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Long straddle

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Topics 4

Long straddle

Basics of stock market

• Induction
• Bull call spread
• Bull put spread
• Call ratio Back Spread
• Bear call ladder
• Synthetic long & Arbitrage
• Bear put spread

• Bear call spread
• put ration back spread
• Long straddle
• Short straddle
• Max pain & PCR ratio
• Iron condor

10.1 – The Directional dilemma

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How often do you find yourself in a position where you decide to trade long or short after giving it a lot of thought, only to see the market move in the exact opposite direction shortly thereafter? Your entire plan, strategy, work, and resources are wasted. I’m positive that we have all been in a situation like this. In fact, this is one of the main reasons why most experienced traders adopt a variety of directional betting strategies that are resistant to the unpredictability of the market.

Market Neutral or Delta Neutral strategies are those whose profitability is largely independent of market direction. In the upcoming chapters, we’ll learn about some market-neutral tactics and how Such trading tactics can be used by everyday retail traders. Let’s start off with a “Long Straddle.”

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10.2 – Long Straddle

The simplest market-neutral strategy to use is probably the long straddle. The direction that the market moves has no bearing on the P&L once it has been implemented. The market must move, regardless of the direction, it moves in. A positive P&L is produced as long as the market is moving (regardless of the direction it is moving). All that is required to execute a long straddle is –

  1. Buy a Call option
  2. Buy a Put option

Ensure –

  1. Both the options belong to the same underlying
  2. Both the options belong to the same expiry
  3. Belong to the same strike

Here is an illustration of how to execute a long straddle and how the overall strategy performed. The market is currently trading at 7579, making the strike price of 7600 “At the money” as of the time of this writing. We would have to buy the ATM call and put options simultaneously if we wanted to long straddle. 

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Based on the scenarios discussed above, we can draw a few conclusions:

Technically speaking, this is a ladder and not a spread. The first two option legs, however, produce a traditional “spread” in which we sell ITM and buy ATM. It is possible to interpret the spread as the difference between ITM and ITM options. It would be 200 in this instance (7800 – 7600).
Net Credit equals Premium collected from ITM CE minus Premium paid to ATM and OTM CE
Spread (difference between the ITM and ITM options) – Net Credit equals the maximum loss.
When ATM and OTM Strike, Max Loss occurs.
When the market declines, the reward equals Net Credit.
Lower Strike plus Net Credit equals Lower break-even.
Upper Breakeven is equal to the sum of the long strike, short strike, and net premium.

Take note of how the strategy loses money between 7660 and 8040 but ends up profiting greatly if the market rises above 8040. You still make a modest profit even if the market declines. However, if the market does not move at all, you will suffer greatly. Because of the Bear Call Ladder’s characteristics, I advise you to use it only when you are positive that the market will move in some way, regardless of the direction.

In my opinion, when the quarterly results are due, it is best to use stocks (rather than an index) to implement this strategy.

10.3 – Effect of Greeks

Volatility does play a significant role when using the straddle. If I said that volatility makes or breaks the straddle, I wouldn’t be exaggerating. Therefore, the success of the straddle depends on a fair assessment of volatility. View the graph below for more information.

The cost of the strategy is shown on the y-axis, which is just the sum of the option premiums, and volatility is shown on the x-axis. With 30, 15, and 5 days until expiration, the blue, green, and red lines show, respectively, how the premium rises as volatility rises. As you can see, this is a linear graph, and regardless of the time until expiration, the cost of the strategy rises as volatility does. In a similar vein, strategy costs drop as volatility does.

Look at the blue line; it indicates that setting up a long straddle will cost you 160 when volatility is 15%. Keep in mind that the price of a long straddle is equal to the total premium needed to purchase both call and put options. When volatility is 15%, setting up a long straddle costs Rs. 160; however, assuming all other factors remain the same, when volatility is 30%, setting up the same long straddle costs Rs. 340. So long as – you are likely to double your investment in the straddle.

  1. You set up the long straddle at the start of the month

  2. The volatility at the time of setting up the long straddle is relatively low

  3. After you set up the long straddle, the volatility doubles

Similar observations can be drawn from the green and red lines, which show the price to volatility behavior at 15 and 5 days from expiration, respectively. This also means that if you execute the straddle when volatility is high and declines after you execute the long straddle, you will lose money. This is a very important thing to keep in mind. Let’s now quickly talk about the delta of the overall strategy. Since we are long on the ATM strike, both options’ deltas are close to 0.5.

  • The call option has a delta of + 0.5

  • The put option has a delta of – 0.5

The delta of the call option cancels out the delta of the put option, leaving a net delta of zero. Remember that delta displays the bias in the position’s direction. A bullish bias is indicated by a +ve delta, whereas a bearish bias is indicated by a -ve delta. Given this, a 0 delta means that there is absolutely no bias toward the market’s direction. Therefore, all strategies with zero deltas are referred to as “Delta Neutral,” and Delta Neutral strategies are protected from the direction of the market.

10.4 – What can go wrong with the straddle?

On the surface, a long straddle appears fantastic. Consider the fact that you stand to gain financially regardless of how the market performs. All you require is an accurate estimation of volatility. So what could possibly go wrong with a straddle? Well, two things stand in the way of your ability to profit from a long straddle.

Theta Decay – In the absence of other factors, options are depreciating assets, which is especially detrimental to long positions. The time value of the option decreases as expiration draws nearer. Holding onto out-of-the-money or in-the-money options into the final week before expiration will result in rapid premium loss because time decay accelerates exponentially during this period.

Remember that the break-even points in the earlier example we discussed were 165 points away from the ATM strike. Taking into account the ATM strike at 7600, the lower breakeven point was 7435 and the upper breakeven point was 7765. To achieve breakeven, the market must move 2.2 percent (either way) in percentage terms. This means that for you to start profiting from the time you start the straddle, the market or the stock must move at least 2.2 percent in either direction. and this transfer must be completed in no more than 30 days. Furthermore, a move of 1 percent over and above 2.2 percent on the index is required if you want to make a profit of at least 1 percent on this trade. A significant change in the index

We can sum up what really needs to go in your favor for the straddle to be profitable by keeping the previous two points plus the effect on volatility in perspective.

When applying the strategy, the volatility ought to be quite low.

During the strategy’s holding period, the volatility should rise.

The market should move significantly; it makes no difference in which way it moves.

The anticipated large move is time-bound and ought to occur quickly – well before the expiration

My trading long straddles have taught me that they are profitable when placed around significant market events, and the impact of such events should be greater than what the market anticipates. Please read the following paragraphs carefully as I will go into more detail about the “event and expectation” part. Consider the Infosys outcomes as an illustration.

Event – Quarterly results of Infosys

Expectation – ‘Muted to flat’ revenue guideline for the coming few quarters.

Actual Results: Infosys announced a “muted to flat” revenue guideline for the upcoming quarters, as was predicted. A long straddle would probably collapse if it were set up against the backdrop of such an event (and its expectation), and eventually, the expectation would be met. This is due to the fact that volatility tends to rise around significant events, which tends to raise premiums.

In other words, if you buy ATM calls and put options close to an event, you are essentially buying options at a time of high volatility. When events are made public and the result is known, the volatility and consequently the premiums fall like a stone. Due to the “bought at high volatility and sold at low volatility” phenomenon, this naturally breaks the straddle down, causing the trader to lose money. I frequently see this happening, and regrettably, I’ve seen plenty of traders lose money precisely because of it.

Favorable Outcome – Now imagine that they announce an “aggressive” guideline in place of the “muted to flat” guideline. This would essentially catch the market off guard and raise premiums significantly, making for a successful straddle trade. This indicates that there is a different perspective to consider: you should evaluate the outcome of the event a little more favorably than the market as a whole.

A straddle cannot be set up with a subpar evaluation of the events and their result. This may seem like a challenging proposition, but trust me when I say that a few good years of trading experience will actually enable you to assess situations far more accurately than the market as a whole. In order to be clear, I’d like to reiterate all the angles that must line up for the straddle to be profitable:

  1. The volatility should be relatively low at the time of strategy execution

  2. The volatility should increase during the holding period of the strategy

  3. The market should make a large move – the direction of the move does not matter

  4. The expected large move is time-bound and should happen quickly – well within the expiry

  5. Long straddles are to be set around major events, and the outcome of these events is to be drastically different from the general market expectation.

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Basics of options jargons

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Options

• Basics of call options
• Basics of options jargon
• How to buy a call option
• How to buy/sell call option
• Buying a put option
• Selling put option
• Call & put options
• Greeks & calculator

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

Learning sharks- stock market institute

2.1– Decoding the basic jargons

We were familiar with the fundamental call option structure from the previous chapter. The goal of the previous chapter was to summarise a few crucial “Call Option” ideas, including:

  1. When you anticipate that the underlying price will rise, it makes sense to purchase a call option.
  2. The buyer of the call option loses money if the underlying price declines or remains unchanged.
  3. The premium (agreement fees) that the buyer of the call option pays to the seller/writer of the call option is equal to the amount of money that the buyer would lose.

We will try to comprehend the call option in greater detail in the following chapter, called Call Option (Part 2). However, let’s first explain a few common option jargons before moving on. Talking about these terminologies now will not only improve our understanding, but it will also make the discussion of the possibilities that will follow simpler to understand.

We shall examine the following jargon:

  1. Strike Cost
  2. Fundamental Price
  3. A contract for an option is
  4. Choice Expires
  5. Choice Premium
  6. Optional Agreement

Please keep in mind that as we have only examined the call option’s fundamental structure, I would advise you to solely comprehend these terms in relation to call options.

Strike Cost

Think of the striking price as the anchor price at which the buyer and seller (of the option) concur to engage in a contract. For instance, the anchor price in the “Ajay – Venu” example from the previous chapter was Rs. 500,000, which also served as the “Strike Price” for their agreement. We also looked at a stock example where the strike price and anchor prices were both 75 rupees. The strike price for all “Call” options denotes the price at which the stock may be  on the expiration day.

For instance, if the buyer is willing to pay a premium today to purchase the right to “buy ITC at Rs. 350 on expiration,” they are eager to buy ITC Limited’s call option with a strike price of Rs. 350. It goes without saying that he will only purchase ITC at a price above Rs. 350.

In reality, below is a screenshot of the NSE website where I have included various ITC strike prices and the corresponding premium.

An “Option Chain” is the table you see above, and it basically summarises all the various strike prices that are  for a contract along with the premium for the same. In addition to this data, the option chain contains a wealth of additional trade data, including Open Interest, volume, bid-ask quantity, etc. I advise you to ignore everything else for the time being and focus just on the material that has been highlighted.

  1. The underlying’s spot price is in the maroon highlight. As we can see, ITC was trading at Rs. 336.9 per share at the time of this picture.
  2. All of the different strike prices that are are highlighted in blue. Strike rates range from Rs. 260 (with Rs. 10 intervals) up to Rs. 480, as can be.

  3. Keep in mind that each striking price stands alone. By paying the necessary premium, one can enter into an options agreement at a particular strike price.

  4. For instance, a 340 call option can be by paying a premium of Rs. 4.75. (highlighted in red)

  1. This gives the buyer the option to purchase ITC shares for Rs. 340 at expiration. Of course, you now see the situation in which purchasing ITC at 340 on expiration day would be advantageous.

Fundamental Price

As is common knowledge, the value of a derivative contract is derived from the underlying asset. The price at which the underlying asset trades on the spot market is known as the underlying price. For instance, ITC was trading at Rs.336.90/- in the spot market when we examined that case. The underlying price is as follows. In order for the buyer of a call option to profit, the underlying price must rise.

A contract for an option is exercised

Claim your right to purchase the options contract at expiration by exercising your option contract. When someone says, “exercise the option contract,” they simply mean that they are asserting their right to purchase the stock at the specified strike price. It is obvious that he or she would only act in this manner if the stock is trading over the strike. A key detail to keep in mind is that you can only exercise the option on the day it expires, not at any other time.

Therefore, let’s imagine that someone purchases an ITC 340 Call option with 15 days remaining when ITC is trading at 330 in the spot market. Assume further that the stock price rises to 360 the following day after he purchases the 340 call option. In such a case, the call option holder cannot exercise his call option and cannot ask for a settlement. Only on the day of the expiry will settlement take place, and it will be  on the price the asset is trading for on that day in the spot market.

Choice Expires

The same as a futures contract, an options contract has an expiration date. In reality, the last Thursday of every month is the expiration date for both equity futures and options contracts. Options contracts have the same current month, mid-month, and far-month ideas as futures contracts.

The call option to purchase Ashok Leyland Ltd. at a strike price of Rs. 70 is shown in this snapshot at a price of Rs. 3.10/-. As you can see, there are three expiration dates: March 26, 2015, April 30, 2015, and May 28, 2015. (far month). Of course, as and when the expiry changes, the option premium also does. We will discuss it further when the moment is right. But at this point, I just want you to keep in mind two things about expiry: just with futures, there are three possible expiry options, and the premium varies depending on which option you choose.

Choice Premium

Since we’ve already talked about the premium on a few occasions, I assume you now understand a few things regarding the “Options Premium.” The premium is the sum of money that the option buyer must pay to the option seller or writer. The option buyer purchases the right to exercise his wish to buy (or sell, in the case of put options) the asset at the strike price upon expiration in exchange for the payment of a premium.

We must be going in the correct direction if you have understood this portion up to this point. We’ll now go on to comprehend a fresh viewpoint on “premiums.” Additionally, I suppose it is crucial to point out at this point that the “Options Premium” is what the entire concept of option theory depends on. When trading options, option premiums are a very important factor. You’ll notice as we go through this lesson that the choice premium will eventually take up a lot of the talks.

Let’s go back to the “Ajay-Venu” scenario from the previous chapter. Think about the conditions in which Venu agreed to accept Ajay’s premium of Rs.

  1. News coverage – There was only speculative coverage of the highway project, and it was unclear whether it would actually proceed.

1. Consider that in the last chapter, we examined 3 potential outcomes, of which 2 were in Venu’s favor. Venu, therefore, stands to gain more from the arrangement while not having an inherent statistical advantage, given that highway news is hypothetical.

2. Time – There were six months to determine if the initiative would be successful or not.

  1. This argument works in Ajay’s favor. There is a greater chance that the event will favor Ajay because there is more time before it expires. Take this as an example: If you were to run 10 kilometers, would you be more likely to finish it in 20 minutes or 70 minutes? Of course, the likelihood of success increases with the length of time.

Now let’s take a look at both of these issues separately and determine how they might affect the options premium.

Due to the completely hypothetical nature of the news at the time of the contract between Ajay and Venu, the latter was happy to accept the premium of Rs. 100,000. Let’s just pretend for a second that the news was  and not hypothetical. Perhaps a local legislator made a suggestion during the most recent news conference that a motorway might be  for that location. The news is no longer a rumor after learning this information. Suddenly, though there is still some speculation, there is a chance that the motorway might actually appear.

Consider this in context: Do you believe Venu will accept Rs. 100,000 as a premium? He is aware that there is a good likelihood the motorway would be built, in which case land prices would rise. But given that there is still a chance component, he might be willing to take the risk if the premium is more alluring. The deal might be more appealing to him if the premium was Rs. 175,000 instead of Rs. 100,000.

Let’s now consider this in the context of the stock market. Assume that Infosys is currently trading at Rs. 2200. The cost of the 2300 Call option with a one-month expiration is Rs. 20. Consider yourself in Venu’s (the option writer’s) position: Would you sign a contract accepting Rs. 20 per share as premium?

You provide the buyer the right to purchase an Infosys option at Rs. 2300 one month from now if you enter into this options agreement as a writer or seller.

Assume that no foreseen corporate activity will cause the share price of Infosys to increase throughout the course of the ensuing month. Given this, you might agree to accept the Rs. 20 premium.

What happens, though, if a corporate event (such as quarterly reports) tends to boost the stock price? Will the option seller continue to accept Rs. 20 as the agreement’s premium? It is obvious that taking the risk of Rs. 20 may not be worthwhile.

Having stated that, what if someone is willing to pay Rs. 75 as premium rather than Rs. 20 notwithstanding the planned corporate event? At Rs. 75, I suppose it could be worthwhile to take a chance.

Let’s keep this conversation in the back of our minds as we move on to the second item, which is time.

Ajay knew for sure that six months would be enough time for the dust to settle and the whole story about the motorway project to come to light. What if there were just 10 days in the future, as opposed to 6 months? There is simply not enough time for the event to take place now that time has passed. Do you believe Ajay will be content to give Venu an Rs. 100,000 premium in this situation (where time is not on Ajay’s side)? I don’t think so because Ajay wouldn’t be motivated to provide Venu with such a high premium.

Perhaps he would settle for a lower premium, like Rs. 20,000.

Anyway, the point I want to convey here is that premium is never a set rate, keeping both news and time in context. It is susceptible to a number of things. In actual markets, all of these factors function simultaneously and have an impact on the premium. Some factors tend to raise the premium while others tend to lower it. In detail, there are 5 factors that tend to influence the premium (akin to news and time). They are referred to as “Option Greeks.” We won’t grasp the Greeks until much later in this module since it’s too early for us to understand them now.

I want you to keep in mind and be grateful for the following things in relation to the option for the time being premium –

  1. The Option Theory depends on the idea of premium.
  2. A premium is never a fixed rate; instead, it depends on a variety of other factors.
  3. Premiums in actual marketplaces fluctuate practically minute by minute.

I can promise you that you are on the right track if you have acquired and comprehended these concepts thus far.

Settlement of Options

This is a call option to purchase JP Associates at Rs. 25 as indicated in the green accent. The deadline is March 26, 2015. The market lot is made up of 8000 shares, and the premium is Rs.1.35/- (highlighted in red).

Assume that “Trader A” and “Trader B” are the only two traders. Both Trader A and Trader B are interested in purchasing this contract (the option buyer).

Given that the contract is for 8000 shares, the cash flow would be as follows:

Trader A must pay the whole amount of Rs.1.35 per share, which is the premium.

= 8000 * 1.35

= A premium payment of Rs. 10,800 to Trader B.

Now, if Trader A decides to exercise his agreement, Trader B is bound to sell Trader A 8000 shares of JP Associates on March 26, 2015, as a result of Trader B receiving this Premium from Trader A. This does not, however, imply that Trader B should be carrying 8000 shares on March 26. Indian options are cash settled, therefore if trader A decides to exercise his right on March 26, trader B is only required to pay the cash difference to Trader A.

Take into account that JP Associates is trading at Rs. 32/- on March 26 in order to better grasp this. As a result, Trader A, the option buyer, will exercise his option to purchase 8000 shares of JP Associates at a price of 25/-. In other words, he receives the opportunity to purchase JP Associates at a discount from its open market price of Rs. 32.

Typically, the cash flow should look like this:

  • Trader A exercises his option to purchase 8000 shares from Trader B on the 26th.
  • The transaction will take place at a predetermined price of Rs. 25. (strike price)
  • Trader A gives Trader B (8000 * 25) rupees.
  • Trader B releases 8000 shares to Trader A for Rs. 25 in exchange for this payment.

  • Trader A quickly sells these shares on the open market for Rs. 32 each, earning Rs. 256,000.

  • In this trade, Trader A earns a profit of Rs. 56,000 (256,000 – 200000).

The option buyer is generating a profit of Rs. 7 per share (32-25) per share, to put it another way. Instead of sending the option buyer 8000 shares since the option is cash-settled, the option seller instead gives him the cash equivalent of the profit he would have made. Therefore, Trader A would get

= 7*8000

= 56,000 rupees from Trader B.

Considering that the option buyer had initially invested Rs. 10,800 in acquiring this privilege, his actual profits would be:

= 56,000 – 10,800

= Rs.45,200/-

This actually yields a staggering return of 419 percent when expressed in terms of percentage return (without annualizing).

Options are a desirable trading instrument due to the substantial asymmetric return that may be achieved. This is only one of the many factors that traders find options to be so appealing.

CONCLUSION

  1. Only when one predicts an increase in the price of an asset does it make sense to purchase a call option
  2. The anchor price at which both the option buyer and writer enter into a contract is known as the strike price.
  3. The asset’s spot price serves as the underlying price.
  4. Claim your right to purchase the options contract at expiration by exercising your option contract.
  5. The expiry of an options contract is similar to that of a futures contract. Every month’s final Thursday is the expiration date for option contracts.
  6. The current month, mid-month, and distant-month contracts of an option contract each have a separate expiration date.
  7. Premiums are not fixed; rather, they change depending on a number of circumstances.
  8. Options are settled in cash in India.

Fibonacci Retracements

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Technical analysis

• Technical analysis
• Introduction
• Types of charts
• Candlesticks
• Candle sticks patterns
• Multiple candlestick Patterns
• Trading – get started
• Trading view

• Support  & resistance
• Volume trading
• News and Events
• Moving averages
• Indicators
• Fibonacci Retracements
• Notes

The subject of Fibonacci retracements is really interesting. To completely comprehend and appreciate the notion of Fibonacci retracements, it is necessary to first comprehend the Fibonacci series. The Fibonacci series’ origins can be traced back to ancient Indian mathematical texts, with some claims reaching back to 200 BC. However, Fibonacci numbers were discovered in the 12th century by Leonardo Pisano Bogollo, an Italian mathematician from Pisa known to his friends as Fibonacci.

The Fibonacci series is a sequence of numbers beginning with zero and structured in such a way that the value of every number in the series is the sum of the two numbers before it.

The Fibonacci sequence looks like this:

0 , 1, 1, 2, 3, 5, 8, 13, 21, 34,  55, 89, 144, 233, 377, 610…

Notice the following:

233 = 144 + 89
144 = 89 + 55
89 = 55 +34

Needless to say, the series goes on indefinitely. The Fibonacci sequence has a few intriguing characteristics.

Divide every number in the series by the previous number; the resulting ratio is consistently around 1.618.

For example:
610/377 = 1.618
377/233 = 1.618
233/144 = 1.618

The Golden Ratio, often known as the Phi, is defined as a ratio of 1.618. Fibonacci numbers have a natural link. The ratio can be found in human faces, flower petals, animal bodies, fruits and vegetables, rock formations, and galaxy formations, among other things. Of course, we shouldn’t go into this debate because it would take us away from the essential point. For those who are interested, I recommend searching the internet for golden ratio instances; you will be pleasantly pleased. Further investigation into the ratio qualities reveals remarkable consistency when a number in the Fibonacci series is split by its immediately subsequent number.

For example:
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618

At this point, keep in mind that 0.618 is 61.8 percent when presented as a percentage.

When any number in the Fibonacci series is divided by a number two places higher, there is a similar consistency.

For example:
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382

0.382, when expressed in percentage terms, is 38.2%

Also, consistency is when a number in the Fibonacci series is divided by a number 3 place higher.

For example:
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
55/233 = 0.236

0.236, when expressed in percentage terms, is 23.6%.

Relevance to stocks markets

The Fibonacci ratios, which are 61.8 percent, 38.2 percent, and 23.6 percent, are thought to be used in stock charts. When there is a noteworthy up-move or down-move in pricing, Fibonacci analysis can be used. Whenever the stock makes a sharp upward or downward move, it tends to retrace back before making the following move. For example, if a stock has risen from Rs.50 to Rs.100, it is likely to retrace to Rs.70 before rising to Rs.120.

The retracement level forecast’ is a strategy that can predict how far a pullback can go. These retracement levels offer traders an excellent opportunity to start new positions in the trend direction. The Fibonacci ratios, 61.8 percent, 38.2 percent, and 23.6 percent, assist the trader in determining the potential amount of the retracement. These levels can be used by the trader to position himself for a trade.

Have a look at the chart below:

learning sharks

I’ve circled two places on the chart: Rs.380, where the stock began its run, and Rs.489, where it peaked.

The Fibonacci upmove would now be defined as 109 (380 – 489). According to the Fibonacci retracement hypothesis, after the upmove, one should expect the stock to correct up to the Fibonacci ratios. For example, the stock’s initial corrective level may be 23.6 percent. If this stock continues to fall, traders should keep an eye on the 38.2 percent and 61.8 percent levels.

In the example below, the stock retraced up to 61.8 percent, which corresponds to 421.9, before resuming its advance.

learning sharks

We can arrive at 421 by using simple math as well –

Total Fibonacci up move = 109

61.8% of Fibonacci up move = 61.8% * 109 = 67.36

Retracement @ 61.8% = 489- 67.36 = 421.6

Similarly, we may compute 38.2 percent and various ratios. However, this does not have to be done manually because the software will do it for us.

Here’s another example of a chart that has risen from Rs.288 to Rs.338. As a result, a 50-point move compensates for the Fibonacci upmove. The stock fell 38.2 percent to Rs.319 before resuming its upward trend.

learning sharks

The Fibonacci retracements can also be used to identify levels above which a declining stock can recover. In the chart below (DLF Limited), the stock began to fall from Rs.187 to Rs.120.6, creating a Fibonacci down move of 67 points.

learning sharks

Following the downtrend, the stock attempted to retrace back to Rs.162, which is the 61.8 percent Fibonacci retracement level.

 

Fibonacci Retracement construction

Fibonacci retracements, as we now know, are chart moves that go against the trend. To apply Fibonacci retracements, we must first determine the 100 percent Fibonacci move. The 100 percent move might be either upward or downward. To determine the 100 percent move, select the most recent peak and trough on the chart. Once this is determined, we use a Fibonacci retracement tool to connect them. This feature is present in the majority of technical analysis software packages, including Zerodha’s Pi.

Here is a step-by-step guide:

Step 1) Identify the immediate peak and trough. In this case, the trough is at 150, and the peak is at 240. The 90-point moves make it 100%.

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Step 2) Select the Fibonacci retracement tool from the chart tools

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Step 3) Use the Fibonacci retracement tool to connect the trough and the peak.

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After selecting the Fibonacci retracement tool from the charts tool, the trader must first click on the trough and then drag the line to the peak without un-clicking. At the same time, the Fibonacci retracement levels begin to be drawn on the chart. However, the software only completes the retracement identification procedure when both the trough and the peak have been selected. After picking both points, the chart looks like this.

learning sharks

The Fibonacci retracement levels have now been calculated and loaded onto the chart. Use this information to determine your market position.

How should you use the Fibonacci retracement levels?

Consider a case in which you wanted to buy a specific stock but were unable to do so due to a significant increase in the stock’s price. In such a case, the most logical course of action would be to wait for a pullback in the stock. Fibonacci retracement levels such as 61.8 percent, 38.2 percent, and 23.6 percent serve as potential levels for stock to correct to.

The trader can detect these retracement levels and position himself for an entry opportunity by plotting the Fibonacci retracement levels. However, as with any signal, the Fibonacci retracement should be used as a confirmation tool.

I would only buy a stock if it met the other criteria on the checklist. In other words, my willingness to buy would be stronger if the stock:

  1. Formed a recognizable candlestick pattern

  2. The stoploss coincides with the S&R level.

  3. Volumes are above average.

Along with the previously mentioned parameters, if the stoploss also coincides with the Fibonacci level, I know the trade setup is properly aligned to all variables, and thus I would go in for a powerful buy. The term “strong” refers to the level of conviction in the trade setup. The stronger the signal, the more confirming factors we utilise to evaluate the trend and reversal. The same approach can be applied to short trades.

Conclusion

  1. Fibonacci retracement is based on the Fibonacci series.

  2. A Fibonacci series possesses numerous mathematical features. These mathematical features can be found in many different elements of nature.

  3. Traders believe the Fibonacci series can be used to identify probable retracement levels in stock charts.

  4. Fibonacci retracements are levels (61.8 percent, 38.2 percent, and 23.6% ) to which a stock can retrace before resuming its initial directional trend.

  5. The trader can consider opening a new trade at the Fibonacci retracement level. However, before proceeding with the trade, other elements on the checklist should be confirmed.

Appreciation

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Even so, we launch new stock market integrated trading programs every 6 months. Despite stock market trends and conditions. While we have you here. Of course, we do not want to miss asking you to share a review. It is necessary and appreciated. our Trading community has been growing evidently. Surely, the credit goes to our mentors and our hard-working trading students. For this reason, we keep coming out with discounts and concessions on our programs. Besides, We believe each citizen has the right to learn about the market.

 

Because we believe each student should be successful. Since our program is so powerful. So, we encourage and invite more applications, therefore. Of course, we feel proud to invite the differently abled students too. Moreover, the stock market does not care about any race, religion, family background, or religion also. Then, again, We are there to assist you with the best education. Finally, head over to our contact page to speak to our counselor. For one thing, we do not want our students to fail, which is why give regular and repeated classes too.

Indicators

by

Technical analysis

• Technical analysis
• Introduction
• Types of charts
• Candlesticks
• Candle sticks patterns
• Multiple candlestick Patterns
• Trading – get started
• Trading view

• Support  & resistance
• Volume trading
• News and Events
• Moving averages
• Indicators
• Fibonacci Retracements
• Notes

When you look at a stock chart on a trader’s trading terminal, you will most certainly see lines flowing all over the screen. These are known as ‘Technical Indicators.’ A technical indicator assists a trader in analyzing a security’s price movement.

Indicators are self-contained trading methods that have been brought to the globe by experienced traders. Indicators are pre-programmed logic that traders can use to supplement their technical analysis (candlesticks, volumes, S&R) to make a trading choice. Indicators aid in the buying, selling, confirming, and sometimes anticipating of trends.

Indicators are classified into two types: leading and lagging. A leading indicator precedes the price, indicating that it predicts the occurrence of a reversal or a new trend. While this seems intriguing, keep in mind that not all leading indicators are reliable. Leading indicators are renowned for sending out incorrect indications. As a result, the trader should exercise extreme caution when employing leading indicators. Indeed, the effectiveness of using leading indicators grows with trading expertise.

The bulk of leading indicators is referred to as oscillators since they oscillate within a defined range. An oscillator often oscillates between two extreme numbers, such as 0 and 100. The trading meaning differs depending on the oscillator reading (for example, 55, 70, etc.).

A lagging indicator, on the other hand, lags behind the price, indicating the occurrence of a reversal or a new trend after it has occurred. What is the point of receiving a signal after the event has occurred? It’s better late than never, right? Moving averages are one of the most widely used lagging indicators.

If the moving average is an indicator in and of itself, you may be wondering why we discussed it before we studied the indicators properly. The reason for this is that moving averages are a fundamental notion in and of themselves. It is used in a variety of indicators, including the RSI, MACD, and Stochastic. As a result, we covered moving averages as a separate topic.

Before delving deeper into various indicators, I believe it is necessary to first define momentum. The rate at which the price moves is referred to as momentum. For example, if the stock price is Rs.100 today and increases to Rs.105 the following day and Rs.115 the next day, we may say the momentum is strong because the stock price has changed by 15% in just three days. However, if the same 15% shift occurred over, say, three months, we can conclude that momentum is modest. As a result, the stronger the momentum, the faster the price changes.

 

Relative Strength Index

The Relative Strength Index (RSI) is a popular indicator established by J.Welles Wilder. The RSI is a leading momentum indicator that can assist spot a trend reversal. The RSI indicator oscillates between 0 and 100, and market expectations are set based on the most recent indicator reading.

The phrase “Relative Strength Index” can be deceptive because it does not measure the relative strength of two securities, but rather shows the security’s internal strength. The most common leading indicator is the RSI, which provides the greatest indications during sideways and non-trending areas.

The RSI is calculated using the following formula:

M2-Ch14-Chart1

Let us examine this indicator using the following example:

With this in mind, assume the stock is trading at 99 on day 0 and evaluate the following data points:

Sl NoClosing PricePoints GainPoints Lost
110010
210220
310530
410720
510304
610003
79901
89702
910030
1010550
1110720
1211030
1311440
1411840
Total2910

The term points gained/lost in the preceding table refers to the number of points gained/lost since the previous day’s closure. For example, if the close today is 104 and the close yesterday was 100, the points gained are 4 and the points lost are 0. Similarly, if the close today was 104 and the close the prior day was 107, the points gained would be 0, and the points lost would be 3. Please keep in mind that the losses are calculated as positive numbers.

For the computation, we used 14 data points, which is the default period setting in the charting software. This is also known as the ‘look-back time.’ If you’re looking at hourly charts, the default period is 14 hours, and if you’re looking at daily charts, the default term is 14 days.

The first step is to calculate ‘RS,’ commonly known as the RSI factor. As seen in the calculation, RS is the ratio of average points gained to average points lost.

Average Points Gained = 29/14

= 2.07

Average Points Lost = 10/14

= 0.714

RS = 2.07/0.714

= 2.8991

Plugging in the value of RS in the RSI formula,

= 100 – [100/ (1+2.8991)]

= 100 – [100/3.8991]

= 100 – 25.6469

RSI = 74.3531

As you can see, calculating the RSI is pretty straightforward. The purpose of using RSI is to help traders discover oversold and overbought price zones. Overbought means that the stock’s positive momentum is so strong that it may not last long, implying that a correction is possible. Similarly, an oversold position indicates that the negative momentum is high, signaling that a reversal is imminent.

Take a peek at Cipla Ltd’s graph; you’ll notice some interesting developments:

learning sharks

To begin, the red line beneath the price chart represents the 14-period RSI. If you look at the RSI scale, you’ll note that it has an upper bound of 100 and a lower bound of 0. However, the numbers 100 and 0 are not visible in the graph.

When the RSI reading falls between 30 and 0, the security is oversold and due for an upward correction. When the security reading is between 70 and 100, it is assumed that the security has been heavily purchased and is due for a downward correction.

The first vertical line from the left indicates a level where the RSI is less than 30; in fact, the RSI is 26.8. As a result, the RSI indicates that the stock is oversold. In this case, the RSI value of 268 also corresponds to a bullish engulfing pattern. This provides the trader with two confirmations to go long! Needless to say, both volumes and S&R should follow suit.

The second vertical line indicates a level where the RSI reaches 81, which is considered overbought. As a result, if not seeking shorting possibilities, the trader should use caution in his decision to purchase the stock. Again, watch how the candles form a bearish engulfing pattern. A bearish engulfing pattern with an RSI of 81 indicates that the stock should be sold short. This is followed by a swift and brief stock correction.

The candlestick pattern and RSI exactly coincide to confirm the occurrence of the same event, as demonstrated above. This is not always the case. This leads us to another intriguing interpretation of RSI. Consider the following two possibilities:

Scenario 1) Because the RSI is upper bound at 100, stock in a prolonged uptrend (remember, uptrends can run from a few days to a few years) will remain locked in the overbought region for a long time. It cannot exceed 100. The trader will invariably be seeking shorting chances, but the stock will be in a different orbit. Eicher Motors Limited, for example, has earned a year-on-year return of about 100 percent.

Scenario 2) The RSI will be locked in the oversold region of a stock that is in a persistent slump since it is lower bound to 0. It cannot exceed 0. The trader will be seeking buying chances in this situation, but the stock will be falling. Suzlon Energy, for example, has achieved a negative 34 percent year-on-year return.

As a result, we can interpret RSI in a variety of ways other than the traditional one (which we discussed earlier)

  1. If the RSI remains in an overbought region for an extended length of time, look for purchasing opportunities rather than short ones. Because of the extra positive momentum, the RSI remains in the overbought range for an extended length of time.

  2. If the RSI remains in an oversold zone for an extended length of time, look for selling opportunities rather than buying. Because of an overabundance of negative momentum, the RSI remains in the oversold region for an extended period.

  3. Look for purchasing opportunities if the RSI value begins to move away from the oversold level after a protracted period. For example, if the RSI rises over 30 after a long period, it may indicate that the stock has bottomed out, implying that it is time to go long.

  4. Look for selling opportunities if the RSI value begins to move away from the overbought value after a protracted period. For example, the RSI fell below 70 for the first time in a long time. This indicates that the stock may have peaked, making shorting a viable option.

One Last Note

None of the measures used to analyze RSI should be rigidly applied. J.Welles Wilder, for example, used a 14-day lookback time simply because it produced the greatest results given the market conditions in 1978. (which is when RSI was introduced to the world). If you like, you can set a look-back time of 5, 10, 20, or even 100 days. This is how you establish your trading edge. You must examine what works for you and replicate it. Please keep in mind that the fewer days you utilize to compute the RSI, the more volatile the indicator.

J.Welles Wilder also opted to use a scale of 0-30 to identify oversold regions and a scale of 70-100 to indicate overbought regions. Again, this is not a hard and fast rule; you can come up with your combination.

I like to use the 0-20 level and the 80-100 level to determine oversold and overbought sectors. I combine this with the traditional 14-day look-back period.

Of course, I encourage you to investigate the parameters that work best for you. Indeed, this is how you will eventually become a successful trader.

Finally, keep in mind that RSI is not commonly utilized as a solo indicator by traders; it is used in conjunction with other candlestick patterns and indicators to examine the market.

Moving Average Convergence and Divergence (MACD)

Gerald Appel created the Moving Average Convergence and Divergence (MACD) indicator in the late 1970s. Traders see MACD as the granddaddy of indicators. Despite being established in the 1970s, MACD is still regarded as one of the most reliable momentum trading indicators.

MACD, as the name implies, is concerned with the convergence and divergence of two moving averages. Convergence happens when the two moving averages move in the same direction, while divergence occurs when the moving averages move in opposite directions.

A conventional MACD is calculated using a 12-day and a 26-day exponential moving average. Please keep in mind that both EMAs are based on closing prices. To get the convergence and divergence (CD) value, subtract the 26 EMA from the 12-day EMA. The ‘MACD Line’ is a simple line graph that depicts this. Let’s start with the math and then move on to the applications of MACD.

DateClose12 Day EMA26 Day EMAMACD Line
1-Jan-146302   
2-Jan-146221   
3-Jan-146211   
6-Jan-146191   
7-Jan-146162   
8-Jan-146175   
9-Jan-146168   
10-Jan-146171   
13-Jan-146273   
14-Jan-146242   
15-Jan-146321   
16-Jan-146319   
17-Jan-1462626230  
20-Jan-1463046226  
21-Jan-1463146233  
22-Jan-1463396242  
23-Jan-1463466254  
24-Jan-1462676269  
27-Jan-1461366277  
28-Jan-1461266274  
29-Jan-1461206271  
30-Jan-1460746258  
31-Jan-1460906244  
3-Feb-1460026225  
4-Feb-1460016198  
5-Feb-1460226176  
6-Feb-14603661536198-45
7-Feb-14606361306188-58
10-Feb-14605361076182-75
11-Feb-14606360836176-94
12-Feb-14608460666171-106
13-Feb-14600160616168-107

Let us go through the table starting from the left:

  1. We have the dates, starting from 1st Jan 2014

  2. Next to the dates, we have the closing price of Nifty

  3. We leave the first 12 data points (closing price of Nifty) to calculate the 12-day EMA

  4. We then leave the first 26 data points to calculate the 26-day EMA

  5. Once we have both 12 and 26-day EMA running parallel to each other (6th Feb 2014) we calculate the MACD value

  6. MACD value = [12 day EMA – 26 day EMA]. For example, on 6th Feb 2014, 12-day EMA was 6153, and 26-day EMA was 6198. Hence the MACD would be 6153-6198 = – 45

The MACD line, which oscillates above and below the middle line, is obtained by calculating the MACD value over 12 and 26-day EMAs and plotting it as a line graph.

DateClose12 Day EMA26 Day EMAMACD Line
1-Jan-146302   
2-Jan-146221   
3-Jan-146211   
6-Jan-146191   
7-Jan-146162   
8-Jan-146175   
9-Jan-146168   
10-Jan-146171   
13-Jan-146273   
14-Jan-146242   
15-Jan-146321   
16-Jan-146319   
17-Jan-1462626230  
20-Jan-1463046226  
21-Jan-1463146233  
22-Jan-1463396242  
23-Jan-1463466254  
24-Jan-1462676269  
27-Jan-1461366277  
28-Jan-1461266274  
29-Jan-1461206271  
30-Jan-1460746258  
31-Jan-1460906244  
3-Feb-1460026225  
4-Feb-1460016198  
5-Feb-1460226176  
6-Feb-14603661536198-45
7-Feb-14606361306188-58
10-Feb-14605361076182-75
11-Feb-14606360836176-94
12-Feb-14608460666171-106
13-Feb-14600160616168-107
14-Feb-14604860516161-111
17-Feb-14607360456157-112
18-Feb-14612760456153-108
19-Feb-14615360486147-100
20-Feb-14609160606144-84
21-Feb-14615560686135-67
24-Feb-14618660796129-50
25-Feb-14620060926126-34
26-Feb-14623961036122-19
28-Feb-14627761186119-1
3-Mar-1462216136611720
4-Mar-1462986148611236
5-Mar-1463296172611359
6-Mar-1464016196612175
7-Mar-1465276223613192
10-Mar-14653762566147110
11-Mar-14651262886165124
12-Mar-14651763246181143
13-Mar-14649363546201153
14-Mar-14650463806220160

Given the MACD value, let’s try and find the answer to a few obvious questions:

  1. What does a negative MACD value indicate?

  2. What does a positive MACD value indicate?

  3. What does the magnitude of the MACD value mean? As in, what information does a -90 MACD  convey versus a – 30 MACD?

The MACD indication simply indicates the direction of the stock’s movement. If the 12 Day EMA is 6380 and the 26 Day EMA is 6220, the MACD value is +160. In what situations do you believe the 12-day EMA will be bigger than the 26-day EMA? We investigated this in the moving average chapter. Only when the stock price is rising will the shorter-term average be greater than the long-term average. Remember that the shorter-term average is usually more sensitive to current market prices than the long-term average.

A good indicator indicates that the stock has positive momentum and is trending upward. The magnitude increases with increasing momentum. For example, +160 indicates a stronger positive trend than +120.

However, when dealing with magnitude, keep in mind that the stock price affects the magnitude. For example, the magnitude of the MACD will automatically increase if the underlying price, such as Bank Nifty, rises.

When the MACD is negative, this indicates that the 12-day EMA is lower than the 26-day EMA. As a result, the momentum is negative. The greater the magnitude of the MACD, the stronger the downward trend.

The MACD spread is the difference between the two moving averages. When momentum slows, the spread narrows; when momentum picks up, the spread widens. Traders typically plot the MACD value chart, also known as the MACD line, to visualize convergence and divergence.

The MACD line chart of the Nifty for data points ranging from January 1st, 2014 to August 18th, 2014 is shown below.

learning sharks

The MACD line, as seen, oscillates over a central zero line. This is also known as the ‘Centerline.’ The MACD indicator can be interpreted as follows:

  1. When the MACD Line crosses the centerline from the negative to the positive zone, it indicates that the two averages are diverging. This is an indication of developing bullish momentum, so watch for purchasing chances. We can see this happening around the 27th of February based on the graphic above.

  2. When the MACD line crosses the centerline from the positive to the negative area, it indicates a convergence of the two averages. This is an indication of developing bearish momentum, therefore watch for selling chances. As you can see, there were two occasions when the MACD nearly turned negative (8th May and 24th July), but it just halted at the zero lines and reversed ways.

Traders typically believe that while waiting for the MACD line to cross the centerline, the majority of the movie would have already been completed and it would be too late to enter a trade. To overcome this, an improvisation is performed over the basic MACD line. The 9-day signal line is an additional MACD component that has been added as an improvisation. The MACD line’s 9-day signal line is an exponential moving average (EMA). If you consider it, we now have two lines:

  1. A MACD line

  2. A 9-day EMA of the MACD line is also called the signal line.

A trader can no longer wait for the centerline to cross over by employing a basic two-line crossover method, as explained in the moving averages chapter.

  1. When the MACD line crosses the 9-day EMA and the MACD line is greater than the 9-day EMA, the emotion is positive. When this occurs, the trader should hunt for purchasing opportunities.

  2. When the MACD line crosses below the 9-day EMA and the MACD line is less than the 9-day EMA, the emotion is bearish. When this occurs, the trader should hunt for opportunities to sell.

The MACD indicator is plotted on Asian Paints Limited in the chart below. The MACD indicator is visible underneath the price chart.

learning sharks

The indicator uses standard parameters of MACD:

  1. 12-day EMA of closing prices

  2. 26-day EMA of closing prices

  3. MACD line (12D EMA – 26D EMA) represented by the black line

  4. 9-day EMA of the MACD line represented by the red line

The chart’s vertical lines highlight the crossing locations where a buy or sell signal originated.

For example, the first vertical line from left to right indicates a crossover in which the MACD line is below the signal line (9-day EMA) and suggests a short trade.

The second vertical line from the left indicates a crossover when the MACD line is above the signal line, indicating a purchasing opportunity. So forth and so on.

Please keep in mind that moving averages are at the heart of the MACD system. As a result, the MACD indicator has qualities comparable to those of a moving average system. They function effectively when there is a strong trend but are less useful when the market is drifting sideways. This is visible between the first two lines, starting from the left.

Needless to add, the MACD parameters are subject to change. The 12 and 26-day EMAs can be changed to whatever time range is preferred. I like to use the MACD in its original form, as pioneered by Gerald Appel.

The Bollinger Bands

Bollinger Bands (BB), introduced by John Bollinger in the 1980s, is one of the most useful technical analysis indicators. The Bollinger Band (BB) is used to assess overbought and oversold levels, with a trader attempting to sell when the price reaches the top of the band and executing a purchase when the price reaches the bottom of the band.

The BB has 3 components:

  1. The middle line which is The 20 day simple moving average of the closing prices

  2. An upper band – this is the +2 standard deviation of the middle line

  3. A lower band – this is the -2 standard deviation of the middle line

The standard deviation (SD) is a statistical concept that estimates the volatility of a value from its average. In finance, the standard deviation of the stock price shows a stock’s volatility. For example, if the standard deviation is 12%, it is equivalent to stating that the stock’s volatility is 12%.

The standard deviation is added to the 20-day SMA in BB. The upper band represents the +2 SD. We multiply the SD by 2 and add it to the average using a +2 SD.

For example if the 20 day SMA is 7800, and the SD is 75 (or 0.96%), then the +2 SD would be 7800 + (75*2) = 7950. Likewise, a -2 SD indicates we multiply the SD by 2 and subtract it from the average. 7800 – (2*75) = 7650.

We now have the components of the BB:

  1. 20 day SMA = 7800

  2. Upper band = 7950

  3. Lower band = 7650

According to statistics, the current market price should be around the 7800 level. If the current market price is around 7950, it is deemed pricey in comparison to the average. As a result, shorting opportunities should be approached with the belief that the price will return to its typical level.

As a result, the trade would be to sell at 7950 and aim at 7800.

Similarly, if the current market price is approximately 7650, it is deemed low in comparison to average pricing. As a result, one should investigate buying opportunities to anticipate that prices will return to their average level.

As a result, the trade would be to purchase at 7650 and target 7800.

The upper and lower bands serve as a signal to begin a trade.

The following is the chart of BPCL Limited,

learning sharks

The central black line is the 20-day SMA. The two red lines above and below the black line represent the +2 SD and -2SD. The aim is to short the stock when it reaches the top band, anticipating it to revert to average. Similarly, one can go long when the price reaches the bottom band, anticipating it to revert to the average.

I’ve highlighted with a down arrow all of the sell signals generated by BB. While most of the signals functioned effectively, there was a period when the price remained trapped in the upper band. The price continued to rise, and therefore the upper band widened. This is known as envelope expansion.

The upper and bottom bands of the BB create an envelope. When the price moves in a specific direction, the envelope expands, suggesting significant momentum. When there is an envelope expansion, the BB signal fails. This leads to a significant conclusion: BB works well in sideways markets but fails in trending ones.

I expect the trade to start working in my favor virtually quickly when I employ BB. If it does not, I start validating the probability of an envelope extension.

Other Indicators

There are a plethora of other technical signs, and the list is seemingly limitless. The question is, do you need to be familiar with all of these indicators to be a good trader? The basic answer is no. Technical indicators are useful to know, but they should not be your primary tool for analysis.

I’ve met many wannabe traders who invest a lot of time and energy learning different indicators, but it’s all for naught in the end. It is sufficient to have a working knowledge of a few basic indicators, such as those taught in this lesson.

The Checklist

In the previous chapters, we began to construct a checklist that would serve as a guiding force in the trader’s decision to buy or sell. It’s time to go over that checklist again.

The indicators serve as a tool for traders to confirm their trading decisions, and it is important to evaluate what the indications are communicating before placing a buy or sell order. While the reliance on indicators is not as strong as it is on S&R, volumes, or candlestick patterns, it is always useful to understand what the basic indicators say. As a result, I would suggest including signs in the checklist, but with a twist. I’ll explain the twist later, but first, let’s go over the new checklist.

  1. The stock should form a recognizable candlestick pattern

  2. S&R should confirm the trade. The stop loss price should be around S&R

    1. For a long trade, the low of the pattern should be around the support

    2. For a short trade, the high of the pattern should be around the resistance

  3. Volumes should confirm

    1. Ensure above average volumes on both buy and sell day

    2. Low volumes are not encouraging, hence do feel free to hesitate while taking trade where the volumes are low

  4. Indicators should confirm

    1. Scale the size higher if the confirm

    2. If they don’t confirm, go ahead with the original plan

The sub-bullet points under indicators are where the twist lies.

Consider a hypothetical case in which you are considering purchasing shares of Karnataka Bank Limited. If Karnataka Bank forms a bullish hammer on a specific day, assuming the following conditions are met:

  1. The bullish hammer is a recognizable candlestick pattern

  2. The low of the bullish hammer also coincides with the support

  3. The volumes are above average

  4. There is also a MACD crossover (signal line turns greater than the MACD line)

I’d be pleased to buy Karnataka Bank if all four of the checklist items were checked off. As a result, I place a buy order, say for 500 shares.

Consider a scenario in which the first three checklist conditions are met but the fourth (indicators should confirm) is not. What do you suggest I do?

I’d still buy, but instead of 500 shares, I’d probably get 300.

This should ideally reflect how I like to utilize (and advocate for) indicators.

When the indicators confirm, I increase my bet amount; when the indicators do not confirm, I continue to buy but reduce my bet size.

However, I would not do this with the first three items on the checklist. For example, if the low of the bullish hammer does not coincide with and around the support, I will seriously ponder buying the stock; in fact, I may forego the opportunity entirely and hunt for another.

But I don’t have the same faith in the indications. It’s always useful to understand what indications mean, but I don’t base my decisions on them. If the indicators confirm, I increase the bet size; if they don’t, I stick to my original strategy.

Conclusion

  1. A MACD is a trend-following indicator.

  2. MACD is made up of a 12-day and a 26-day EMA.

  3. The MACD line measures 12d EMA – 26d EMA.

  4. The signal line is the MACD line’s 9-day SMA.

  5. Between the MACD Line and the signal line, a crossover method can be used.

  6. The volatility is captured by the Bollinger band. It has a 20-day average, a +2 standard deviation, and a -2 standard deviation.

  7. When the current price is at +2SD, one can short with the hope that the price will revert to the average.

  8. When the current price is at -2SD, one might go along with the hope that the price will revert to the average.

  9. In a sideways market, BB performs well. In a trending market, the BB’s envelope increases and produces a large number of false signals.

  10. Indicators are useful to know, but they should not be used as the sole basis of decision-making.

Basics of call options

by

Options

• Basics of call options
• Basics of options jargon
• How to buy a call option
• How to buy/sell call option
• Buying put option
• Selling put option
• Call & put options
• Greeks & calculator

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

learning sharks stock market institute

1.1– Breaking the Ice

We will once again operate on the presumption that you are unfamiliar with alternatives and as a result know nothing about them, just like we did with any of the previous Varsity modules. We shall therefore start from scratch and gradually build up as we go. Let’s begin by going over some fundamental background details.

 

Particularly in India, the derivative market is dominated by the options market. If I said that options made up roughly 80% of the derivatives traded and that the remaining 20% came from the futures market, I wouldn’t be exaggerating. The options market has been internationally for some time; for a fast overview, see the following:

 

  • Since the 1920s, custom options have been sold over the counter (OTC). These options mostly covered commodities.
  • The Chicago Board Options Exchange (CBOE) started trading options on stocks in 1972.
  • Bond and currency options were first offered in the late 1970s. Once more, they were OTC trades.
  • The Philadelphia Stock Exchange introduced exchange-traded options on currencies in 1982.
  • Trading in interest rate options on the CME first started in 1985.

 

Clearly, since the OTC era, the global markets have undergone significant change. The exchanges in India, however, have supported the options market since its start. However, the off-market “Badla” system offered possibilities. Consider the “badla system” as a shadow market for derivatives deals. The badla system is no longer in use; it is out of date. An overview of the development of the Indian derivative markets is provided below:

 

  • Launch of index futures on June 12th, 2000
  • Launch of index options on June 4th, 2001
  • On July 2, 2001, stock options became available.
  • Launch of single stock futures on November 9th, 2001.

 

Despite the options market’s existence since 2001, it wasn’t until 2006 that it experienced real liquidity for Indian index options. Back then, when I was trading options, the spreads were wide, and obtaining fills was a major thing. The value was however unlocked for the shareholders in 2006 when the Ambani brothers formally split up and their various businesses were listed as separate corporations.

 

 

 

1.2 – A Special Agreement

There are two different kinds of options: call and put. You have the option of buying or selling these options. Your actions affect how the P&L profile looks. Of course, we’ll talk about the P&L profile much later. Let’s first define what “The Call Option” means. The greatest method to comprehend a call option is really to start with concrete, real-world example. Once we comprehend this example, we can generalize the concept to stock markets. Therefore, let’s begin.

 

Think about this scenario: Ajay and Venu are two close buddies. Ajay is actively weighing the possibility of purchasing an acre of land from Venu. The worth of the land is Rs. 500,000. Ajay has been advised that a new roadway project is most likely to be approved next to the property owned by Venu within the next six months. Ajay would profit from the investment he would make today if the motorway is built because it is likely to improve the value of the land. Ajay would be stuck with a useless plot of property if the “highway news” turns out to be untrue, meaning he would purchase the land from Venu today and there would be no roadway tomorrow.

 

What then ought Ajay to do? Ajay is unsure whether or not to purchase the land from Venu, therefore it is clear that this event has put him in a difficult position. Ajay is confused about this, but Venu is adamant about selling the land to Ajay if he wants to buy it.

 

Ajay wants to be cautious, so he considers everything that is going on and ultimately suggests to Venu a unique, organized arrangement that he believes will benefit both of them. The specifics of the agreement are as follows:

 

  1. Ajay makes a one-time payment of Rs. 100,000 today. Consider this to be Ajay’s non-refundable agreement fee.
  2. In exchange for these monies, Venu consents to sell the land to Ajay after six months.
  3. The sale price, which is anticipated to take place in six months, has been set at Rs. 500,000.
  4. Only Ajay can cancel the agreement after six months because he paid an upfront fee; Venu is unable to do so.
  5. If Ajay cancels the agreement after six months, Venu keeps the upfront costs.

 

What do you think of this unique deal, then? Who do you believe is smarter in this situation, Ajay for suggesting such a complex arrangement or Venu for accepting it? Well, until you thoroughly investigate the agreement’s terms, the answers to these questions are not simple. You should carefully read through the example because Ajay has crafted a very sophisticated arrangement there. It also serves as the foundation for understanding alternatives. In actuality, this agreement contains a variety of sides.

 

To grasp the specifics of Ajay’s plan, let’s split it down:

 

  • Ajay enters into a deal with Venu by paying a fee of Rs. 100,000. For the next six months, he is compelling Venu to lock the land on his behalf.

  • Ajay is determining the sale price of the land based on the current price, which is Rs. 500,000. This means that regardless of the price six months from now, he would be able to purchase the land at the current price. Please take note that he is setting a price and paying an extra Rs. 100,000 today.

  • Ajay has the right to tell Venu “no” at the conclusion of the six months if he decides not to purchase the land, but since Venu has already collected the agreement fee from Ajay, he is unable to do so.

  • The agreement fee is not refundable and cannot be negotiated.

 

After starting this deal, Ajay and Venu must now wait the ensuing six months to find out what will truly occur. It is obvious that the cost of the land will change depending on how the “highway project” turns out. However, there are only three scenarios that could occur regardless of what happens to the highway:

 

  1. The cost of the land would increase once the highway building was underway, perhaps soaring to Rs. 10,000,000.
  2. People are disappointed when the highway project is abandoned and the price of land drops to, say, Rs. 300,000.
  3. Nothing changes; the price remains at Rs. 500,000.

 

Additional to the three eventualities described above, I’m positive there are no other outcomes that might happen.

 

We will now put ourselves in Ajay’s position and consider what he would do in each of the aforementioned circumstances.

 

Scenario 1: The price increases to Rs.10,000.

 

The price of land has increased since the motorway project materialized as Ajay had anticipated. Keep in mind that, according to the contract, Ajay has the right to terminate the relationship after six months. Do you think Ajay would cancel the transaction now that the land price has increased? Not exactly, as Ajay stands to gain from the sale’s dynamics.

 

The land is currently being sold for Rs.10,000,000.

 

Value of the Sale Agreement: Rs. 500,000

 

As a result, Ajay now has the option to purchase a plot of land for Rs. 500,000 even though it would normally sell for Rs. 10,000 in the free market. Ajay is definitely getting a great deal here. He would therefore demand that Venu sell the land to him. For no other reason than the fact that he had previously collected Rs. 100,000 from Ajay as agreement fees, Venu is compelled to sell him the land at a lower price.

 

How much money does Ajay now make? Here is the math, though:

 

Purchase Price: Rs. 500,000

 

Additional Fees = Rs. 100,000 (remember this is a non refundable amount)

 

Total Cost = (500,000 + 100,000)/-

 

The land’s current market value is Rs. 10,000,000.

 

His profit is therefore Rs. 10,000, 000 – Rs. 600, 000, or Rs. 400,000.

 

Another way to look at this is that Ajay is now earning four times as much money for an initial monetary commitment of Rs. 100,000! Even though Venu is well aware that the land would fetch a far greater price on the open market, he feels compelled to give Ajay a considerably lesser price. Ajay’s profit of Rs. 400,000 corresponds exactly to the hypothetical loss that Venu would suffer.

 

Situation 2: Price drops to Rs. 300,000

 

It turns out that the highway project was only a rumor, and nothing significant is truly anticipated to come of it. People are dissatisfied, thus there is an unexpected rush to sell the land. The cost of the land decreases to Rs. 300,000/- as a result.

 

What do you suppose Ajay will do going forward? He would back out of the contract because it is obvious that buying the land is not a good idea. Here is the math that demonstrates why purchasing the land is ineffective:

Keep in mind that the sale price was set at Rs. 500,000 six months ago. Therefore, Ajay would need to pay Rs. 500,000 to purchase the land in addition to the Rs. 100,000 he had already paid for the agreement costs. Thus, he is effectively spending Rs. 600,000 to purchase a plot of land that is only worth Rs. 300,000 in total. Ajay would obviously not understand this since he has the authority to cancel the contract and would just refuse to purchase the land.

 

Keep in mind, too, that Ajay is required to forfeit Rs. 100,000 per the agreement, giving Venu the money instead.

 

Situation 3: The price remains at Rs. 500,000.

 

For whatever reason, the price does not significantly alter after six months and remains at Rs. 500,000. What do you anticipate Ajay doing? He won’t buy the land, of course, and will walk away from the agreement. If you’re wondering why the math is as follows:

 

The land cost is Rs. 500,000.

 

Fee for Agreement: Rs. 100,000

 

Total: 600,000 rupees

 

The open market value of the land is Rs. 500,000.

 

It is obvious that purchasing a plot of land for Rs. 600,000 when its value is Rs. 500,000 is absurd. Remember that Ajay can still purchase the land even if he has already committed Rs 1lakh, but he will incur an additional cost of Rs 1lakh. Due to this, Ajay will terminate the contract and forfeit the agreement price of Rs. 100,000. (which Venu obviously pockets).

 

I hope you comprehended this transaction completely, and if you did, that’s great since it means you already understand how call options operate thanks to the example! But let’s wait before applying this to the stock markets; we’ll continue to focus on the Ajay-Venu transaction.

 

Here are some questions and answers concerning the transaction that may help to clarify the example:

 

  1. Why do you suppose Ajay placed such a wager even though he is aware that he will lose his one lakh rupees if land prices do not rise or remain the same?

1. Agreed The best aspect is that Ajay already knows his maximum loss (which is one lakh) before the event. Therefore, he won’t experience any unpleasant surprises. Additionally, his profits would increase as and when the price of the land did (and therefore his returns). At Rs.10,000, he would have a 400 percent profit on his investment of Rs.100,000, or Rs.400,000.

 

2. What conditions would make sense for a position like Ajay’s?

  1. only in the event that the cost of the land rises

3. What conditions might Venu’s position make sense in?

  1. only in the event that land prices drop or remain unchanged

4. Do you know why Venu is taking such a large chance? If land prices rose after six months, he would suffer a significant financial loss, correct?

  1. Well, consider it. There are only 3 conceivable outcomes, and only 2 of them are favorable to Venu. According to statistics, Venu has a 66.6% chance of winning the wager compared to Ajay’s 33.3% likelihood.

 

Now, let’s review a few crucial issues.

 

  • The payment made by Ajay to Venu ensures that Ajay has a right (keep in mind that only he has the authority to cancel the agreement) and Venu has a duty (if the circumstances call for it, he must uphold Ajay’s claim).
  • The cost of the land will decide how the agreement turns out when it expires (at the end of six months). Without the land, the contract is worthless.
  • Thus, the arrangement is referred to as a derivative, and land is referred to as an underlying.
  • Such a contract is known as an “Options Agreement.”
  • Venu is referred to as the “agreement seller or Writer” and Ajay is referred to as the “agreement buyer” because Venu received the advance from Ajay.

  • In other words, Ajay can be referred to as an Options Buyer and Venu as the Options Seller/writer as this arrangement is referred to as “an options agreement”.

  • The price of this option agreement is 1 lakh because it was entered into after exchanging 1 lakh. Additionally known as the “Premium” amount

  • Each and every variable in the agreement, including the price and the sale date, is fixed.

  • As a general rule, the buyer always has a right and the seller always has a responsibility in an options agreement.

 

You should use this example very carefully, in my opinion. If not, read it once more to fully get the dynamics. Please keep in mind this example as well, as we will refer to it several times in the chapters that follow.

 

Let’s now examine the identical case from the viewpoint of the stock market.

 

1.3 – The Call Option

In order to better comprehend the “Call Option,” let’s try extrapolating the same scenario to the stock market. Please take note that I will purposely omit the specifics of options trading at this point. The goal is to comprehend the call option contract’s basic elements.

 

Let’s say a stock is currently trading at Rs. 67. If you were given the option to purchase the identical security one month from today for, let’s say, Rs. 75/-, would you do so only if the share price was higher on that day than Rs. 75? Of course, you would, since this means that even if the share is trading at 85 after a month, you can still get to buy it at Rs. 75!

 

You need to pay a tiny fee today, let’s say Rs. 5.0/-, to get this right. You have the option to exercise your right and purchase shares at Rs. 75 if the share price rises above that level. If the share price remains at or below Rs. 75, you are not required to exercise your entitlement to purchase shares and do not need to do so. You only stand to lose Rs. 5 in this scenario. This type of agreement is known as an option contract, specifically a “call option.”

 

There are only three possible outcomes after you enter into this arrangement. They are, too.

 

  1. The stock price may increase, say by Rs. 85.
  2. The stock price may decrease, say by Rs. 65.
  3. The share price may remain at Rs.75/-

 

Case 1: It would make sense to exercise your right and purchase the stock at Rs. 75 if the stock price increases.


The P&L would seem as follows:

 

The purchase price of the shares is Rs. 75.

 

Paid premium equals Rs.

 

The cost incurred equals Rs. 80.

 

Price in the Open Market: Rs. 85

 

Profit: 85 minus 80, or Rs. 5

 

Case 2: If the stock price drops to, say, Rs. 65, buying it for Rs. 75 makes no sense because you would be effectively paying Rs. 80 (75 + 5) for a stock that is accessible at Rs. 65 on the open market.

 

Case 3: Similarly, if the stock price remains unchanged at Rs. 75, it simply means that you are spending Rs. 80 to purchase a stock that is on the market for Rs. 75. As a result, you would not exercise your option to purchase the stock at Rs. 75.

 

It’s so easy, right? If you comprehend this, you really comprehend the fundamental reasoning behind a call option. The finer details, all of which we will shortly understand, remain unexplained.

 

What you need to realize at this point is that purchasing a call option always makes sense whenever you anticipate that the price of a stock (or any other asset) will grow for the reasons we have already covered.

 

Here is a formal definition of a call options contract before I conclude this chapter.

 

“The buyer of the call option has the right, but not the responsibility, to purchase from the option seller at a specific time (the expiration date) for a specific price an agreed-upon quantity of a specific commodity or financial instrument (the underlying)” (the strike price). If the buyer chooses to purchase the commodity or financial instrument, the seller (or “writer”) is compelled to do so. For this right, the purchaser pays a charge (known as a premium).

 

The “Call Option” will be examined in more detail in the following chapter.

 

 

CONCLUSION

  1. Options have been traded in Indian exchanges for more than 15 years, although actual liquidity only became available in 2006.
  2. A tool for defending your position and lowering risk is an option.
  3. The seller is required to deliver to the call option buyer, and the buyer has the right to do so.
  4. Only one side to the transaction is given the option (the buyer of an option)
  5. The option writer is another name for the option seller.
  6. The “Premium” amount is what the option buyer pays the option seller at the time of the agreement.

  7. The agreement takes place at a predetermined cost, frequently referred to as the “Strike Price.”

  8. Only when the asset’s price rises over the strike price do the option buyer profit.

  9. It always makes sense to buy options when you anticipate a price gain since if the asset price remains at or below the strike, the buyer is not rewarded.

  10. In a typical option deal, the option seller has a better statistical chance of succeeding.

  11. The option will become worthless if the directional perspective does not materialize before the expiration date.

DCF Primer

by

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

learning sharks stock market institute

14.1 – The Stock Price

Firslty, We discussed stage 1 and stage 2 of equity research in the previous chapter. Understanding the business was the focus of stage 1, and comprehending the company’s financial performance was the focus of stage 2. Only those who are convinced by the conclusions of the first two rounds may move on to step 3. The valuation of stock prices is covered in Stage 3.

Only when a great business is acquired at a great price is an investment deemed to be a great investment. In fact, if you can get a terrific deal on it, I’d go so far as to suggest that buying a subpar company is fantastic. This just serves to highlight the importance of “the price” in terms of investing.

The purpose of the following two chapters is to clarify “the price” for you. The price of a stock can be estimated using a valuation method. You can determine the company’s “intrinsic value” with valuation per se. Undoubtedly, The “Discounted Cash Flow (DCF) approach” is a valuation method that we employ to determine the company’s intrinsic value. The intrinsic value as determined by the DCF approach involves assessing a company’s “perceived stock price” while taking into account all potential future cash flows.

The DCF model is composed of a number of principles that are interconnected. Naturally, we must first comprehend each of these ideas on its own before applying them to DCF. We will first learn about the fundamental DCF concept known as “The Net Present Value (NPV)” in this chapter, after which we will learn about the other DCF ideas before learning about DCF as a whole.

14.2 – The future cash flow

The DCF model’s central idea is future cash flow. A straightforward example will allow us to comprehend this.

Let’s say Vishal sells the best pizzas in the area. His love of making pizzas inspires him to innovate. He creates a pizza oven that bakes pizzas automatically. He only needs to place the components for a pizza in the slots supplied, and within five minutes, a fresh pizza will emerge. He calculates that he can generate Rs. 500,000 in annual earnings and that the machine will last 10 years with this one.

George, a buddy of his, is a big fan of Vishal’s pizza maker. George offers to buy it because it is so bad.

Besides, What do you believe should be George’s minimum price to Vishal in order to purchase this machine? We must first determine how economically beneficial this machine will be for George in order to respond to this question. If he purchases this equipment today (2014), it will bring in Rs. 500,000 for him every year for the following ten years.

Especially, I was hoping you could take notice that I’ve assumed the machine will begin producing money in 2015 out of convenience.

It is obvious that George will make Rs. 50,000,00 during the course of the following ten years, after which the machine will be useless. At this point, one thing is certain: whatever the price of this gadget is, it cannot be higher than Rs. 50,000,000.

Consider whether it makes sense to pay a price that exceeds the economic advantage that an entity provides.

Let’s imagine Vishal asking George to pay “Rs. X” to the machine in order to move forward with our calculation. At this point, let’s say that George has two choices: either invest the same amount of money in a fixed deposit program that ensures his capital and gives him an interest rate of 8.5 percent or pay Rs. X and buy the machine. Assume George chooses to purchase the machine over the fixed deposit option. This suggests that George has lost out on the chance to earn risk-free interest of 8.5 percent. This represents the “opportunity cost” of choosing to purchase the device.

We have determined three significant pieces of information thus far in our attempt to determine the pricing of the robotic pizza maker:

  1. First of all, Over the following ten years, the pizza company will generate Rs. 50,000,00 in total cash flow.

  2. secondly, Since the whole cash flow is known, it also follows that the cost of the machine should be lower than the cash flow it generates overall.

  3. Thirdly, The investment option of earning 8.5 percent interest is the opportunity cost of purchasing the pizza machine.

Let’s continue while keeping the aforementioned three things in mind. Now let’s concentrate on cash flows. We are aware that George will profit from the machine for the following ten years, earning Rs. 500,000 years. Consider this: George is looking toward the future in 2014.

  1. What is the current value of the Rs. 500,000 that he will receive in 2016?

  2. What is the current value of the Rs. 500,000 that he would receive in 2018?

  3. What is the current value of the Rs. 500,000 that he will receive in 2020?

  4. How much, on average, is the present value of the future cash flow?

Surely, These questions can be answered by considering the “Time value of money.” In other words, I would be in a better position to price that machine if I could determine the value of all the projected cash flows from it in terms of today’s value.

Apart From this, Please be aware that in the section after this one, we will depart from the pizza issue.

14.3 – Time Value of Money (TMV)

Definitely, The time value of money is incredibly important in the world of finance. Almost all financial concepts use the TMV in some way. The time value of money is relevant in all areas, including discounted cash flow analysis, financial derivatives pricing, project financing, calculating annuities, etc. Consider the “Time value of money” as the engine, and the “Financial World” as the car itself.

Importantly, The idea of the time value of money is based on the idea that the value of money changes with time. In other words, a hundred rupees now may not be worth one hundred rupees in two years. In contrast, a hundred rupees in two years won’t be worth a hundred rupees now. There is always a window of opportunity as time passes. For that chance, money must be accounted for (adjusted).

Moving the “money today” through the future is necessary if we need to determine what the worth of our current currency would be in the future. The “Future Value (FV)” of the money is what is meant by this. The future money must be converted back to today’s terms if we must determine the value of money that we anticipate receiving in the future in terms of today. The “Present Value (PV)” of money is what is meant by this.

Eventually, Both times, the money must be adjusted for opportunity cost due to the passage of time. Compounding is the term used to describe this adjustment when determining the future worth of a financial asset. When we need to determine the present value of money, the process is known as “discounting.”

For that reason, I will give you the formula needed to compute the FV and PV without going into the really easy maths involved.

Example 1: Assuming an opportunity cost of 8.5 percent, what is Rs. 5000/- worth in 2014 dollars five years from now?

We are attempting to determine the future value of the money we currently possess, which is a case of future value (FV) computation.

Future Value = Amount * (Opportunity Cost Rate + 1) Age in years.

= 5000 * (1% plus 8.5%) 5

= 7518.3

This suggests that assuming an opportunity cost of 8.5 percent, Rs. 5000 today is equivalent to Rs. 7518.3 after 5 years.

Example 2: Assuming an opportunity cost of 8.5 percent, how much is Rs. 10,000/- in receivables worth today?

As we attempt to calculate the present value of future cash receipts in terms of today’s value, this is unmistakably a case of present value (PV) computation.

Amount / (1+Discount Rate) Equals Present Value Ages in years

10,000 divided by 1 plus 8.5% ^ 6

= 6129.5

Assuming a discount rate of 8.5 percent, this indicates that Rs. 10,000/- payable after 6 years is equivalent to Rs. 6,129.5 today.

Example 3: If I rephrase the first example’s question, how much is Rs. 7518.3 in receivables worth today at an opportunity cost of 8.5 percent?

We are aware that doing so necessitates computing the present value. Additionally, since we performed the opposite of this in Example 1, we are aware that the correct response is Rs. 5000. To verify this, let’s calculate the present value:

= 7518.3 / (1 plus 8.5%) 5

= 5000.0

Lastly, I suppose we are now prepared to return to the pizza problem, assuming you understand the idea of the time worth money.

14.4 – The Net Present Value of cash flows

We are still determining how much the pizza maker will cost. We are aware that in the future, George is qualified to receive a stream of cash flows as a result of owning the pizza machine.

How much is the future cash flow worth in terms of today’s money? is a query we previously posed. Please allow me to repeat it.

As can be seen, the cash flow is evenly distributed over time. Each future cash flow that is due must be discounted with the opportunity cost in order to be calculated.

Clearly, The term “Net Present Value (NPV)” refers to the total present value of all future cash flows. In this instance, the NPV is Rs. 32,80,842. This also indicates that the total present value of all future cash flows from the pizza machine is Rs. 32,80,842. This is roughly how much the pizza machine should cost George if he had to purchase it from Vishal. George must make sure the price is Rs. 32,80,842 or less, but definitely not more.

Consider this: What if a business took the place of the pizza machine? Can we discount every future cash flow the company generates to determine the value of its stock? Yes, we can accomplish this, and under the “Discounted Cash Flow” model, we actually will.

CONCLUSION

  1. Firstly, We can estimate a stock’s price using a valuation model, such as the DCF model.
  2. Next, The DCF model is composed of a number of interconnected financial ideas.
  3. As you know, One of the most important financial concepts is the “Time Value of Money,” which is used in the DCF technique among other economic theories.
  4. In Fact, The worth of money cannot be treated uniformly through time, therefore its value in today’s terms won’t necessarily be the same at some point in the future.
  5. However, We must “time travel the money” after taking opportunity cost into account in order to compare money over time.
  6. Generally, The estimated value of the money we have today at some point in the future is known as the “future value of money.”

  7. The present value of money calculates the amount of money due in the future based on its current value.

  8. Lastly, The total of all the present values of the future cash flows is what is known as the Present Net Value (NPV) of money.

Moving Average

by

Technical analysis

• Technical analysis
• Introduction
• Types of charts
• Candlesticks
• Candle sticks patterns
• Multiple candlestick Patterns
• Trading – get started
• Trading view

• Support  & resistance
• Volume trading
• News and Events
• Moving averages
• Indicators
• Fibonacci Retracements
• Notes

Firstly, We all learned about averages in school; moving averages are simply an extension of that. Moving averages are trend indicators that are widely utilized due to their ease of use and efficiency. Before we go into moving averages, let’s go over how averages are calculated.

For example, Assume five people are relaxing on a sunny beach, sipping a cool bottled beverage. Secondly, Because the sun is so bright and pleasant, each of them consumes several bottles of the beverage. Assume the final tally is something like this:

Sl No

Person

No of Bottles

1

A

7

2

B

5

3

C

6

4

D

3

5

E

8

Total # of bottles consumed

29

In this case, it would be:

=29/5
=5.8 bottles per head.

So, For example, the average tells us roughly how many bottles each person had consumed. Obviously, there would be few who had consumed more or less than the average. Person E, for example, consumed 8 bottles of beverage, which is much more than the average of 5.8 bottles. Similarly, person D drank only 3 bottles of beverage, which is much less than the average of 5.8 bottles. As a result, the average is only an estimate, and it cannot be expected to be correct.

Clearly, Extending the principle to equities, here are ITC Limited’s closing prices for the last 5 trading sessions. The previous 5-day average close is calculated as follows:

Date

Closing Price

14/07/14

344.95

15/07/14

342.35

16/07/14

344.2

17/07/14

344.25

18/07/14

344

Total

1719.75

= 1719.75 / 5
= 343.95

Hence the average closing price of ITC over the last 5 trading sessions is 343.95.

The moving average also called the simple moving average

Also, Consider the following scenario: you wish to calculate the average closing price of Marico Limited for the last five days. The information is as follows:

Date

Closing Price

21/07/14

239.2

22/07/14

240.6

23/07/14

241.8

24/07/14

242.8

25/07/14

247.9

Total

1212.3

= 1212.3/ 5
= 242.5

Since,  the average closing price of Marico over the last 5 trading sessions is 242.5

Moving forward, we have a fresh data point on the 28th of July (the 26th and 27th being Saturday and Sunday, respectively). Moreover, This means that the ‘new’ most recent five days are the 22nd, 23rd, 24th, 25th, and 28th. We will exclude the data point from the 21st because our goal is to get the most recent 5-day average.

Date

Closing Price

22/07/14

240.6

23/07/14

241.8

24/07/14

242.8

25/07/14

247.9

28/07/14

250.2

Total

1223.3

= 1223.3/ 5
= 244.66

Hence the average closing price of Marico over the last 5 trading sessions is 244.66

As you can see, to calculate the 5-day average, we used the most recent data (28th July) and eliminated the oldest data (21st July). On the 29th, we would include the 29th data point but exclude the 22nd data, on the 30th, we would include the 30th data point but exclude the 23rd data, and so on.

Furthermore, To get the most recent 5-day average, we are effectively going to the most recent data point and deleting the oldest. As a result, the term “moving” average was coined!

Absolutely, In the preceding example, the moving average is calculated using the closing prices. Moving averages are sometimes generated using additional factors such as high, low, and open. However, closing prices are primarily used by traders and investors since they indicate the price at which the market finally settles.

Definitely, Moving averages can be computed over any time period, ranging from minutes to hours to years. Based on your needs, you can choose any time window from the charting software.

Surely, For those of you who are familiar with MS Excel, here is a screenshot of how moving averages are computed. Take note of how the cell reference changes in the average formula, removing the oldest to incorporate the most recent data points.

Cell Ref

Date

Close Price

5 Day Average

Average Formula

D3

1-Jan-14

1287.7

  

D4

2-Jan-14

1279.25

  

D5

3-Jan-14

1258.95

  

D6

6-Jan-14

1249.7

  

D7

7-Jan-14

1242.4

  

D8

8-Jan-14

1268.75

1263.6

1265.05

D9

9-Jan-14

1231.2

1259.81

1274

D10

10-Jan-14

1201.75

1250.2

1245.075

D11

13-Jan-14

1159.2

1238.76

1225.725

D12

14-Jan-14

1157.25

1220.66

1200.8

D13

15-Jan-14

1141.35

1203.63

1213

D14

16-Jan-14

1152.5

1178.15

1186.275

D15

17-Jan-14

1139.5

1162.41

1177.125

D16

20-Jan-14

1140.6

1149.98

1149.35

D17

21-Jan-14

1166.35

1146.26

1148.925

D18

22-Jan-14

1165.4

1148.08

1153.85

D19

23-Jan-14

1168.25

1152.89

1158.95

As can be seen, the moving average fluctuates in response to changes in the closing price. A moving average, as determined above, is known as a ‘Simple Moving Average’ (SMA). Because we are calculating it using the most recent 5 days of data, it is known as the 5-Day SMA.

Undoubtedly, The averages for the 5 days (or any number of 5, 10, 50, 100, or 200 days) are then linked to produce a smooth curving line known as the moving average line, which moves as time passes.

In the chart below, I’ve superimposed a 5-day SMA over an ACC candlestick graph.

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So, what exactly is a moving average indicator, and how does it work? Yet, There are numerous moving average applications, and I will soon present a basic trading method based on moving averages. But first, let’s talk about the Exponential Moving Average.

The exponential moving average

Consider the data points used in this example,

Date

Closing Price

22/07/14

240.6

23/07/14

241.8

24/07/14

242.8

25/07/14

247.9

28/07/14

250.2

Total

1214.5

Despite this, When calculating the average of these statistics, an unspoken assumption is made. We are simply assigning equal weight to each data point. We assume that the data point on July 22nd is as significant as the data point on July 28th. When it comes to markets, however, this may not always be the case.

At last, Remember the fundamental premise of technical analysis: markets discount everything. This means that the most recent price you see (on July 28th) takes into account all known and unknown information. This suggests that the price on the 28th is more sacrosanct than the price on the 25th.

In addition to this, The ‘newness’ of the data should be used to allocate weightage to data points. As a result, the data point on July 28th receives the most weightage, the data point on July 25th receives the next highest weightage, the data point on July 24th receives the third highest, and so on.

By doing so, I have essentially scaled the data points according to their newness – the most recent data point receives the most attention, while the oldest data point receives the least.

Therefore, The Exponential Moving Average is calculated by taking the average of these scaled figures (EMA). Thus,  I purposefully skipped the EMA calculation because most technical analysis software allows us to drag and drop the EMA on prices. As a result, we shall concentrate on EMA’s application rather than its calculation as well as.

Not only, but also Cipla Ltd’s chart is also shown below. On Cipla’s closing prices, I’ve drawn a 50-day simple moving average (black) and a 50-day exponential moving average (red). Though both the SMA and the EMA are for a 50-day period, you can see that the EMA is more responsive to price changes and stays closer to the price.

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Even so, Because EMA prioritizes the most recent data points, it reacts to market price changes faster. Even though, This allows the trader to make more timely trading selections. As a result, traders prefer to employ the EMA rather than the SMA.

A simple application of moving average

With its own worth, the moving average can be utilized to discover buying and selling opportunities. When the stock price trades above its average price, it indicates that traders are willing to pay more for the stock. This indicates that traders believe the stock price will rise. As a result, one should consider purchasing opportunities.

Similarly, when the stock price trades below its average price, it indicates that traders are eager to sell the shares at a lower price. This indicates that traders are bearish on the stock price trend. As a result, one should consider selling opportunities.

Based on these findings, we can create a simple trading system. A trading system is a set of rules that assists you in identifying entry and exit locations.

Based on a 50-day exponential moving average, we will now attempt to develop one such trading system. Remember that a smart trading system will offer you a signal to start a trade as well as a signal to exit the transaction. The moving average trading system can be defined as follows:

 

Rule 1) When the current market price exceeds the 50-day EMA, it is time to buy (go long). When you go long, you should stay invested until the required sell condition is met.

Rule2) Exit the long position (square off) when the current market price falls below the 50-day moving average.

The graphic below depicts the trading system’s implementation on Ambuja cement. The price chart’s black line represents the 50-day exponential moving average.

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Starting from the left, the first buying opportunity arose at 165, which was indicated on the charts as B1@165. At point B1, the stock price moved above its 50-day moving average. As a result, we begin a new long position in accordance with the trading system regulation.

The trading algorithm keeps us invested until we receive an exit signal, which we eventually received at 187, denoted as S1@187. This transaction resulted in a profit of Rs.22 per share.

The following long signal arrived at B2@178, followed by a square-off signal at S2@182. This deal was less noteworthy because it only yielded a profit of Rs.4. The last trade, however, B3@165 and S3@215 were pretty spectacular, resulting in a profit of Rs.50.

Based on how the trading system performed, here is a concise summary of these trades:

Sl No

Buy Price

Sell Price

Gain/Loss

% Return

1

165

187

22

13%

2

178

182

4

2.20%

3

165

215

50

30%

The preceding table clearly shows that the first and last trades were lucrative, but the second trade was not. If you look at why this happened, you can see that the stock was trending throughout the first and third trades, but it moved sideways on the second trade.

This leads to an important conclusion concerning moving averages. Moving averages perform admirably when there is a trend but poorly when the stock swings sideways. In its most basic form, the ‘Moving average’ is a trend-following method.

I’ve noticed a few key traits from my own personal experience trading with moving averages:

1.      During a sideways market, moving averages provide numerous trading indications (buy and sell). The majority of these signals produce modest profits, if not losses.

2.      However, one of those several deals usually results in a major rally (such as the B3@165 trade), resulting in substantial gains.

3.      It would be difficult to separate the large winner from the many minor trades.

4.      As a result, the trader should not be picky about the indications the moving average algorithm suggests. In fact, the trader should engage in all of the deals recommended by the algorithm.

5.      Remember that losses are minimized in a moving average strategy, but one big transaction might compensate for all losses and provide you with significant profits.

6.      Profitable trading ensures that you remain in the trend for the duration of the trend. Sometimes it can take several months. As a result, MA can be utilized as a proxy for identifying long-term investment opportunities.

7.      The key to the MA trading system is to take all trades and not be critical of the signals given by the system.

Here’s another BPCL example: the MA system proposed many trades during the sideways market, but none of them were successful. However, the most recent trade resulted in a 67 percent profit in approximately 5 months.

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Moving average crossover system

The problem with the basic vanilla moving average approach, as it is clearly clear, is that it provides much too many trading signals in a sideways market. A moving average crossover system is an improvement on the standard moving average method. In a sideways market, it allows the trader to take fewer deals.

In an MA crossover system, instead of a single moving average, the trader mixes two moving averages. This is commonly referred to as smooth.’

Combining a 50-day EMA with a 100-day EMA is a common example of this. The shorter moving average (in this case, 50 days) is also known as the faster-moving average. The slower moving average is the longer moving average (100 days moving average).

Because the shorter moving average uses fewer data points to create the average, it tends to stick closer to the current market price and hence reacts more swiftly. Because a longer moving average requires more data points to calculate the average, it tends to deviate from the current market price. As a result, reflexes are slower.

As can be seen, the black 50-day EMA line is closer to the current market price (since it reacts faster) than the pink 100-day EMA line (as it reacts slower).

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Traders have combined the crossover strategy with the simple vanilla MA system to smooth out the entry and exit locations. The trader receives significantly fewer indications as a result of the process, but the likelihood of the transaction being lucrative is relatively high.

The crossover system’s entry and exit rules are as follows:

Rule 1) When the short-term moving averages exceed the long-term moving average, it is time to buy (new long). Stay in the business as long as this criterion is met.

Rule 2) When the short-term moving average falls below the longer-term moving average, exit the long position (square off).

Let’s use the MA crossover mechanism on the same BPCL example we looked at before. I have replicated the BPCL chart with a single 50-day MA for ease of comparison.

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When the markets were trending sideways, MA offered at least three trade signals. However, the fourth trade was a triumph, resulting in a 67 percent profit.

The figure below depicts the use of an MA crossover system with 50 and 100-day EMA.

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The pink line represents the 100-day moving average, while the black line represents the 50-day moving average. The signal to go long is generated when the 50-day moving average (short term MA) crosses over the 100-day moving average, according to the cross overrule (long term MA). An arrow has been drawn to indicate the crossover point. Please take note of how the crossover strategy keeps the trader out of the three unprofitable transactions. This is the most significant advantage of a cross-over system.

A trader can design an MA cross-over strategy using any combination. Some popular combinations for a swing trader include:

1.      Use the 9-day EMA in conjunction with the 21-day EMA for short-term trades ( upto few trading session)

2.      Use the 25-day EMA in conjunction with the 50-day EMA to identify medium-term trades (up to few weeks)

3.      Use the 50-day EMA in conjunction with the 100-day EMA to discover trades that can last for several months.

4.      Use the 100-day EMA in conjunction with the 200-day EMA to find long-term trades (investment opportunities), some of which can run for a year or more.

Remember that the larger the time range, the fewer the trade indications.

Here’s an illustration of a 25 x 50 EMA crossover. The crossover rule applies to three trading signals.

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The MA crossover strategy, of course, can also be used for intraday trading. For example, the 15 x 30 minutes crossover might be used to detect intraday possibilities. A 5 x 10-minute crossover could be used by a more aggressive trader.

You may have heard the common market adage, “The trend is your friend.” Moving averages might help you identify this friend.

Remember that moving averages are a trend-following system; as long as there is a trend, they function magnificently. It makes no difference which time frame or cross-over combo you use.

Conclusion

1.      A standard average calculation is a rapid approximation of a number series.

2.      A Moving Average is a type of average computation that uses the most recent data and excludes the oldest.

3.      All data points in the series are given equal weightage by the simple moving average (SMA).

4.      An exponential moving average (EMA) scales data based on its freshness. The most recent data is given the most weight, while the oldest is given the least weight.

5.      Use an EMA instead of an SMA for all practical applications. This is due to the EMA’s preference for the most current data points.

6.      When the current market price exceeds the EMA, the outlook is optimistic. When the current market price falls below the EMA, the outlook becomes bearish.

7.      Moving averages can cause whipsaws in a non-trending market, resulting in repeated losses. To address this, an EMA crossover mechanism is used.

8.      A typical crossover system overlays the price chart with two EMAs. The shorter the EMA, the faster the reaction, while the longer the EMA, the slower the reaction.

9.      When the faster EMA crosses and is above the slower EMA, the outlook becomes bullish. As a result, one should consider purchasing the stock. The trade lasts until the quicker EMA begins to fall below the slower EMA.

10.   The lower the trade signals, the longer the time frame for a crossover system.

 

 

Appreciation

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Even so, we launch new stock market integrated trading programs every 6 months. Despite stock market trends and conditions. While we have you here. Of course, we do not want to miss asking you to share a review. It is necessary and appreciated. our Trading community has been growing evidently. Surely, the credit goes to our mentors and our hard-working trading students. For this reason, we keep coming out with discounts and concessions on our programs. Besides, We believe each citizen has the right to learn about the market.

 

Clearly, Because we believe each student should be successful. Since our program is so powerful. So, we encourage and invite more applications, therefore. Of course, we feel proud to invite the differently abled students too. Moreover, the stock market does not care about any race, religion, family background, or religion also. Then, again, We are there to assist you with the best education. Finally, head over to our contact page to speak to our counselor. For one thing, we do not want our students to fail, which is why give regular and repeated classes too.

Equity research

by

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

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What to expect?

In this chapter, we will build a methodology for carrying out a “limited resource” equity research after establishing the context in the previous chapter. I use the term “limited resource” because there aren’t many resources available to you and me as retail investors to do equities research. These sources include the internet, MS Excel, and the annual report of the company. While an Institution has access to financial databases like Bloomberg, Reuters, Factset, and others, access to corporate management, human resources (analysts), industry publications, etc. So, using the limited tools at my disposal, I want to show how one might better understand a company and its business. Of course, we’ll approach this exercise with the ultimate goal in mind, which is deciding whether to buy or not to buy a stock.

As stated in the previous chapter, the method of doing equity research will be divided into three stages:

  1. Knowledge of the Business
  2. the use of the checklist
  3. Calculating intrinsic value (valuation) to determine the stock’s fair market value

Each of the aforementioned stages is divided into multiple steps. There is no fast way to do this, and none of these procedures should be compromised.

Stock Price vs Business Fundamentals

The first thing we do while researching a firm is to learn as much as we can about the industry. People frequently skip over this important stage and jump right into the stock price analysis. Well, if you have a short-term perspective, simply examining the stock price is fantastic. Understanding the business, though, is crucial for long-term investments.

 

You might be wondering why it’s significant. The answer is straightforward: the more you understand the business, the more likely you are to stick with your investment—especially in difficult times— (aka bear markets). Always keep in mind that during bad markets, prices react rather than business fundamentals. Knowing the firm and its operations inside and out provides you the conviction you need to continue holding the stock even if the market thinks otherwise. Bad markets are said to produce value, therefore if you have a strong belief in the company, you should think about investing in the stock during bear markets rather than actually selling it. This goes without saying, and it takes years of investing experience to grasp the reality that it is highly counter-intuitive.

 

Anyway, moving on, the company’s website and annual report are the greatest places to find information about the business. To understand how it is changing during business cycles, we need to at least review the most recent five years of annual reports.

Understanding the Business

Making a list of the questions we need to get answers to is a necessary first step in understanding the company. Please take note that you can read the company’s annual report and website to find the answers to all of these inquiries.

Here are a number of queries that, in my opinion, will aid us in our effort to comprehend the business.

These inquiries serve as discussion starters for comprehending any business. As you search for solutions, you’ll unavoidably start asking new questions that require solutions. If you use this Q&A format, it doesn’t matter which company you are considering. I have no doubt that you would significantly improve your understanding of the business. This is because participating in the Q&A process forces you to read and research the firm so extensively that you will begin to gain a deeper grasp of it.

Keep in mind that this is the first stage of the equity research procedure. Regardless of how appealing the organization appears, I would encourage you to stop further research if you notice red flags (or something amiss) while looking for the answers. Stage 2 of equity research is pointless in cases where there is a red signal.

I can tell you from experience that the first step of equity research, known as “Understanding the Company,” takes roughly 15 hours. After going through this process, I often try to write down my ideas in a way that captures all the crucial information I have learned about the organization. This fact sheet needs to be succinct and direct. If I can’t do this, it is obvious that I don’t know enough about the business. I move on to stage 2 of equity research, or “Application of Checklist,” after completing stage 1. Please keep in mind that the stages of equity research are sequential and ought to be completed in that sequence.

The second step of our equity investigation will now be conducted. Stage 2 can best be understood by putting the checklist into practice in a business.

Throughout this module, we have collaborated with Amara Raja Batteries Limited (ARBL). So I suppose it makes sense to review the checklist for the same company. Do not forget that while the firm may change, the foundation for equity research does not.

A word of warning before we continue: when we learn more about this company, the conversation will focus primarily on ARBL moving ahead. The purpose of this is not to demonstrate how effective or ineffective ARBL is, but rather to provide a framework for what I consider to be a “pretty adequate” equity research procedure.

Application of checklist

The first stage of the equity research procedure enables us to comprehend the how what, who, and why. We are better able to see the business as a whole thanks to it. No matter how appealing a business may appear to be, its financial results should also be appealing since, as they say, the proof of the pudding is in the eating.

The goal of the second stage of equity research is to aid in our understanding of the data and enable us to assess if the nature of the company and its financial performance are complementary. It is obvious that the company will not meet the criteria for an investible grade if they do not complement one another.

Let’s assess each item on the Amara Raja Batteries checklist and see what the statistics indicate. We’ll start by looking at the P&L elements for the company: Gross Profit, Net Profit, and EPS.

Earnings & Pat Growth

The rate of a company’s growth is the first indication that it might meet the criteria for the investable grade. We must look at the sales and PAT growth to assess the company’s expansion. We shall assess growth from two angles:

  1. Growth year over year will show us how much the business improves each year. Keep in mind that there are cyclical changes in industries. From that angle, it is acceptable if a company experiences flat growth. Simply make sure you assess the competition and confirm that industry-wide growth is stable.

  2. Compounded Annual Growth Rate (CAGR): The CAGR reveals how the business is developing and expanding over time and throughout business cycles. A strong, investable-grade business is typically the first to weather changes in business cycles. A healthy CAGR will eventually show this.

I favor making investments in businesses with a CAGR of over 15% that are growing (revenue and PAT).

18.6 percent is the 5-year CAGR revenue growth, while 17.01 percent is the 5-year CAGR PAT growth. These data points are intriguing and fit the definition of a healthy data set. We must still assess the other figures on the checklist, though.

The income per Share (EPS)

The profitability per share is shown by the earnings per share. The fact that the company’s EPS and PAT are increasing at comparable rates suggests that it does not dilute earnings by issuing new shares, which is positive for the existing shareholders. This can be viewed as a testament to the management’s abilities at the organization.

For FY14, the five-year EPS CAGR is 1.90 percent.

The margin of gross profits

Gross profit margins are determined using the following formula:

Profits/Net Sales in Gross

Where,

Net sales less the cost of goods sold equals gross profits.

As we learned about the inventory turnover ratio, the cost of goods sold is the price associated with producing the finished product. Let’s check how the gross profit margins of ARBL have changed over time.

The Gross Profit Margins (GPM) appear to be really impressive. The checklist demands a minimum GPM of 20 percent. ARBL has a lot more GPM than is necessary. This suggests a few things:

  1. ARBL has a privileged position within the market hierarchy. This can be due to a lack of competition in the market, which allows a select few businesses to have higher margins.

  2. Excellent operational effectiveness, which in turn reflects the management’s ability

Debt level – examine the balance sheet

The company’s profit and loss statement was mostly addressed in the first three items on the checklist. We’ll examine a couple of balance sheet items right now. The debt is among the most crucial lines on the balance sheet that we should pay close attention to. A significant degree of financial leverage is indicated by a rising level of debt. The growth that comes at the expense of financial leverage is highly risky. Also, keep in mind that a high debt level on the balance sheet indicates a high financial expense. This reduces the company’s retained earnings.

The debt status for ARBL is as follows:

Debt(INR Crs) Assessment –

Around 85Cr, the debt appears to have reached stability. In reality, the fact that the debt has decreased from FY 09–10 is good. I like to verify the debt as a percentage of “Earnings before Interest and Taxes” in addition to the interest coverage ratio (which we have already discussed) (EBIT). This only provides a brief overview of the company’s financial management. The ratio of debt to EBIT has decreased steadily, as is evident.

In my opinion, ARBL has managed its debt level effectively, which is a good thing.

Inventory Review

It only makes sense to check the inventory data if the business under evaluation is a manufacturer. Examining the inventory data benefits us in a number of ways:

  1. A growing corporation will have rising PAT indicators and rising inventory levels.

  2. A consistent number of inventory days reflects management’s operational effectiveness to some extent.

The number of days for inventory is more or less constant. In actuality, there are some indications of a minor deterioration. Please take note that we covered the calculation of the inventory number of days in the chapter before. Another encouraging aspect is that both the inventory and PAT are exhibiting a similar growth trend.

Sales against Receivables

We now examine the company’s receivables along with the sales figure. A sale supported by receivables is not a promising development. Many questions stem from the fact that it denotes credit sales. For instance, do the sales representatives of the corporation sell goods on credit? Is the business attempting to boost sales by giving suppliers tempting (but unsustainable) credit?

Here, the business has demonstrated steadiness. We might infer from the table above that a significant portion of their sales is not actually supported by receivables, which is very good. In fact, the receivables as a percentage of net sales have also exhibited symptoms of a drop, which is rather impressive, just like the inventory number of days.

Proceeds from Operations

In truth, this is among the most significant inquiries to make before choosing to invest in a business. The business should produce cash flows from operations; here is actually where the truth is revealed. There is some kind of warning sign when a business drains its operating cash flow.

Despite being somewhat unpredictable, the cash flow from operations has been positive for the past five years. This only indicates that ARBL’s primary business operations are profitable and can be deemed successful.

Income from Equity

In chapter 9 of this lesson, we spoke at length about return on equity. If you want to review it, I’ll encourage you to do so. Return on Equity (ROE) evaluates the return produced by the business in percentage while keeping the equity of the shareholders in mind. In a way, ROE gauges how profitable the company’s promoters are after investing their own money in it.

These figures are astounding. Personally, I prefer to invest in businesses with ROEs of over 20%. Keep in mind that the debt for ARBL is rather minimal. Since there is no undue financial leverage backing the good set of return on equity metrics, this is again very desired.

Conclusion

Remember that the equity research is still at stage 2. I believe ARBL will qualify for stage 2 on practically all of the necessary criteria. As an equities research analyst, you must consider stage 2’s output in light of your stage 1 findings (which deal with understanding the business). After going through these two steps, if you can form a comfortable judgment (based on facts), the company looks to have qualities that make it an attractive investment.

However, you must make sure the pricing is reasonable before purchasing the stock. We conduct exactly this in step 3 of the equity research process.

Getting started with the DCF Analysis

The preceding chapter covered “The Net Present Value (NPV)”. The DCF valuation model heavily relies on NPV. After grasping this idea, we must now comprehend a couple of additional subjects connected to the DCF valuation model. In fact, by using the DCF model for Amara Raja Batteries Limited, we shall learn more about these ideas (ARBL). This brings the third stage of equity research—the valuation—to a close.

 

Then looked at the future cash flows from the pizza machine in the previous chapter to determine the price, and we discounted those future cash flows back to determine the present value. To calculate the NPV, we totaled together all of the future cash flows’ current values. We also considered the possibility of the pizza machine being replaced by the company’s shares toward the end of the previous chapter. In that instance, all we’ll need to price the company’s shares with is an estimate of its expected future cash flows.

 

But what kind of financial flow are we referring to? And how do we predict a company’s future cash flow?

The Free Cash Flow (FCF)

The “Free Cash flow (FCF)” of the organization is the cash flow that we must take into account for the DCF Analysis. Free cash flow is essentially the surplus operational cash that the business earns after deducting capital expenses like the cost of land, buildings, and equipment purchases. After capital expenditures are taken into account, this is the money that shareholders receive. How much free cash a corporation can produce ultimately determines how healthy it is.

Free cash is the sum of money that remains after all expenses, including investments, have been met by the company.

The presence of free cash flows is a sign of a healthy business. As a result, investors frequently search for companies with discounted stock prices but strong or rising free cash flow because they assume that over time, the discrepancy will vanish and the share price will soon rise.

Therefore, free cash flow is useful in determining whether or not a company has made profits over a given year. In order to determine the company’s true financial health as an investor, consider the free cash flow in addition to the earnings.

Any company’s FCF can be easily computed by consulting the cash flow statement. The equation is –

FCF is the sum of cash from operating activities and capital outlays.

Please take note that after accounting for income tax, net cash from operating operations is calculated. The capital expenditure is shown in red, whereas the net cash from operating activities is highlighted in green.

You may now be asking yourself a reasonable question: Why calculate historical free cash flow when the goal is to determine future free cash flow? The simple explanation is that, as we work on the DCF model, we must project future free cash flow. The best method for predicting future free cash flow is to estimate historical average free cash flow and then increase free cash flow at regular intervals by a specific rate. The industry employs this routinely.

The next crucial question is how much our free cash flow will increase. So, you should anticipate a growth rate that is as conservative as feasible. Personally, I prefer to project the FCF out for at least ten years. To achieve this, I factor in a higher rate of growth for the first five years and a lower rate for the following five years. If you’re having trouble following along with this, I’ll advise you to do the following step-by-step computation.

Determine the typical free cash flow in step 1.

I start by estimating ARBL’s average cash flow for the last three years.

= 209.7 + 262.99 + (51.6) / 3

=Rs.140.36

To guarantee that we are averaging out excessive cash flows and taking into account the cyclical nature of the business, we took the average cash flow for the previous three years. For instance, ARBL’s most recent year’s cash flow was negative by Rs. 51.6 Cr. It is obvious that this does not accurately reflect ARBL’s cash flow, hence it is usually recommended to use average free cash flow estimates.

Determine the growth rate in step two.

Choose a price that seems affordable to you. The average cash flow will increase at this rate moving ahead. Typically, I develop the FCF in two stages. The first stage addresses the first five years, and the second stage addresses the subsequent last 5 years. 

With regard to ARBL specifically, I like using 18 percent for the first five years and somewhere around 10 percent for the next five. I would prefer to utilize growth rates of 15% and 10%, respectively if the company under consideration is an established business that has reached a specific size (such as a large-cap corporation). Being as conservative as you can is the goal here.

Step 3: Calculate projected cash flows.

As of 2013, there was an average cash flow of Rs. 140.26 crores. The cash flow for the years 2014 and 2015 is anticipated to be – at an 18 percent growth rate.

= 140.36 * (1 + 18 %)

= Rs. 165.62 Crs.

According to estimates, the free cash flow for the years 2015 to 2016 will be.

165.62 * (1 plus 18%)

= Rs. 195.43 Crs.

Now that we know this, we can fairly forecast the free cash flow in the future. You might be wondering how trustworthy these numbers are. Since forecasting free cash flow entails forecasting revenues, expenses, business cycles, and almost every other facet of the company. The estimated future cash flow is, after all, just that—an estimate. The key here is to assume the free cash flow growth rate while remaining as conservative as you can. For the future, we have anticipated growth rates of 18 and 10 percent, which are moderate growth rates for a successfully run business.

The Terminal Value

We have made an effort to forecast free cash flow for the next 10 years. However, what would happen to the business after ten years? Would it eventually vanish? Actually, it wouldn’t. It is believed that a business would always be a “going concern.” This implies that some free cash is produced for as long as the business is in business. The rate at which free cash is generated, however, starts to slow down as businesses get older.

 

The “Terminal Growth Rate” is the rate of free cash flow growth after 10 years (2024 onward). The terminal growth rate is typically thought to be less than 5%. Personally, I prefer to keep this rate between 3 and 4 percent, never going above that.

 

The “Terminal Value” is the total of all free cash flow that will be generated after the 10th year, also known as the terminal year. We only need to multiply the cash flow from the 10th year by the terminal growth rate to determine the terminal value. However, since we are physically calculating the value to infinity, the formula to achieve this is different.

 

FCF * (1 + Terminal Growth Rate) / Terminal Value (Discount Rate – Terminal growth rate)

 

Please take note that the FCF utilized to determine the terminal value is the one from the 10th year. Let’s determine the ARBL’s terminal value using a 9 percent discount rate and a 3.5 percent terminal growth rate.

 

= 517.12 * (1 + 3.5%) / (9 percent – 3.5 percent )

= Rs.9731.25 Crs

The Net Present Value (NPV)

The terminal value and anticipated free cash flow for the following ten years are both known (which is the future free cash flow of ARBL beyond the 10th year and up to infinity). The worth of these cash flows in today’s dollars must now be determined. This is the current value calculation, as you may remember. We will add these present values once we have determined their present values in order to calculate the ARBL’s net present value (NPV).

 

The discount rate will be set at 9 percent.

 

For instance, ARBL is anticipated to collect Rs. 195.29 Cr. in 2015–16, which is two years from now. The present value would be – at a 9 percent discount rate.

 

is 195.29 / (1+9%)2.

= Rs.164.37 Crs

 

Additionally, we must figure out the terminal value’s net present value. We just multiply the terminal value by the discount rate to arrive at this calculation.

 

= 9731.25 / (1 + 9%) 10

= Rs.4110.69 Crores

 

As a result, the sum of the cash flow present values is equal to the net present value of future free cash flows plus the terminal value.

 

= 1968.14 + 4110.69

= Rs.6078.83 Crores

 

In other words, from where I am now and going ahead, I anticipate ARBL to generate a totally free cash flow of Rs. 6078.83 Cr., all of which would belong to the company’s stockholders.

The Share Price

The DCF analysis has reached its conclusion. On the basis of the company’s projected free cash flow, we will now determine ARBL’s share price.

We now know the estimated total free cash flow that ARBL will produce. We are also aware of the number of outstanding shares on the market. We might calculate the price per share of ARBL by dividing the total free cash flow by the entire number of shares.

But first, we have to figure out how much “Net Debt” the company has based on its balance sheet. Current year total debt less current year cash and cash balance equal current year net debt.

‘

Net Debt = Total Debt for the Current Year – Cash and Cash Balance.

This would be (according to the FY14 Balance sheet) for ARBL:

Net Debt  = 75.94 – 294.5

= (Rs.218.6 Crs)

A bad omen means that the business has more cash than debt. The entire present value of free cash flows must, of course, include this.

= Rs.6078.83 Crs – (Rs. 218.6 Crs)

= Rs.6297.43 Crores

The share price of the company, also known as the company’s intrinsic value, can be calculated by dividing the aforementioned figure by the total number of shares.

Share Price is calculated as Shares Outstanding / Total Present Value of Free Cash Flow.

According to ARBL’s annual report, there are currently 17.081 billion shares outstanding. Consequently, the intrinsic value or the value per share is –

= Rs.6297.43 Crs / 17.081 Crores

~ Rs.368 per share!

This, in fact, is the final output of the DCF model.

Modeling Error & the intrinsic value band

The DCF model is predicated on a number of assumptions, despite being quite scientific. Especially in finance, assuming becomes an art form. As you continue and get more experience, you get better at it. Therefore, for all practical purposes, we should assume (yet another assumption) that we made a few mistakes when performing the intrinsic value computation. We should therefore make room for modeling inaccuracies.

Simply said, a margin for modeling error enables us to be adaptable when determining the per-share value. For what I believe to be the stock’s fundamental worth, I personally like to add a +10% upper band and a -10% lower band.

Using that to inform our calculation:

The lower intrinsic value is equal to 368 * (1- 10%), which is Rs.

additional intrinsic value=Rs.405

As a result, I would now think that the stock is fairly valued between Rs. 331 and 405, as opposed to Rs. 368 as the previous assumption. The intrinsic value band would be this.

We now check the stock’s market value while maintaining this value in context. On the basis of its current market price, we draw the following conclusions:

  1. We deem a stock to be undervalued if its price is below the lower bound of its intrinsic value band. Therefore, one should consider purchasing the stock.

  2. The stock is deemed to be reasonably priced if its price falls within the range of its intrinsic value. While it is not advisable to make a new purchase, it is still possible to hold onto the stock without adding to current positions.

  3. The stock is regarded as overvalued if its price is higher than the higher intrinsic value band. At these prices, the investor has the option of taking a profit or staying put. But you should not buy at these prices.

A share of the stock is currently trading for Rs. 726.70! Much greater than the intrinsic value band’s highest limit. Buying the stock at these prices means that one is purchasing at extraordinarily high valuations, which is obvious.

Spotting buying opportunities

Long-term investments and the activities that surround them go slowly, like a locomotive train. Contrarily, active trading is comparable to a swift bullet train. When a long-term value opportunity arises, it remains in the market for some time. It doesn’t actually vanish quickly. For instance, we now understand that the current market price of Amara Raja Batteries Limited is excessive. Trading is much above the intrinsic value band’s upper bound. But a year ago, the situation was entirely different. Remember that ARBL’s intrinsic value ranges from Rs. 331 to Rs. 405 depending on the FY 2013–2014.

 

The stock traded comfortably within the band for almost five months, as evidenced by the blue accent. The stock was available for purchase for the entire year. All you had to do after purchasing was wait for the returns to arrive!

 

Actually, it is for this very reason that it is said that bear markets produce value. The markets remained gloomy during the entire year 2013 and provided excellent purchasing opportunities in high-quality equities.

Conclusion

Three chapters ago, we looked at many facets of equity research. Equity research is just the act of examining the company from three various angles, as you may have guessed (stages).

Stage 1 involved examining the company’s qualitative features. We have now established the who, what, when, how, and why of the business. I see this level of equity research as being absolutely vital. I don’t move on if something in this is not very convincing. Markets are an ocean of possibility, so resist the urge to force yourself to commit to one that does not feel right.

Only when I am completely satisfied with my results from stage 1, do I move on to stage 2. Stage 2 is essentially the implementation of the typical checklist, where we assess the performance of the business. The checklist we’ve discussed is simply my interpretation of what, in my opinion, is a rather reasonable checklist. I would advise you to create your own checklist, but make sure each item is supported by a sound argument.

I go on to stage three of the equity research process if the business passes stages one and two. In stage 3, we assess the intrinsic value of the stock and contrast it with its market value. A stock is said to be good if it is trading for less than its intrinsic value.

You will undoubtedly be convinced to acquire the stock after all three stages coincide with your delight. Once you’ve made a purchase, hold onto it, don’t worry about the daily volatility (which is actually a benefit of capital markets), and let the market develop naturally.

Please take note that I constructed a DCF Model using Excel and have included it on ARBL. This calculator is available for download and can be used by other businesses as well.

CONCLUSION

1. Equity Research for Limited Resources can be carried out in three steps.

      1. Knowledge of the Business

      2. the use of the checklist

      3. Valuations

2. To achieve stage 1’s goal of understanding the business, we must compile all relevant business data. The Q&A method is the most effective strategy here.

3. In the Q&A format, we start by submitting a few uncomplicated queries for which we can discover solutions.

4. We should be finished with all business-related information by the time we complete stage 1 of the process.

5. The majority of the answers needed for stage 1 are available on the company’s website and annual report.

6. Do you recall that during stage one of researching the firm, it is frequently a good idea to suspend further investigation if there is something that is not very convincing about the organization?

7. In stage 1, you must get persuaded (based on facts) about the business. This is how you will strengthen your resolve to hold onto your investments during bear markets.

8. You must assess the company’s success in Stage 2 of the equity research process on a number of different fronts.

9. After the company passes stages 1 and 2 only then will you move on to stage 3.

10. By subtracting capital expenses from net cash from operating activities, the company’s free cash flow (FCF) is determined.

11. The amount of money left over for investors is tracked by free cash flow.

12. To predict the cash flow for the coming year, the most recent FCF is used.

13. The FCF must be grown at a conservative pace of growth.

14. When the company’s cash flow is anticipated to increase after the terminal year, this is known as the terminal growth rate.

15. The worth of the company’s cash flow from the terminal year up to infinity is what is known as the terminal value.

16. The terminal value must be discounted back to today’s value along with the future cash flow.

17. The total net present value of cash flows is the total discounted cash flows plus the terminal value.

18. The net debt must be subtracted from the sum of the net present values of the cash flows. We may calculate the company’s per-share value by dividing this amount by the total number of shares.

19. By adding a 10% range around the share price, one must account for modeling inaccuracies.

20. We define an intrinsic value band by adding a 10% tolerance.

21. The stock price above the intrinsic value band is regarded as pricey, while the stock price within the range is regarded as a good buy.

22. Long-term ownership of inexpensive stocks generates wealth.

23. As a result, the DCF analysis aids investors in determining if the current share price of the company is appropriate.

Volume and Trading

by

Technical analysis

• Technical analysis
• Introduction
• Types of charts
• Candlesticks
• Candle sticks patterns
• Multiple candlestick Patterns
• Trading – get started
• Trading view

• Support  & resistance
• Volume trading
• News and Events
• Moving averages
• Indicators
• Fibonacci Retracements
• Notes

Firstly, Volume is particularly important in technical analysis since it helps us confirm trends and patterns. Consider volumes to acquire insight into how other market participants perceive the market.

Secondly, Volumes show how many shares are bought and sold in a certain time period. The bigger the volume, the more active the share. For example, suppose you decide to buy 100 Amara Raja Batteries shares for $485 and I decide to sell 100 Amara Raja Batteries shares at $485. A price and quantity match occurs, resulting in a deal. You and I have created a total of 100 shares. Many people consider volume to be 200 (100 buys + 100 sales), which is not the correct way to think about volumes.

Thirdly, The hypothetical scenario below should help you understand how volumes accumulate on a normal trading day:

Sl No

Time

Buy Quantity

Sell Quantity

Price

Volume

Cumulative Volume

1

9:30 AM

400

400

62.2

400

400

2

10:30 AM

500

500

62.75

500

900

3

11:30 AM

350

350

63.1

350

1250

4

12:30 PM

150

150

63.5

150

1400

5

1:30 PM

625

625

64.75

625

2025

6

2:30 PM

475

475

64.2

475

2500

7

3:30 PM

800

800

64.5

800

3300

For example, At 9:30 a.m., 400 shares were traded at a price of 62.20. After an hour, 500 shares were trading at 62.75. If you checked the overall volume for the day at 10:30 a.m., it would be 900 (400 + 500). Similarly, at 11:30 AM, 350 shares were traded at 63.10, and the volume was 1,250 (400+500+350). And so on and so on.

At last, Here’s a live market screenshot showcasing the volumes for some of the stocks. The screenshot was taken at approximately 2:55 PM on August 5, 2014.

learning sharks

Along with, The volume for Cummins India Limited is 12,72,737 shares, as you can see. The volume on Naukri (Info Edge India Limited) is also 85,427 shares.

On the other hand, The volume information displayed here is the total volume. At 2:55 PM, a total of 12,72,737 Cummins shares were traded at various price points ranging from 634.90 (low) to 689.85 (high) (high).

While, With 35 minutes till the markets close, it is only natural for volumes to rise (assuming traders continue to trade the stock for the rest of the day). In fact, here’s another screenshot from 3:30 PM of the same group of stocks, this time with volume highlighted.

learning sharks

As well as, As you can see, Cummins India Limited’s volume has climbed from 12,72,737 to 13,49,736. As a result, the volume for Cummins India for the day is 13,49,736 shares. The volume for Naukri has climbed from 85,427 to 86,712, bringing the total volume for the day 86,712 shares. It is important to note that the quantities shown here are cumulative.

The volume trend table

Importantly, Volume information is completely meaningless on its own. We know, for example, that the volume on Cummins India is 13,49,736 shares. So, how useful is this information on its own? When you think about it, it has no merit and hence means nothing. However, when you combine today’s volume data with the previous price and volume trend, volume data becomes more important.

Moreover, A summary of how to use volume information is provided in the table below:

Sl No

Price

Volume

What is the expectation?

1

Increases

Increases

Bullish

2

Increases

Decreases

Caution – weak hands buying

3

Decreases

Increases

Bearish

4

Decreases

Decreases

Caution – weak hands selling

I believe that,  According to the first line of the table above, when the price rises alongside an increase in volume, the anticipation is bullish.

Besides, Before we get into the details of the chart above, consider this: we’re talking about an ‘increase in volume.’ What exactly does this mean? What is the starting point? Should it be an increase over the previous day’s volume or the aggregate volume over the previous week?

Surely, Traders typically compare today’s volume to the average of the previous ten days’ volume. The general rule of thumb is as follows:

High Volume = Today’s volume > last 10 days average volume

Low Volume = Today’s volume < last 10 days average volume

Average Volume = Today’s volume = last 10 days average volume

To get the last 10-day average, simply draw a moving average line on the volume bars, and you’re done. Moving averages will, of course, be covered in the following chapter.

learning sharks

Undoubtedly, The volumes are indicated by blue bars in the chart above (at the bottom of the chart). The 10-day average is indicated by the red line placed on the volume bars. As you can see, all of the volume bars that are over the 10-day average can be interpreted as the increased volume where some institutional engagement (or large involvement) has occurred.

Keeping this in mind, I recommend you look at the volume – price table.

The thought process behind the volume trend table

Clearly, When institutional investors purchase or sell, they clearly do not do so in small increments. Consider India’s LIC, which is one of the country’s largest domestic institutional investors. Indeed, Do you believe they’d acquire 500 shares of Cummins India if they bought them? They would very certainly buy 500,000 shares, if not more. Furthermore, If they bought 500,000 shares on the open market, the volume would begin to rise. Furthermore, because they are purchasing a big number of shares, the share price tends to rise. Institutional money is commonly referred to as “smart money.” It is widely assumed that smart money’ always makes better market decisions than retail traders. As a result, following smart money appears to be a prudent decision.

Especially, If both the price and the volume are rising, it can only suggest one thing: a major player is interested in the stock. Based on the concept that clever money always makes wise decisions, the expectation becomes bullish, and one should hunt for a buying opportunity in the stock.

Similarly, As a corollary, anytime you decide to buy, make sure the quantities are substantial. Yet, This implies you’re investing with smart money.

This is exactly what the first row of the volume trend table shows: as both price and volume rise, anticipation rises.

What do you believe happens when the price rises but the volume falls, as shown in the second row?

Consider it in the following terms:

  • Why is the price going up?
    1. As a result of market participants purchasing
  • Are any institutional purchasers involved in the price increase?
    1. Most likely not.
  • How would you know if there are no significant purchases by institutional investors?
    1. Simply said, if they were buying, the volumes would have climbed rather than decreased.
  • So, what does a rise in price accompanied by a decrease in volume indicate?
    1. It means that the price is rising as a result of low retail activity and ineffective purchasing. As a result, you should be wary because this could be a trap.

According to the third row, a decline in price combined with an increase in volume signals a bearish outlook in the future. Why do you believe this?

Definitely, A decline in price suggests that the stock is being sold by market players. The existence of smart money is indicated by an increase in volume. Both events (price decrease + volume increase) signal that the smart money is selling equities. Based on the notion that smart money always makes wise decisions, the expectation is bearish, and one should consider selling the stock.

Absolutely, As a corollary, whenever you decide to sell, make sure the volumes are adequate. This suggests that you, like the smart money, are selling.

Moving forward, what do you think will happen if both volume and price fall, as seen in the fourth row?

Consider it in the following terms:

  • Why is the price falling?
    1. Because players in the market are selling.
  • Are there any institutional sellers involved in the price drop?
    1. Most likely not.
  • How would you know there are no significant sell orders from institutional investors?
    1. Simply put, if they were selling, the volume would rise rather than fall.
  • So how would you interpret a drop in price and a drop in volume?
    1. It means that prices fall as a result of low retail involvement and ineffective (read: smart money) selling. As a result, you should be cautious because this could be a bear trap.

Revisiting the checklist

Let us go over the checklist again and evaluate it in terms of volume. Consider the following hypothetical technical condition in a stock:

  • The appearance of a bullish engulfing pattern – this indicates a long trade for the reasons stated above.
  • A level of support at the low of a bullish engulfing – support signals demand. As a result, the appearance of a bullish engulfing pattern around the support level indicates that there is certainly considerable demand for the stock, and the trader might consider purchasing it.
    1. The trader receives double confirmation to go long with a recognisable candlestick pattern and support at the stoploss.

In addition to this, Imagine heavy volumes on the second day of the bullish engulfing pattern, i.e. on P2, in addition to support at the low (blue candle). What conclusions can you draw from this?

Apart from this, The conclusion is obvious: big volumes and a price increase indicate that major, prominent market participants are positioning themselves to buy the stock.

Despite, All three independent factors, namely candlesticks, S&R, and volumes, point to the same move, namely going long. If you’re paying attention, this is a triple confirmation!

Also, I want to emphasise the importance of volumes in helping traders confirm trades. As a result, it is a crucial component that must be mentioned in the checklist.

The modified checklist now reads as follows:

  • First, The stock should develop a distinct candlestick pattern.
  • Second, S&R should confirm the transaction. The stop-loss price should be near S&R.
    1. For a long trade, the pattern’s low should be near the support.
    2. For a short trade, the pattern’s high should be near the resistance.
  • Third, Volumes should back up the trade.
    1. Above-average volume on both the purchase and sale days
    2. Low quantities are not encouraging, therefore feel free to be hesitant to enter a trade where volumes are low.

Conclusion

Volumes are utilised to confirm a trend. If you buy 100 shares and sell 100 shares, the overall volume is 100, not 200.

The end-of-day volume represents the total volume of trades executed throughout the day.

The existence of smart money is indicated by high volumes.

Low volumes suggest a lack of retail activity.

When you start a trade, whether long or short, always check to see if volumes confirm.

Avoid trading on days with low volume.

 

Appreciation

Undoubtedly,  learning sharks institute works hard to maintain this list of share market Training courses up to date. However, In the event of a dispute between the programs mentioned in the Learning sharks Academic Calendar and this list, the Calendar will take precedence nevertheless. In addition,  Please contact the Enrollment Desk if you have any further questions about admissions or program offerings. Nevertheless, Please contact us at feedback@learninghsharks.in to edit a program listing. Alternatively, you can reach us directly for any course queries. On the contrary, one can call our number 8595071711.

 

Even so, we launch new stock market integrated trading programs every 6 months. In spite of stock market trends and conditions. While we have you here. Of course, we do not want to miss asking you to share a review. Clearly, It is necessary and appreciated. our Trading community has been growing evidently. Surely, the credit goes to our mentors and our hard-working trading students. For this reason, we keep coming out with discounts and concessions on our programs. Besides, We believe each citizen has the right to learn about the market.

 

Because we believe each student should be successful. Since our program is so powerful. So, we encourage and invite more applications, therefore. Of course, we feel proud to invite the differently abled students too. Moreover, the stock market does not care about any race, religion, family background, or religion also. Then, again, We are there to assist you with the best education. Finally, head over to our contact page to speak to our counselor. For one thing, we do not want our students to fail, which is why give regular and repeated classes too.

Investment Due Diligence

by

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

learning sharks stock market institute

12.1 – Taking stock

Firstly, We learned how to interpret financial accounts and compute a few crucial financial ratios during the course of the previous chapters. The eventual goal of this module has its roots in these chapters: – to choose the equities to invest in using fundamental analysis. If you recall, we talked about the characteristics of investable grades in the prior chapters. The conditions for a company that must be verified before making an investment choice are defined by its investable grade features. Consider the investable grade characteristics as a checklist based on the company’s fundamentals. A business is deemed investment-worthy if it checks off the majority of the checklist’s requirements.

Here are a few areas where there are variations. For instance, you might not place as much importance on an attribute that I would consider an investable grade. For instance, although I may choose to pay close attention to corporate governance, another investor may choose to pay less attention. He might dismiss it by saying, “All businesses have some murky areas, but as long as the statistics add up, I’m okay with investing in the business.”

The key idea is that there is no set checklist. Based on his prior financial expertise, each investor must create his or her own checklist. But one must make sure that each item on the checklist is justified by reason. I’ll give a checklist that I believe is relatively well-curated later in this chapter. If you are starting from scratch, you could get some advice from this list. As we continue with this subject, we will use this checklist as a guide.

12.2-Generating a stock idea

Now, before we continue and create a checklist, we need to deal with a more fundamental problem. Choosing an intriguing stock is the first step in the investment process. After choosing the stock, we must check it against the checklist to see if it satisfies all the requirements. If so, we must invest, and if not, we must explore alternative alternatives.

So how do we choose a stock that appears appealing in the first place? How can we create a list of stocks that look worthwhile enough to research further, in other words? There are a number of ways to accomplish this, including:

General Observation: Although it may seem elementary, this is one of the best methods for creating a stock idea. All you have to do is pay attention to the economic activities around you by keeping your eyes and ears open. Keep an eye out for what individuals are purchasing and selling, what things are being consumed, and what topics are being discussed in the area. In his book “One up on Wall Street,” one of the most renowned Wall Street investors, Peter Lynch, actually recommends this strategy. Personally, I have applied this strategy to some of my investments, including PVR Cinemas Ltd., Cummins India Limited, and Info Edge Limited. I chose these companies because I noticed the proliferation of PVR multiplexes in the City, Cummins diesel generators in most of the buildings, and PVR Cinemas Ltd. (Info Edge owns naukri.com, which is probably the most preferred job portal).

Stock screener – A stock screener assists in finding stocks based on the criteria you provide and enables investors to do a thorough stock analysis. For instance, you can use a stock screener to find stocks with a 25 percent ROE and a 20 percent PAT margin. When you wish to select a small number of investment ideas from a large pool of potential investments, a stock screener is a useful tool. There are other stock screeners accessible; however, my personal favorite is the stock screener and screener on Google Finance. In.

Macro Trends – Keeping an eye on the macroeconomic trend, in general, is a terrific approach to spot high-quality stocks. Here is an example of the same: At the moment, India is pushing hard for infrastructural projects. Cement businesses operating in India would clearly benefit from this effort. So, in order to determine which cement companies are best positioned to take advantage of this macro trend, I would search through all of the cement companies and use the checklist.

Sector-specific trends are covered by this. To find developing trends and businesses inside the sector that can profit from them, one needs to monitor sectors. For instance, the market for non-alcoholic beverages is a fairly established industry. Coffee, tea, and bottled water are the three main product categories. As a result, the majority of businesses only produce and market these three items. However, there has recently been a small change in consumer preferences; a promising new market for energy drinks is emerging. As a result, the investor can look for businesses in the industry that is best positioned to benefit from and adjust to this transition.

Special Situation: This method of coming up with a stock concept is a little more difficult. For the purpose of coming up with an idea based on a unique circumstance, one must watch businesses, company-related news, corporate events, etc. One instance that comes to mind immediately is Cox & Kings. You may be aware that Cox & Kings is one of the oldest and largest travel operators in India. Mr. Keki Mistry (from HDFC Bank) joined the company’s advisory board in late 2013. Corporate India has a great deal of respect for him because he is regarded as a very ethical and effective businessperson. A coworker of mine was certain that having Mr. Keki Mistry on the board of Cox & Kings would be beneficial. This alone served as the main impetus for my colleague to look into the stock more. After more investigation, my colleague made a happy investment in Cox & Kings Limited. Good for him, I know he is sitting on a 200 percent gain as I type this.

Circle of Competence: Use this to uncover potential stock ideas by utilizing your professional expertise. For a beginner investor, this strategy comes highly recommended. You must identify stocks using this strategy within the context of your line of work. If you work in medicine, for instance, your competence circle would include the healthcare sector. You are more likely to be knowledgeable about that sector than a stockbroker or an equities research analyst.

All you have to do is locate the listed businesses in this industry and select the top ones based on your evaluation. Similar to this, if you work in banking, you probably know more about banks than anyone else. Utilize your network of expertise to choose your investments.

The key idea is that any source could serve as the impetus for researching stocks. In fact, add stocks to your list as and when you think they appear interesting. Your “watch list” will eventually be this list. It’s important to note that while a stock may not meet the checklist items right now, as time goes on and company conditions evolve, it may eventually line up with the criteria. As a result, it’s crucial to periodically assess the stocks on your watch list.

12.3 – The Moat

One must use the checklist after choosing a stock to further research it. “Investment due diligence” refers to this. One must give every part of the due diligence procedure the utmost attention because it is so important. I’ll soon give a checklist that I believe is fair. However, we must first discuss “The Moat”.

The word “moat” (sometimes known as an “economic moat”) was made popular by Warren Buffet. The phrase describes the firm’s competitive advantage (over its competitors). Strong moats ensure that a company’s long-term profits are protected. Of course, the business should be able to survive for a very long time in addition to having a moat. A business would be more sustainable if it possessed a larger range of moat qualities, such as a stronger brand identity, greater pricing power, and greater market share. It would be challenging for the business’ competitors to reduce its market share.

Consider “Eicher Motors Limited” in order to comprehend moats. A significant Indian automaker is Eicher Motors. Along with the recognizable Royal Enfield bikes, it also produces commercial vehicles. There is a sizable fan base for Royal Enfield motorcycles both inside and outside of India. Its brand memory is extremely strong. Royal Enfield serves a rapidly expanding niche market. Their motorcycles are neither as cheap as TVS motorcycles nor as pricey as Harley Davidson motorcycles.

It would be difficult for any competitor to enter this market and undermine the support that consumers have for Royal Enfield. In other words, it will take a lot of work from its rivals to push Eicher Motors out of this sweet place. One of Eicher Motors’ moats is this.

Many businesses display these fascinating moats. In actuality, a sustained moat is one of the fundamental components of great wealth-creating businesses. Consider Infosys, whose competitive advantage was labor arbitrage between the US and India, Page Industries, which had the manufacturing and distribution rights to Jockey undergarments, Prestige Industries, which produced and sold pressure cookers, Gruh Finance Limited, which had small ticket size credits distributed to a particular market segment, and so on. Decide to always invest in businesses that have wider economic moats.

12.4 – Due Diligence

The following steps are included in the equity research due diligence process:

  1. Reading the yearly reports is necessary for understanding the business.

  2. utilize the checklist, and

  3. Estimating the business’s intrinsic value is known as valuation.

In step 1, “understanding the business,” we go deeply into the industry to get to know the business from top to bottom. The questions that need responses must be compiled into a list. Posting a basic inquiry about the company, such as “What business is the company involved in,” might be a nice place to start.

Instead of using Google to seek for the solution, we look for it on the company’s website or in the most recent Annual Report. This clarifies what the business has to say about itself.

When it comes to my own investing strategy, I often prefer to invest in businesses where there is little to no government interference and little to no competition. For instance, there were only 3 listed competitors in that market when I made the decision to invest in PVR Cinemas. INOX, Cinemax, and PVR. Two publicly traded companies remain in that industry following the merger of PVR and Cinemax. However, a few new firms have recently entered this market. So it’s time for me to reconsider my PVR investment idea.

When we feel confident about our knowledge of the industry, we go to stage 2 or use the checklist. We now receive some performance-related responses.

Finally, even if a business checks every item on the checklist above, buying its stock makes little sense if it is not trading at a fair price. How can we determine whether the stock is trading at the appropriate price or not? Well, this is what stage 3 entails. We must perform a stock valuation exercise. The “Discounted Cash Flow (DCF) Analysis” is the most used method of valuation.

We will go over the foundation for conducting formal research on the company in the next chapters. It is known as “Equity Research.” Our discussion of equity research will be mostly centered on Stages 2 and 3, as I believe Stage 1 entails reading the annual report quite thoroughly.

CONCLUSION

  1. Any source can provide a stock concept.
  2. It is a good idea to keep a watch list of stocks that you find intriguing.
  3. After a stock has been located, we ought to search for sustainable moats.
  4. Understanding the business, going through the checklist to understand its financial performance, and performing the valuation exercise is all part of the due diligence process.
  5. One should be entirely comprehensive with the business operation of the organization when it comes to knowing the business.
  6. As the investor gets to experience it, the checklist should be adjusted accordingly.
  7. One of the greatest methods for determining the business’s intrinsic worth is the DCF approach.