- Introduction – What are you looking for?
First, I would like to say that just about everything you’ve ever been taught consists of beliefs. Anything that seems to be a fact is still relative and depends upon the semantics of the situation. It depends upon some assumptions you are making and the perspective you are bringing to the situation -all of which are also beliefs. You’ll become a lot less rigid and much more flexible and open in your thinking if you just consider “facts” to be “useful beliefs” that you’ve made up. What you will read from my articles also consists of beliefs. So try to view this in a relative fashion. I don’t really know up to what level you know about technical analysis and other concepts. You may be better than me and your concepts may be healthier than mine. I am not trying to teach you anything or prove myself. There are several ways to reach one destination. I hope by the end of these articles, you will come to understand my point. ~~~
- Who is losing?
First let us see who are losing in the market. Statistics say that 90% of total number of traders loses in the market. 5% breakeven and only the remaining 5% make money. Why this happens? Because they don’t have the discipline to apply themselves. People just don’t understand that without effort, nothing will pay. They will spend 20 years for becoming a graduate. Then they will spend several years for getting a professional qualification. They will spend five years to become a doctor after they decide to take that route. But they will become investors overnight. So the people who are losing in the market are not pure technical analysts or fundamental analysts. Getting tips or reading papers will not make them analysts. All these are aids in better understanding, but the basic concepts should be strong which should be made up by you. Just imagine a man acting as a doctor and treating people just by reading newspapers and watching TV channels. Or in this case (of stock market), I should say prescribes medicines for himself! Being a carpenter doesn’t happen by reading. It happens with experience. ~~~
- Fundamental analysis and Technical Analysis
Fundamental analysis is seeking the reason and technical analysis is gauging the effect. Fundamental analysis needs certain privileged information which is hard to get. Information in technical analysis is easy to get provided you can read it. There are several ways to reach the destination. These are just two ways of it. Fundamental analysis is the technique of the big players and technical analysis is the technique of the common man. If you ask me which is better, I will definitely say fundamental analysis, because it satisfies your logic and rational thinking. But if you ask me what you can do, I can only say technical analysis because it is the only thing available for me to ever study about the market. If you ask me which is easier, I will definitely say, a microphone in each of these big players’ (the people who manipulate the market like FIIs and Mutual Funds) office! There you get the final result of these analysis reports! Since it is not available, and information in fundamental analysis is very hard to get, let us choose the difficult path of technical analysis. ~~~
- What is Technical Analysis?
Technical Analysis is not something like rocket science or brain surgery. But it sure is like the army training. What you need is not utmost intelligence, but the resolve to act on your decisions quickly, given the decisions are derived from an objective analysis. There is no place for your hunch or this is no place for you to apply your intuition. Sixth sense just doesn’t work here for long. Mostly what people do is to walk into a terminal, look at the tape (the trading screen at the terminal) for sometime, then buy something just because it is either going up or going down. How will he know when it will stop going down or going up? This is what hunch trading is all about. And most people, who lose, lose in this fashion. ~~~
Then comes the technical traders who use the charts to trade. They will draw some lines and other things on the graph and say “bullish above 60, bearish below 50”. If you ask them after one week, they will say “bullish above 65, bearish below 55”. All in all, you won’t be able to trade at any time. ~~~
One thing we hear most in the trading circles is “If it takes out the high of today, the market will go up. So tomorrow is the day when you will know if this market is going to go up or down.” The next day also the same thing happens. But believe me, both of these things have a point. They truly hold some information. But the problem is the belief in your decision. If scrip breaks its previous high, it shows the intent of the big players to take it higher. There are false breakouts which are crafted to drag people into long positions before a correction. There are other breakouts which catches the stop orders above the previous high (normally there are a lot at these points) and then retreats back into the previous trading range. So everyday evolves before you as different scenes of a film. But you have to read the story right. So each day is important. Technical analysis is not about looking for some strange patterns in a complex picture which represents the Open, High, Low, Close, Volume data in a strange way. Most people who look at technical charts for the first time will have a question at which the technical analyst will say “it needs a big explanation”. The question is – “How in this world can these strange lines and some curves predict a market which is manipulated by some big guns like foreign institutional investors and mutual funds?” Valid indeed. So we will try to answer this question. ~~~
- Is Technical Analysis Effective?
One of the primary points people tend to make against technical analysis is that the Indian markets are highly manipulated by selected people such as Harshad Mehta and Parekh. So any rational approach such as fundamental analysis or technical analysis will not work in such an environment. But we have to understand that market is that which is manipulated. Without manipulation no market would move. People tend to think in the opposite direction and once they buy, they will become sellers soon. And at any given time, there will be equal number of people who think exactly in the opposite ways. So the markets would not move beyond a limit if it was not for manipulators. They also manipulate in the direction of the basic economic tides. They can’t swim against the tide for long and those are the people who perish quickly who swim against the tide (like Harshad Mehta and Parekh). So the market consists of people who are manipulators, professional traders and the general public. Technical analysis is a concept made for the market which consists of manipulators also. ~~~
“No man can learn what he has not preparation for learning, however near to his eyes is the object. A chemist may tell his most precious secrets to a carpenter — and he shall be never the wiser — the secrets he would not utter to another chemist for an estate.” Everybody sees people with diseases, anybody can buy medicines from the shops. But it will only be the doctor who can diagnose and prescribe the correct medicines. Why? Because he has the learning to do it. He uses some other tools to do it, but he knows how to use them. ~~~
- How is Technical Analysis Effective? – The Market Story
In the long term, what manipulators are doing can be told as a story. Once they identify that a particular scrip or market is priced below its real worth (they have information), they will try to bring it down to a place where they can comfortably get in. They will spread bearish news and squeeze out all the available stock into the market. They will steadily work on this and accumulate shares up to the level which they can afford or which they can get. After that they will slowly mark it up using insider news spreading. They will use other insiders to slowly bid up the price and the prices start to move up. They will be ready to support it whenever needed so that the momentum is not lost. ~~~
Lastly the news spreads to the public and they start jumping into the market. The prices will normally more than double or even go up several times from the levels they started it all. When the volumes reach a particular level where the insiders can unwind what they have without bringing the price down too much, they start to unload. Once you try to read this kind of a story from the charts, it will not look as mystifying as it was before. You will be able to distinguish between scrips where big players are present and where they aren’t. But when the market trends, almost all of the scrips start to move up. But only those scrips which are supported by the insiders will be having minimum downside movement because they don’t want the selling pressure to be too much. Because then they will have to buy more at a higher price than the price at which they had accumulated. Even for the manipulators, there is a limit up to which they can raise the money. Then at the top, at the end of the bull market, these scrips won’t go down all the way because they need time to unload quantity. But the other scrips which were moving only because of the trend and which were carried on by the public suffers the most in even the smallest of corrections. Like this, there are several ways to reason. Now what a technical analyst should do is to identify the different phases of this story. First a market goes down, then somebody accumulates the shares. At this point, it will be visible on the charts. The scrip will trade between a range. This itself is tradable. After the accumulation, it starts to move up. Then the trader also gets in. When the scrip roars to astounding levels, and there is selling, he gets out. But where does this go wrong? When people get in early, the operators will shake them out. Why? Because they are the ones who are manipulating the trading and somebody has to lose if somebody has to gain. If you gain, they will lose. ~~~
Now suppose after an accumulation phase, a scrip is starting to move up. Then a lot of people are also getting in. From where this stock is available? Now that the operator has cornered the scrip by accumulating a certain percentage of the available stock, the remaining floating stock will be available when it slowly goes up. If the normal traders get it at the beginning, they will sell it as the scrip goes up. Then who has to buy? The operator has to buy because he has to take the prices still up. So what he will prefer? Buying that stock at a cheaper price or at a higher price? Definitely cheaper. The operator will daytrade also to keep things safe. So when he sells some stock in daytrading, if you buy it, you gain at his expense. Will he like it? So when the people get in at the early stages, they will shake them out. This can only happen when there are a lot of people interested in it. So that is why they say, “when everybody sells, buy and when everybody buys, sell”. Now the good trader gets in when an accumulated share dips, and gets out when it spurts. He can do it several times in this long story. “Buy on weakness, sell on strength”. But if you choose the wrong stock, you sell yourself. So what a trader needs to do is to find out when the operator has the intention to take the scrip up. As I said earlier, there are several ways to reach the destination. ~~~
- How to make Money?
There are several other ways for making money from the markets. Broker’s tip, advise from other analysts, so-called inside information etc. First let me tell you nobody is perfect. Only god is perfect, but he is not a perfect creator. When the creation is perfect, the creator dies. Even the big players in the market make mistakes. So it is quite natural for you, me or the other analysts to go wrong. So the question is how much you are wrong. 30%? 50%? 70%? Even the greatest of traders have only about 80% of accuracy. So when you follow an analyst, first realize that he is not always right. He will also go wrong sometimes. It depends on his strategy how much he is wrong. ~~~
Now if he is right 70% of the time, you can make money if you lose the same amount of money on the losing trades as you gain on the winning trades. Suppose you make one rupee on a winning trade. You will make 70 rupees after 100 trades. If you lose the same one rupee on the 30 losing trades, you will lose 30 rupees. The remaining 40 rupees is your profit. ~~~
But if he is right only 40% of the time, you can only make money if you are making slightly better on winning trades than what you lose on losing trades. If you win 1.5 rupees on winning trades and lose one rupee on losing trades, you will breakeven. This is called risk\reward ratio and it is what is most important than the overall statistical advantage of the strategy. ~~~
So the most important point is to trade all his trades. If you follow only some trades, what if those trades were from the 30% losing trades? But before this, the analyst should have a strategy. How many people have this? How important it is to have a strategy? Suppose you are tossing a coin 100 times. You have 50% chance for heads and 50% chance for tails. So it becomes a gamble. If you consistently bet 100 rupees on each toss, in the end you will break even (lets hope!). But in trading, even this is not enough. You have to add the commission to both sides. Then you will be a consistent loser. ~~~
Now let us use a betting method. Suppose you are betting one rupee on the first toss. If you lose it, you will bet two rupees on the next toss. Then four rupees in the next trade and like this, keep on doubling for losing tosses unless you meet with a winning toss. But if you win, you will go back to the one rupee bet and then again keep on doubling for losing tosses until you meet with a winning toss. You will always be a winner provided that you have unlimited betting power. This is the power of a strategy. ~~~
Now this technique is not possible in real trading, because you will run out of capital if you have a long run of losses. But still one strategy makes whole lot of a difference. So what I venture to say is that you need to have a strategy for trading. Otherwise how can you expect to make money? You are always betting 100 rupees on each trade (or even worse, varying bets) not knowing which trade and how many is going to make money. This is what people are doing and they are bound to lose money in the long run. They may make money now and then. It may be at the end of the cycle or it may be at the beginning, but they are sure to lose in the long run. Because nobody is 100% right. Losses are a part of trading but what matters is how you handle the losses. This is exactly why most of the common traders lose, even if they are following the recommendations of a good analyst. The trades can appear to be great ones, but you will always end up losing money. I can challenge that if you make a strategy with a 1:1 risk/reward ratio and a 70:30 strike rate, still you will lose money. Even if the R/R ratio is 2:1, you will lose in the end. If the strike rate is 80:20, still you will lose. Now you will be wondering, what is this man trying to say? Here is the answer – You lose money because it needs a big effort and discipline to execute a strategy. After making the strategy, in the real world of trading, everything goes against you. Firstly the commission. Secondly Slippage (the difference between your strategy entry price and the real entry price you are able to get). Finally failure to execute the stop loss. The market works in such a way that it makes you thinks against what you have written down for the day. People who fall for it will perish. Believe me, most of the people do. It needs some seasoning in the real world of trading to execute a strategy without emotions (it is very much fine if you can execute even with emotions). ~~~
- Working with Strategies
Let us see how the belief (strategy) will be used in the real world by a common man. Normally what people do is buy 100 reliance @ 309, then buy 100 zee tele @ 103. Now this way, the risk will not be equally divided. You never know which trade goes wrong. For any trade, you have to risk a constant value so that finally your statistical advantage is not washed out. (Actually, you can buy 100 lots of these two scrips provided your exit levels are adjusting itself to the risk level. It is another topic that is money management. There are several ways in money management to maintain the statistical advantage of the strategy. Suppose your stop loss in reliance is three units and the stop loss in zee is also three units. The risk for reliance will be 100 * 3 = 300 and zee 100 * 3 = 300. The risk will be the same. You can risk a certain percent of equity or you can keep on adjusting the betting sizes using algorithms which is widely followed by successful people in order to maximize the output of the system. It is a very complex subject and it is beyond the scope of this letter. I am also not an expert in it to comment on it. But this is where the discipline comes in. You have to keep the risk and target levels at certain levels so that you get the maximum benefit of the statistical advantage. I will give you one more example to show that the science behind the strategy is not important. There is one commonly used strategy which is called one bar swing trading. It is very simple. If one bar low is preceded and followed by two higher lows, you can buy it at the following bar close. Vice versa, if one bar high is preceded and followed by two lower highs, you can sell it at the following bar close. So wherever you see one bar standing up above the nearby bars or standing below the nearby bars, you have a trade. Your stop loss will be the lowest low or the highest high of the three bars. Statistics shows that this has 58% accuracy in Indian markets. The risk\reward ratio is 1:1. This itself is good, but it is not big money because if you add the slippage and commission, it is only as good as breakeven. If you can tweak the entry and exit rules and improve on the risk\reward ratio, it will be good enough to earn you considerable money. So a strategy which is not at all related to technical tools even can make you money. It is the risk control and discipline which is critical. ~~~
- Being a Technical Analyst
So in my opinion, Technical Analysis is not about predicting the future. It is all about probability and discipline. ~~~
What People Do on CNBC?
A technical analyst can’t predict the movement of all the scrips at all the time. He trades only certain aspects of the market. If someone asks him what will be the direction of reliance now, he may not be able to answer it. He need not. Actually the question is not relevant. It doesn’t matter whether the next trade makes money or goes wrong because what matters is the overall probability. He can comment on a scrip only when he has a signal in that particular scrip. According to his trading rules, if he hasn’t got a buy or a sell signal in reliance, it means that he doesn’t know. He is not sure which way it is going to go. Then how can he comment on what is going to happen? So I believe what happens on these channels is just advertising. They are advertising for their advisory services. If they can comment on any scrip at any time, how are they going to trade? Buy or sell the entire market and take positions in all the scrips? So it just doesn’t make sense. If you have a signal according to your trading rules, trade. But still you don’t know if it is going to be a success or a failure. But what matters is, after the full cycle, you outnumber the losers with winners or gain more on winners than what you lose on losers. ~~~
It doesn’t matter whether the manipulator or the exchange itself manipulates with the market and makes the chart worse for the analyst. Because it also shows in the price. The price knows everything. The market does nothing without a reason. The only requirement is that the analyst should understand the basic concepts of his system. His system will be based on some basic principles which are common sense. A good analyst will know all the possible outcomes of his system in whatever circumstances. He doesn’t care if a meteor hits the earth and wipes out a billion people. He has clearly defined exits which he will be executing in order to control losses. The times at which he will not be able to execute his exits because of external factors, are the only exceptions. But you know that a meteor doesn’t hit the earth everyday. But here too, he will only be late, not totally helpless. The only requirement is that the stock markets should exist. In other words, the economies should exist. Losses are a part of trading. But he will be well guarded against the losses of any kind. He will not bet his house in the stock market. He doesn’t blame it on the market or the manipulators when he loses in the market. He should accept the losses as a part of trading and he knows it will be profitable after a full cycle. For exceptional events, like I said before, you need to understand your system well. ~~~
The technical analyst is not having a magic wand which he can use and make money. He has to know when to stay away with his system. He knows when it might bring drawdown because of volatility. When the risk becomes too much for his system, he stays out. Or it can be said that when the events turn out to be too much for him, he stays out. The market will crack you down mentally now and then. Although it may not be a big financial loss, the hunger for perfection will weigh you down sometimes. Recognize these times and take a break. Opportunities are always there. Don’t feel disappointed if you miss one. If your system is good in the long run, you will always end up making money. It is common sense and experience. He has to be also watchful when his system wins more than what he expects although he will like it very much than the other way around. It means that risk is around the corner. One of the things I do to avoid high volatility is to stay away from the market on big news days (like result days, budget day etc.). Now, where does this volatility come from? You don’t need to know. The way I see it, I keep it simple. It is experience and discipline. ~~~
- Where to Start?
How you are going to build such an understanding so that you will be able to build a strategy? For this, first you have to learn what other people have done in the market. Softwares, books and other materials will help you get a deeper understanding about these technical tools and the basic functioning of the market. Why man took thousands of years from his coming to existence to reach the moon? One by one, inventions were made by men and the next generation kept on building on their ancestors’ works. Finally, all the ingredients for reaching the destination were put together and the goal was achieved. So it is very important to know what the people who have walked this path before have done. Once you come to know what other people are doing, you will be surprised to see that all successful people are following a particular route to success. So you can say that there are rules for success. Once you get a sound understanding of the functioning of the market, you will be able to identify certain aspects of the market which are tradable. Information is what you need to survive in this world and it is information whether it is software or a book. Once you delve deeply into this world of information, you will find yourself attached with a certain aspect (or many) of the market. It will come automatically to you which will depend on your mind frame and requirements. It is sure to happen and once you start to believe in it firmly, the journey really starts. Now what will happen if any of such ideas doesn’t strike? You have to be a total fool if you study mathematics and not understand even one formula. So a strategy is not something divine, but it is something you are comfortable with and you believe in. But it will not be just some weird lines over a chart because you know you can’t believe in it. You will never be able to fully believe it unless you back it up with something you understand well. This belief will automatically come to you after you study the subject with reasonable application. Your talents and efforts will shorten the time taken to complete this journey. But, nevertheless, you will reach there for sure. So it doesn’t matter which strategy you are using, but it is the second part which is most important. Almost everyone who has been in this market for sometime and who has applied himself has this kind of beliefs and most of them are strong concepts. But what they lack is the second part. ~~~
- Tools for the Work
First what you need is a software to chart the data. There are many free types of software available in the market, but somewhat limited in its capacity to the paid ones. Normally technical analysis softwares are priced a little bit higher. But you need a scanning unit when you run the hospital, right? Different softwares uses different types of charting methods, but you need at least one to start with. Then secondly, you have to get the data for the software. Different softwares read different types of data and you have to find the type suited for your software. Either you can subscribe to a data vending agency or you can get the data free of cost from internet (in.finance.yahoo.com, www.nseindia.com etc.). The free data needs a little bit of manipulation to make it readable by the softwares. ~~~
After getting these things ready, you have to learn the basics. You have to understand what these technical tools are. What are the chart patterns? There will be help files with the software, but if you can grab a good book, it will be real good. Some of them are: – Technical Analysis of Stock Trends by Edward and Magee, Technical Analysis of the Financial Markets by John Murphy etc. ~~~
Once you have started, you start looking for the story I had told you before. DONOT directly jump into using the technical tools in the software. It will not make any sense at this stage. We will look at it in a later part of this article. Look carefully at the charts and try to distinguish between different scrips behavior. Test your hunch trading by marking buys and sells on your charts and look at the results. Believe me, when you look at charts, you will do most of the trades accurately because human has a special ability to recognize pictures. How a child recognizes his mother? He has looked at her several times and the pattern of her face is memorized in his brain. So he matches the image from his eyes with the one stored in his brain and if the two are same, he says it is his mother. ~~~
But in the real world of trading, all your intuitions will lead you into the wrong directions. Most people wonder why the stock goes down exactly from the point where he has bought. It is because the decision is based on emotions and this emotional gene works exactly the same way in most people. When the strength appears to the naked eye, there will be several of them. That is exactly where the manipulator recognizes the high volume and steers it into the opposite direction. When you look at the charts without emotions, these things will not interfere with your decision making and you will be better placed. After some practice, you can get an overall feel as to how the manipulation works and where you can profit in between. ~~~
- Technical Patterns and Indicators
If you delve deeply into each of these technical patterns, you will come to understand that all these patterns and technical tools are telling the different parts of the same story with different timeframes. For example, if you study about the Head and Shoulders pattern, you will come to know that you need to confirm it with volume behavior. Basically it is an unwinding pattern. It appears after a long trend. This is where the insiders are unwinding the big load of stocks they have. Another pattern, the Cup and Saucer, is an accumulating pattern. A good trend is expected after it because the insiders have accumulated the stock and they are ready to move up. But on both these occasions, the volume behavior is most important, because it has to be clear that if they have unwinded or accumulated stocks. Without any volume confirmation, these patterns will mean nothing. Another key point is where they are appearing. If the accumulation pattern appears after a good uptrend, it is difficult to reason with. Like this, you have to attach common sense to different methods. ~~~
One of the main accusations of the anti-technical analysis people is, you can find a head and shoulders pattern even in the temperature charts. If you look at the Electro cardiogram tapes, you can see all kinds of patterns! But it is not the beauty of the picture that counts, but the meaning of it. The pattern should fit into the market story. Otherwise it is only as useful as what you throw into the dustbin. I will give you one more example. Moving average is a technical tool, which is widely used for measuring the trend and support and resistance points during a trend. Now when a trend appears on the scene, the insiders are not ready give up the momentum because it will require considerable effort to re-establish the trend if the momentum is lost. So when a good trend takes place, normally it won’t break a medium-term moving average. Now you will understand how much importance we should imply on moving averages. It is only an approximate guideline as to whether the trend has lost momentum or not. It is not a well-defined trading tool. So while trading moving average crossovers (where you trade long when the short term moving average cuts above the long term one), you should confirm it with an accumulation pattern at the bottom. Here it can be used as a trigger. While the trend is in place, you can trade with the trend when the price comes back to the moving average line. Normally if the momentum is not lost, it will trade up again. ~~~