of the stock. In conventional microeconomics, with an increase
in the price of a product, supply tends to increase. However, the total shares of any company
that can be traded are fixed. It is only that with an increase in prices, some existing holders of
the shares may like to sell them and the shares just change hands. Nothing new is created with
a rise in prices.

Book Value per Share, BVPS, is defined as the total owner’s funds in a company divided by
the total paid up shares of the company. Total owners funds, or net worth of a company, is a
stock concept and it is the sum of equity capital and reserves and surplus. It is calculated at the
end of a year and reserves and surplus is the sum of retained profits over the years. So BVPS is
the inherent worth of a single share and P/BVPS indicates whether the market is appropriately
pricing a share vis-a-vis its intrinsic value. If this ratio is less than one, we say that it is
undervalued. If it is greater than one, we say that it is overvalued. A value of P/BVPS around 4
is considered tolerable. In order to look at the shares of a company for acquisition purposes, it
is advisable to look at its P/BVPS.

Interest coverage ratio

Interest coverage ratio is an important indicator for judging whether a company’s operations
are sustainable and whether the profitability can be maintained. Any company generally funds
its operations through a mix of equity and borrowings. Interest coverage ratio is defined as

Gross Profit (PBDIT) / Interest expenses

If this ratio is less than one, then clearly the company cannot cover its fixed interest costs and
may find it difficult to continue operations. Banks or lenders may grant some relief in terms of
time for repayment, but the company is not clearly earning enough to service its liabilities. It
may be able to cover operating expenses, but not fixed costs. This ratio is dependent on the
debt-equity ratio, and if a company is overleveraged, it may find itself in a difficult spot. It is
not advisable to buy shares of a company whose interest coverage ratio is low as there is a little
cushion. With a small adverse change in demand conditions, the company may end up making
a loss.

Growth Stocks, Value Stocks, Dividend Stocks, Momentum Stocks

Growth stocks are shares of those companies who are perceived to have strong growth
potential. Their prices tend to be high and they trade at high multiples. Value stocks are those
who’s P/BVPS is less than or close to one. Dividend companies are those companies that have
a track record of consistent dividend payment. Momentum stocks are the ones where stock
prices are rising very fast and quick money can be made, but one needs to be careful. All the
four kinds of stocks have their positives and negatives, and acquisition depends on the risk
appetite of the investor. Growth stocks may not give the desired yield as P/E ratio tends to be
high. Value stocks are difficult to identify as everyone would be buying them thus forcing
prices to rise. One way would be looking at small companies, with a low volume of trade, but a
strong business model. However, holding period could be long. Dividend stocks are generally
not that rewarding in terms of capital gains. One should be aware of dividend date declaration,
as prices of such stocks tend to rise after dividend is declared. In India, PSUs are generally
high dividend paying companies. Momentum stocks can be speculative buys. One needs to be
careful.

TECHNICAL ANALYSIS OF STOCK PRICES

According to Murphy (1986), the three premises on which technical analysis is based are

i. Market action discounts everything;

ii. Prices move in trends; and
iii. History repeats itself.

The first premise states that market price of a share of a company subsumes within it all
necessary information about the company, be it fundamental performance, be it market
perception, or be it effects of external environmental factors like interest rate movements,
exchange rate movement, policy changes etc. Thus a household, while allocating his or her
savings to the stock of a company need not look beyond market price of a company and its
movement over time. The second premise states that, in spite of the first premise, prices of
stocks tend to move in trends. One can break up the movement of stock prices over time in
long-term trends, medium-term trends and short-term trends. Stock prices show an independent
momentum - a movement of their own, which may be unrelated to the actual physical
performance of the company. Things do not change overnight. The market takes some time to
adjust and move away from an old trend to establish a new trend. The third premise, which in
my view is an interesting aspect of the stock market, states that something that rises has to fall
and something that falls has to rise. That is the price of a stock, which is rising, will fall, and
the price of a stock that is falling will rise. No stock price can go on rising forever and no stock
price can go on falling for ever. In that sense, history repeats itself. Nature, age composition,
income levels and also risk-taking appetite of stock market participants change with time. The
same set of players do not continue to participate in the market. Thus even if there is some
learning from past experience or history, due to the changing nature of participants, this
knowledge is not shared homogenously across individuals. Thus same mistakes may be
observed in the market, but by a different group of people. We can observe common errors
made in the market and thus history can be observed to repeat itself.

In this chapter, we discuss some technical indicators which can help guide individual investors
and institutional investors in choosing stocks for portfolio management.

Support

It is that level of a stock, below which prices do not fall for the time being. It acts like a floor
where the price gets support and rebounds upwards. It assumes importance when prices are
falling.

Suppose we look at the price action of a stock. For example, the price of ABC Ltd is falling
and each time it falls it does not fall beyond Rs 140.65. Buyers understand that maybe this
stock is strong enough not to fall further and maybe it is worth buying the stock at the support.
If we look from seller’s side, we can interpret that sellers are not willing to sell the stock at less
than Rs.140.65. So, the stock price do not fall further. Support is a level where there are more
buyers than sellers, who keep the prices from falling further. These buyers always think that
the price will rise now and hence either they don’t sell or they keep buying.

For example, from current data on Nifty, we observe three levels of support as shown in Figure
6. These are 4792, 5172 and 5349. The 5349 level of support was also observed in August
2010 and can be taken as a medium-term support. If this is broken, then a short-term support
can be 5172. If this is also broken, we are looking at a support at 4792 levels. This is how
market movements are analyzed and trends understood.

Resistance

It is that level of a stock, from where prices of the stock may not go up. It acts as a roof for the
time being. Prices are expected to hit this roof and fall. It assumes importance when prices are
rising. It gives an estimate as to up to what level prices can rise under the prevailing scenario.

The price of ABC Ltd is rising and each time it rises, suppose it fails to rise further than
Rs.210.40. In this case, investors think that, whenever the stock reaches this price, it may fall,
prompting them to sell the stock. Further, buyers wait for the prices to fall to pick it up cheap
later. Thus there is selling pressure and little buying interest leading to a fall in prices from this
level.

Consider the example of Reliance Industries Ltd. as given in Figure 7.

Figure 6

Source: Drawn from Metastock

Figure 7
Source: Drawn from Metastock

We observe 3 resistance levels. One is at Rs. 1152, the second at Rs. 1091 and the third at Rs.
1055. It can be clearly observed from the diagram that these levels are working as ceilings and
the subsequent resistance levels have also fallen. This indicates, that for the time being, a trend
reversal will not be observed. Investor expectation of prices to fall further may actually push
prices down.

Support and resistance levels help an investor understand trend in technical analysis. In an
uptrend, resistance levels keep changing and every time a new resistance is created. And
similarly, with the support level in a downtrend, every time the price of the stock falls, a new
support is created. In other words, if a breakout happens there can a trend reversal. For
example, if support level is violated then the trend may reverse from and uptrend to downtrend
and vice versa with resistance.

It is also possible that support becomes resistance and resistance becomes support. When
resistance becomes support, this indicates an uptrend. Similarly, when prices drop below the
support level, that level becomes a resistance level and indicates a downtrend. An example is
given in Figure 3 where support at Rs.680 in October – December 2010 has become resistance
in March 2011.

Figure 8
Source: Drawn from Metastock

Andrew’s Pitchfork

Andrew’s Pitchfork requires three pivot point: an early high (or low), a subsequent reaction
low (or high) and a still later high (or low). For example, while viewing a downtrend, select the
high that marks the end of a previous uptrend and the beginning of the downtrend. Then select
the subsequent low and the next reaction high. The high point will be the median and will form
the handle of the pitchfork. The other two lines will be the pines of the pitchfork. The handles
and the pines are the various “support” and “resistance” lines.

The following figure gives two examples of Andrew’s Pitchfork for Tata Chemicals Ltd. On
the left, we drew it as High Low High and the pitchfork was downward sloping. For trend
reversal, we require the upper band to be pierced from below. On the right, we have drawn it as
Low High Low and the fork is upward sloping. Here, the bottom support has to be broken for a
trend reversal.

Figure 9
Source: Drawn from Metastock

Bollinger Band

Bollinger Band is like an envelope where a “resistance line” is drawn at some fixed percentage
point above a moving average and a “support line” at the same percentage point below the
moving average. For the intermediate trend, a 20-day moving average plus/minus 2 times the
standard deviation is taken. For the short term trend, a 10-day moving average plus/minus 1.5
times the standard deviation and for the long term, a 50 day moving average plus/minus 2.5
times the standard deviation is taken. The recommendation is to buy when the actual price falls
below the lower band and is sell when the actual price is above the upper band.

Besides the above, there are a few characteristics of the Bollinger Ban. During a trend, if the
band narrows, then there will be a trend reversal. The band narrowing means that the market is
trading sideways and a correction is in the offing. If the price line hugs the upper band, then the
upward trend will continue for a short period. Similarly, if it hugs the lower band, then the
downtrend will continue for a short while. The following Figure 10 for Mahindra and
Mahindra reflects aspects of the discussion above.
Figure 10

Source: Drawn from Metastock

Fibonacci Fan
Fibonacci Fans provide “support” and “resistance” lines based on percentage retracement and
are useful for predicting future price movements.

Figure 11
Source: Drawn from Metastock

In Figure 11, a Fibonacci Fan has been drawn on the downtrend for Bharat Petroleum. In a
downtrend, the three lines from resistance lines. If all three are broken, then prices should
continue to rise.

For an uptrend, the three lines form support lines as shown in Figure 12.

Figure 12
Source: Drawn from Metastock

Moving average
Moving averages are simple to understand and are widely used for taking positions in the
market. Generally, a short period and a long period moving average are taken and plotted
together. When the short period moving average intersects the long period moving average
from below, it is time to buy as it provides a bullish signal. When the short period moving
average intersects the long period moving average from above, it is time to sell as it is a bearish
signal.

Long-run moving averages also act as support and resistance. If the actual time series moves
above the 200 Day Moving Average (DMA), the stock has crossed a strong resistance. If it
moves below the 200 DMA, it has broken a long-term support.

In Figure 13, the actual price line of Finolex Cables is moving up towards the 200DMA (red)
and the latter is working as a resistance. The price line has intersected and crossed the 100
DMA (blue) from below, and hence that resistance was broken, The 30 DMA (green), the
fastest, has crossed the 100DMA from below, giving a bullish signal. It is currently acting as a
support to the actual price line. So the price of Finolex cables is caught within the 200DMA as
resistance and 30 DMA as support.

Figure 13
Source: Drawn from Metastock

Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD) is drawn as the difference between two
exponential moving averages of the closes: a slower 26-day exponential moving average is
subtracted from a faster 12-day exponential moving average. Then a 9-day exponential moving
average is taken of the MACD as the trigger line. The recommendation is “buy” when the
difference crosses the trigger line from below and “sell” when the difference crosses the trigger
line from above.

When the MACD line moves above the zero line, the stock is said to be overbought. If it moves
below the zero line, the stock is said to be oversold. In Figure 14, the dark line is the MACD
line and the dotted line is the trigger line. Currently, the shares of Power Grid Corporation are
oversold, and MACD is giving the sell signal. Wherever, the dark line intersects the dotted line
from above, it is a sell signal. When the dark line intersects the dotted line from below, it is a
buy signal.

Figure 14
Source: Drawn from Metastock

Parabolic Stop and Reverse Price (Parabolic SAR)

Parabolic Stop and Reverse Price (Parabolic SAR) is an adaptive technique which allows a new
trend some breathing space and then closes in to tighten the stop order. It uses a series of
progressively smaller period exponential moving averages where each period of moving
average is shorter than the previous one. This way, first some time is given for the trend to set
itself. Then the moving average comes close to the actual data set. The signal is “buy” when
the daily high price is lower than the SAR and “sell” when the daily low price is higher than
the SAR.

As an example, we can observe from Figure 15 on the stock price movement of Rural
Electrification Corporation, the Parabolic SAR line (red) always converges to the price line as
the period of moving average falls. So the red line always catches up with the price line, and
whenever that happens, there is a reversal. So when the red line crosses the price line from
above, it is time to buy. When it crosses from below, it is time to sell. Currently, it has not yet
given the buy signal implying the downward trend has not yet slowed down. Observe however,
that there is a small lag between the reversal and the actual intersection. This point cannot be
hit upon and timed.
Figure 15

Source: Drawn from Metastock

Head and Shoulders

A Head and Shoulders pattern, as shown in Figure 16 for Dishman Pharma, has a high (H) with
two lows (S) on two sides at almost the same level. The two shoulders are drawn at the neck
level. The Head is the resistance and the shoulders are the support. If the right neckline is
broken, then prices will fall. If the neckline is not broken, then prices will be rebound back. An
inverse Head and Shoulders pattern is shown in Figure 17.

Figure 16
 H

S S
H

Source: Drawn from Metastock

Figure 17

Source: Drawn from Metastock

Trend
Figure 18

Source: Drawn from Metastock

Figure 18 shows both a medium-term and a short-term trend in the share prices of TVS Motor
Co. Here trend has been drawn as a regression line and there has been steepening of the trend
for the share prices of the company. Normally, a trend can be of three types: uptrend,
downtrend and sideways trend. An uptrend is drawn connecting lows and downtrend is drawn
connecting the highs. Some examples of downtrend and uptrend are drawn in Figure 19 for
Larsen and Toubro.

We also observe from Figure 20, that for Larsen and Toubro, there has been a channel
formation in the recent months. This channel is more or less flat and thus prices have been
range bound with variations within the band.
Figure 19

Source: Drawn from Metastock

Figure 20

Source: Drawn from Metastock

An interesting formation is given in Figure 21 for price movement of Thermax Ltd. The prices
have moved in 6 waves over a period of two years and the seventh wave is in the offing. Prices
are set to fall and the overall recommendation is 100% sell.

Figure 21

6
2
4 5

Source: Drawn from Metastock

With the announcement of recapitalization of state-owned banks in India, there was a

breakaway gap in the share price movement of State Bank of India as shown in Figure 22.
However, it was a one-shot thing and we did not see a runaway after that. Prices have
stabilized and the gap was news driven.
Figure 22

Source: Drawn from Metastock

% retracement

Figure 23

Source: Drawn from Metastock

% retracement indicates the extent to which prices have retraced back after a fall or rise.
Figure 23 for Aurobindo Pharma has been drawn after the rise. Ideally, after a retracement of
around 63%, there is a pullback. If the 63% line is violated, then the downward trend continues
for some time. In the above figure, the 63% line became a resistance, and prices continued to
fall.

Chaikin Money Flow

This technical indicator shows the extent of net money inflow into a stock. In Figure 24, for
Marico Ltd., after net money outflow, the Chaikin Money Flow indicator turned negative. This
is, quite naturally, accompanied by a fall in the share prices. Lately, with net money inflow, the
decline in prices has stabilized. Note that, a short-term net outflow of money from a stock need
not imply a change in the trend of prices.
Figure 24

Source: Drawn from Metastock

Momentum

Momentum is defined as the ratio of the price today divided by price yesterday. This is known
as one-period momentum. If you take price say 5 days ago, then it will be momentum for that
period. Momentum, as the English word suggests, is an object in motion. If momentum rises,
the motion has increased and if it falls, then motion falls. Clearly, if there is an increased
buying interest in a stock relative to selling interest, then momentum will increase. If there is
relatively higher selling interest than demand, then momentum falling, and if the trend
continues, will turn negative.

The upper band of Figure 25 shows movement in momentum for Dr. Reddy’s Laboratories.
The diagram is self-explanatory. However, the graph of momentum does not reflect the trend in
the stock price. When momentum is rising and crosses the zero line, it implies that prices are
accelerating upwards. When momentum starts falling, but still positive, prices are rising, but
the rate of rising has flattened out. When momentum touches zero, then a reversal in price
trend takes place, and prices start to fall.

Figure 25

Source: Drawn from Metastock

Relative Strength Index (RSI)

RSI is defined as

100 – (100) / (1 + RS)

Where RS is average of x days up closes divided by average of x days down closes. The
general practice is to use a 14-day RSI. The value of RSI ranges between 0 and 100. Generally,
the range for taking decisions is 30 to 70. If RSI falls below 30, it is a buy, if it rises above 70,
it is a sell. However, one can be finer and look at a bull period between 40 and 80 and bear
period RSI between 30 and 65.

In Figure 26, we show the price movement as well as RSI for LIC Housing Finance
Corporation. Currently, RSI has been between 30 and 40 levels and prices are really low. It is a
good buy. Observe, that during the bull run, RSI increased and crossed the 80 levels. These
levels are definite reversal levels. RSI falling below 35 is also a buy situation.

Figure 26

Source: Drawn from Metastock

Stochastics
In this technical indicator, two lines are used. One is the %K line and the other is the %D line.
The %K line is defined as

100 [today’s close – lowest low in %K periods] / [highest high in %K periods – lowest low in

%K periods]

The K periods can be chosen as 10 or 14.

Generally, as prices tend to rise, the close tends to move towards the high. As prices fall, the
close tends to move towards the low. If the value of %K tends to be 40% say over a 10-day
span, then it can be concluded that the current price is 40% of its range in the last 10 days.

%D is calculated as the 3-day moving average of %K. Thus %D is a slower stochastic as

compared to %K. If prices are in the higher range, then %K would be high. If prices are in the
lower range, %K would be low in value.
Figure 27 gives the stochastics for Vardhan Textiles. We can interpret the diagram for
stochastics in the following way - buy when the dark line (%K) or the dotted line (%D) touches
the 20 line and sell when it touches the 80 line. Or buy when the dark line intersects the dotted
line from below, and sell when the dark line intersects the dotted line from above.

Figure 27

Source: Drawn from Metastock

Intraday trading: Pivot Point

The constituents for pivot point trading are defined below:

Resistance 3 = High + 2*(Pivot - Low)

Resistance 2 = Pivot + (R1 - S1)
Resistance 1 = 2 * Pivot - Low
Pivot Point = (High + Close + Low)/3
Support 1 = 2 * Pivot - High
Support 2 = Pivot - (R1 - S1)
Support 3 = Low - 2*(High - Pivot)

As you can see from the above formula, just by having the previous days high, low and close
you eventually finish up with 7 points, 3 resistance levels, 3 support levels and the actual pivot
point.
If the market opens above the pivot point then the bias for the day is for long trades as long as
price remains above the pivot point. If the market opens below the pivot point then the bias for
the day is for short trades as long as the market remains below the pivot point.

The three most important pivot points are R1, S1 and the actual pivot point.

The general idea behind trading pivot points is to look for a reversal or break of R1 or S1. By
the time the market reaches R2, R3 or S2, S3 the market will already be overbought or
oversold and these levels should be used for exits rather than entries.

Pairs Trading

Pairs Trading is an arbitrage strategy which generates profits from the movement in the ratio of
prices of two stocks. Ideally, the ratio of the price of the two stocks, which belong to the same
sector and whose prices are highly correlated, should be stable. However, given the inherent
randomness of stock price movements, this ratio may fluctuate. The fundamental basis of Pairs
Trading is that although there would be fluctuations in the ratio of the prices, it would be mean
reverting. Thus if the ratio rises, it is expected that it would fall and if the ratio falls, then it is
expected to rise. For the ratio to rise, one reason could be that the price of one stock is rising at
a faster rate than the other one, in spite of the fact that they are from the same sector and are
having highly correlated prices. The trading strategy, in this case, is to short the faster-moving
stock and long the slower moving stock; the expectation being that the stock whose price is
rising faster will fall, and the stock whose price is not rising that fast, will continue to rise.
Similarly, if the ratio falls, then we long the faster falling one and short the slower falling one.

Movement in the ratio of stock prices of Mahindra and Mahindra and Tata Motors is shown in
Figure 28. Although they belong to the auto sector, they actually cater to two different
segments of the market.

Figure 28
Source: Drawn from Metastock

The ratio of prices do tend to be mean reverting, with occasional spikes. The only problem is
that the short position cannot be kept open overnight. So we may have to plan, to take a day
trading position.

Growth Stocks, Value Stocks, Dividend Stocks, Momentum Stocks

Growth stocks are shares of those companies who are perceived to have strong growth
potential. Their prices tend to be high and they trade at high multiples. Value stocks are those
who’s P/BVPS is less than or close to one. Dividend companies are those companies that have
a track record of consistent dividend payment. Momentum stocks are the ones where stock
prices are rising very fast and quick money can be made, but be careful. All the four kinds of
stocks have their positives and negatives, and acquisition depends on the risk appetite of the
investor. Growth stocks may not give the desired yield as P/E ratio tends to be high. Value
stocks are difficult to identify as everyone would be buying them thus forcing prices to rise.
One way would be looking at small companies, with a low volume of trade, but a strong
business model. However, holding period could be long. Dividend stocks are generally not that
rewarding in terms of capital gains. One should be aware of dividend date declaration, as prices
of such stocks tend to rise right after the dividend is declared. In India, PSUs are generally high
dividend paying companies. Momentum stocks can be speculative buys. One needs to be
careful.