In your interest

The accuracy with which an investor predicts the market direction can determine his success quotient. Big market players like hedge funds and banks use statistical and quantitative forecasting models to judge the near- or medium-term market sentiment, but these are too complicated for retail participants. While most investors rely on technical analysis, derivative market tools can also help judge the cash market direction. The most effective of these tools are open interest and futures prices. Considered simultaneously, they give an idea of the upcoming opportunities. Let us look at open interest.

Open interest is the total number of outstanding positions in the futures and options market at the end of the day. In other words, these are the unsettled contracts. Suppose A buys 20 futures contracts from B (futures seller) on May 3. The open interest for May 3 will be 20. On May 4, C buys 25 futures contracts from D (futures seller); the open interest for May 4 will rise to 45. On May 5, A squares off his position. If the counterparty is B or D, the open interest will fall to 25. But if the counterparty is a new entrant E, the open interest will be unchanged at 45. This is because though A has offset his position, E's position is still open.

Open interest is the most widely tracked indicator and is reported in real time. If it is positive, it implies an increase in open positions, and if it is negative, it means a fall in open positions. An increase in open interest along with a rise in price confirms near-term market bullishness, while a flat open interest along with an increase or decrease in price indicates a possible trend reversal. It is advisable to use average open interest along with the daily open interest and futures prices while predicting the cash market direction. Here are some open interest rules:

Rising prices and rising open interest: If prices are rising and open interest is moving above its average, it indicates buying interest. It means more participants with long positions are entering the market, indicating bullishness.

Rising prices and falling open interest: If prices are rising but open interest is going down at a rate higher than its average, it indicates bearishness. It signifies that prices are rising due to short covering, not due to any fundamental factors. A fall in open interest implies that the money is flowing out of the market.

Falling prices and rising open interest: If prices fall and open interest rises (more than its average), it shows bearishness. This is due to an increase in short positions that cause a price fall. The market will fall till investors continue to enter short positions.

Falling prices and falling open interest: If price falls along with the above-average fall in open interest, it shows a very short-term bearishness. Both go down as investors with long positions exit the market. Analysts describe this as a predecessor of a strengthening market as the price fall will stop when all disgruntled long position holders exit their positions. The falling open interest means no new aggressive short-sellers are entering the market.

Open interest numbers are available on the Webistes of the NSE and the BSE and investors must consider these along with prices and other technical analysis indicators for predicting market.

How Stocks Trade & how price movement take place

Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. In the beginning most exchanges are physical locations where transactions are carried out on a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made electronically. Most of the markets use this type of trading only.

The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. Really, a stock market is nothing more than a super-sophisticated farmers’ market linking buyers and sellers.

Before we go on, we should know the difference between the primary market and the secondary market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company’s stock does not directly involve that company.

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don’t equate a company’s value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at Rs100 per share and has 1 million shares outstanding has a lesser value than a company that trades at Rs 50 that has 5 million shares outstanding (RS100 x 1 million = Rs100 million while Rs50 x 5 million = Rs 250 million). To further complicate things, the price of a stock doesn’t only reflect a company’s current value; it also reflects the growth that investors expect in the future.

The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn’t going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Market watches with extreme attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company’s results surprise (are better than expected), the price jumps up. If a company’s results disappoint (are worse than expected), then the price will fall.

Of course, it’s not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Chaikin oscillator or moving average convergence divergence.

So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn’t possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly.

The important conclusion grasp about this subject are the following:

• At the most fundamental level, supply and demand in the market determines stock prices.

• Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.

• Theoretically, earnings are what affect investors’ valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors’ sentiments, attitudes and expectations that ultimately affect stock prices.

• There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain everything.

Taking stock of price trends

“I just missed the bus,” said an investor once he saw the stocks that had become the top gainers of the day. Every trading session leaves behind top gainers and top losers of the day.

One can become a billionaire in no time by buying stocks in advance that consequently become top gainers and going short on scrips, which later turn top losers.

However, it is difficult to have such a right timing unless you are incredibly lucky, but one can always use some of the trading strategies with stocks that figure among top gainers and losers.

SundayET tries to bring to you the trading strategies but before that let’s try to understand the kind of price trends that are generally observed. Either the price trend continues for a few days before there is a reversal or the trend reverses on very second day.

Look for volume
In several cases the trend continues for a few days. For instance, Sundaram Brake Linings was one of the major losers in the National Stock Exchange on June 2, 2009, and kept losing in consequent days.

It finally closed at Rs 165 on June 4, from Rs 200 three days ago. Similarly, SKM Egg Products Export was one of the top gainers on May 27, 2009 and the trend continued till June 1, when it closed at Rs 29.

According to RK Gupta, MD at Taurus Asset Management, investors should not look at these stocks for longterm investment opportunity but shortterm trading. One should look at two things, price movement and trading volume, before taking any decision.

If the price of any stock is moving north and is supported by higher volume, most likely the trend may continue for a few more days. Similarly, declining prices with high trading volume indicate that prices may fall further.

Hence, if you observe a high volume built up on the stock you can take a position in the direction of the trend. This means if the price is going up you should buy.

Get fundamentals right

However, if you already have shares of any company and you want to book profit seeing the rise in the price before you sell, you must see the volume that the share has. In case the share prices are rising supported by strong volume, you should not sell all the stocks in one go.

Instead, one should go for gradual profit booking. Similarly, if the prices are falling dismally, you should not jump to buy the stocks even if the valuation looks compelling, rather one should wait for the prices to correct further and the trend to reverse.

Get fundamentals right:

However, one must differentiate between a fundamental story and a market-driven wave. “When an investor wishes to make money in the short term through several trading strategies, he/she should not consider the fundamental story behind the stock because the fundamental story would bear the fruits in long term,” said Mr Gupta.

Stop loss to be winner
In several cases, the cycles are much shorter. A company, which figures in the table of top gainers today, may be found out among the top losers tomorrow.

For instance, Ranbaxy Laboratories gained as much as 21% on May 25, 2009, but on very next day it lost around 8% to close at Rs 244. To avoid such losses one must use stop loss option. It is disappointing that almost 90% of the investors don’t put stop loss, says, Motilal Oswal, chairman & MD of Motilal Oswal Financial Services. “Winners of the stock market are those who use the stop-loss option,” he adds.

One must use ‘trailing stop-loss order’, which helps in gaining the maximum, while limiting the downside. Under the option of trailing stop loss, an investor fixes the stop loss price in percentage terms and not in absolute terms.

Thus, if the price of the particular scrip goes up, the stop loss price also moves up simultaneously. But in case, the price falls the stop loss price doesn’t change and gets triggered once the price touches the stop loss order price.