Setting up a trading system technical analysis-I(part II)

The dynamics of the stock market is changing every day. Easy money cannot be made from it anymore. There is actually no room for those traders who depend on blatant speculation and ignore studies. In the last one and half year the benchmark Index has given 50% returns but majority of retail participants have not even earned 10% profits on their portfolio. The reason behind this is the lack of basic knowledge, information and rational thinking.

If one wants to construct their monument of success, one needs a proper toolbox i.e, an effective Trading System, the principal components of which are the below mentioned tools:

  • Data Analysis
  • Fundamental Analysis
  • Technical Analysis
  • Macro News/Event Analysis

No single component can predict the markets effectively; hence one should use all the tools collectively to study the market. One needs to have idea as to which tool is to be used, when and how. One needs to have comprehensive idea about the strengths and limitations of each tool, so that one could use them effectively. It is beyond any argument that nothing is certain in the Stock Market and there is no theory in this earth which could predict the Markets with definite certainty; since not all the participants are rational. However, what one could do at best, is to make a logical guess and to incorporate the logic, one needs the above tools i.e. they need a proper ‘Trading System’.

We shall discuss each of above tool briefly in this Article. This article is not meant for an expert analyst, but for general retail participants, who are interested to participate in the Stock Markets in an informed manner.

‘A Trading System is nothing but a noise free environment, one trading terminal and the Tool Box’

It should be noted that the strength of any individual tool is not very high but the collective strength of all the tools put together is very high. Like one cannot build a wooden structure only with a hammer; other tools like handsaw, Sandpaper, Planer, Screwdriver, Measure Tape etc are also needed. Similarly, if one tries to tackle the market with any single tool, he/she will not succeed.  Also, if one applies screw driver for cutting a piece of wood, the problem will arise. Similarly, one needs to have the knowledge about when and how to use a particular trading tool and what are its strengths and limitations.

For example, the technical chart of a particular Stock Future provides three resistance levels but it does not specify whether the stock will breach the resistance or not. It is simply saying that if the stock goes up then it could reach level 1, level 2 or level 3. It is also saying that the chart pattern is bullish. Now, at this moment, if the OI data of this particular stock future suggests it will rise, then it would be easy for an investor to take the trading decision. Further, if there is any positive news, in addition, at this moment, the combined signal will be strong enough to suggest that the stock will go up. When ARSS Infra, for example, was trading above Rs. 1000, its technical chart appeared good plenty of times and a strong buy signal was generated. Some traders bought and booked the profits at higher levels but many traders bought and are still holding the stock at the current level of Rs. 50. The price was good but the valuation was terribly stretched. Technical analysts will say, there was stop loss but how many retail clients maintain stop loss diligently? Therefore, trading in fundamentally poor stock is always risky. Traders need technical analysis of fundamentally strong stocks. Price is important, but valuation is also important. On the other hand, apart from very long term investments, if you are looking for a logical entry point in a fundamentally good stock, the chart might provide you that help. A particular stock might be very strong fundamentally, but a wrong entry and exit could wipe out your capital. There is absolutely no clash between technical analysis and fundamental or data analysis; rather they are intimate friends to each other. It is not a very wise idea to create self imposed clash between technical analysis and data analysis or fundamental analysis.

Let us start our discussion with very simple data analysis, which are apparently known to many but is not applied as often.

Data Analysis

When people see the last 5 ‘buy’ and ‘sell’ bids and the total quantity of ‘buy’ and ‘sell’ orders by pressing F6 on the Trading Screen, and if the number of buyers exceeds number of sellers in any particular scrip, they think that the price will inevitably rise. This is not always true. This does not work in many cases, especially in any liquid scrip or any F&O scrip. In cash stocks, however, where liquidity is less, F6 picture works some time and any significant difference between buyers and sellers often indicate the intraday trend. While using F6, always remember that traders have the option, while placing orders, to not disclose the full quantity of their bid.

In case of many midcap stocks, whose Futures and Options are not traded, there is a good indicator which suggests a trend for short to medium term. If the percentage of deliverable quantity to total traded quantity rises with the increase in price, it implies delivery based buying and the medium term trend goes up and the chances of price increase of the stock in the short to medium term increases. The reverse also holds true, when delivery percentage rises with fall in prices, it implies delivery based selling and the short to medium term trend goes down. Any single day’s data would not suggest any thing; one needs to watch the delivery percentage of one or few selected stocks for few days. This data is available on the website of NSE. However, as discussed earlier, it would not be wise to take buy or sell decision only on this basis, it is just an indicator and one needs to consult the charts as well to make trading decision. In case of many quality midcaps, where liquidity is very low the charts do not work effectively; continuous price rise (may be little) with high delivery percentage and rise in volume strongly indicate the possibility of price rise in short to medium term.

FII Data

We all appreciate that FII (Foreign Institutional Investor) activities are the key driver of our domestic markets. Therefore, data related to FII activities are extremely important. We have their data available for the Cash segment, F&O and Debt Segment.

FII data in Cash Segment is very important to get an idea about the medium term trend. Continuous selling by FIIs in cash segment implies delivery based selling and that could downplay the medium term trend. Daily provisional data is available on the NSE website as early as 6 PM on the same day, however final data is available on NSDL website later. Apart from the daily data, historical data archive is also available on the NSDL website.

FIIs data in the Derivatives Segment is very important to get an idea about very short term trend or maybe the next day’s trend. In case of net buy figure, it is important to analyse whether there is fresh long addition or short covering. Similarly, in case of net sell figure, it is important to check whether there is fresh short addition or long liquidation. It is generally observed that fresh long addition is more bullish than short covering and short addition is more bearish than long liquidation. Another aspect is that not only the daily net buy or sell figure, but the cumulative net long and short position as on date is also very important, to see that FIIs are in net long or in net short and the ratio of their net long position and net short position in Index Future also holds importance.  Any abnormal ratio generally does not sustain and is corrected in due course. For example, in the month of March, the ratio of net long and short contract in Index Future reached almost 8:1, which is presently 1:1 and as a result, Nifty has corrected almost 1000 points. Not only in Index Futures, but traders should also note the net buy and sell figure in Index Options.

FIIs derivatives data is available on NSE website under the heading – Products –> Equity Derivatives –> Current Market Reports –> View all daily reports –> FII Derivative Statistics and participant wise open interest.

Other Derivatives Data

Another very important aspect is Open Interest data in Index Futures and Stock Futures. General theory is, rise in OI with rise in price implies long addition whereas rise in OI with fall in price implies short addition, fall in OI with rise in price implies short covering and fall in OI with fall in price implies long liquidation (if the stock already rallied) or short profit booking (if the stock already hammered). It is generally observed that, on intraday basis, if any particular stock rises moderately with a decent rise in OI in the first hour of trade, that particular stock future may rise further on the same day, if other conditions remain in favor and if there is sufficient volume. This is extremely helpful for intraday trades in Futures, particularly when the intraday chart of this particular stock shows any strong bullishness or break out. This is true in case of stock futures as well as in Index Futures. Such change in OI and Price are available on the trading terminal itself and also on various technical software, NSE website, etc.

On an end-of-day basis, the analysis of price, OI and volume of the stock futures helps a trader to organize the trading strategy for next day. However, the desired result may not be seen next day itself, in few cases, and it could be seen after few sessions and in these cases you need to follow the price action of the particular stock. Once again, do not forget to consult the corresponding chart. If you get the same signal from the chart and data, the probability of profitable trade gets higher and your conviction will enhance. However, if you can analyze such data for a particular stock future on daily basis, say for a period of one entire clearing, you will find amazing result. In such cases, a perfect blend of Chart and Data can give amazing results.

Another very important data is Cost of carry (CoC). In case of Index Future, Nifty and Bank Nifty, correlation of CoC with OI and Price is important to understand the trend. Cost of carry is an indicator of the demand-supply forces in the Futures market. It basically means the annualized interest cost players decides to pay (receive) for buying (selling) a respective contract or simply it is the difference between Future Price and Spot price i.e, Premium. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is more interpretable being an annualized figure as compared to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and Open Interest in highlighting the market trend. The theory is Change in CoC seen along with open interest shapes a clear picture of broader sentiment for the stock or index. For a rising OI, an increase in CoC indicates accumulation of long(or bullish) positions, while an accompanied fall in the CoC indicates addition of short positions and bearishness. Likewise, a fall in OI, accompanied with a rise in CoC, indicates closure of short positions. A falling of both OI and CoC indicates that traders are closing long positions. Thus, you can understand whether long or short is entering into the system.

Now let us discuss one of the most important data- Option Table. Nifty Option table is one of the most significant inputs which are provided by NSE on their website, on real time basis. This data is also available in the trading terminal but all strike prices are displayed in the Option Table at one time, which is much more effective.

The basic concept of Option data is that FIIs and HNIs generally prefer to write options at ATM or near to OTM or ITM strikes, rather than buying option while,  the retail category generally prefers buying option.  Writing options involve margins and buying options involve payment of only premium amount, so higher investment is required for writing and hence it is generally opted by the big players. It is needless to mention that in majority cases option writers only win the game. After the shift of Option style from American to European few years back, writing option has been rising sharply thereby volume in option trading has increased significantly which in turn has provided unbelievable depth and liquidity in Nifty.

Now, based on the above theory, any rise in open interest at ATM/near to OTM strike on Put side implies the support and on call side, it implies resistance. The strike at which highest OI is accumulated on Put side is treated as best support and highest OI is accumulated on call side is best resistance. Thus, a trading range is emerged from the option data, which could be utilized in trading. Further, on intraday basis, if you find that OI is being added at ATM strike on call side and/or OI is being liquidated at ATM strikes on Put side, it is an alarm for the bulls and similarly the addition on Put side and liquidation on call side is an alarm for the bears. For example, Nifty is trading at 8140, now if 8100-8200PE adds OI then it implies 8100 support will work and it may move towards 8200. On the other hand, if 8200-8100CE adds OI and 8200-8100PE liquidates OI, it will suggest 8100 support is weak and may be broken soon. Another example is, suppose Nifty is trading at 8140 and a sudden fall takes it to 8080 – now if OI at 8100PE is not liquidated and/or OI at 8100CE is not added, the chance of recovery gets higher. Study and analysis of Option table gives fantastic result in intraday trades as well as in next day’s trade. Sometimes, you may not get the desired effect on the same day or on very next day but you would definitely find it shortly, until and unless the Option data changes rapidly and drastically.

Technical Charts gives several resistance levels and support levels. Suppose, for a counter A, current price is 100, resistance levels are 110, 120 and 130. Now, what will you do? Will you sell at 109.90 and then if it crossed 110, buy again at 110.20 then again sell at 119.90 and then again buy at 121 and finally sell at 130? If you can do so, nothing like that. However, if the data gives you confidence before 1st resistance level that it will breach the 1st resistance and will move higher then you may hold and wait for 2nd resistance or 3rd resistance. However, this does not mean that you don’t need the technical levels of resistance. It is definitely required otherwise you will continue to hold and counter will rise and then will start booking profit and you will miss the entire profit. Therefore, if you interpolate the chart and data, your chance of making profits enhances immensely and even taking trading decision will be easier.

There is another important data, with respect to Nifty, called PCR or Put Call Ratio. PCR is simply derived from dividing Put Volume by Call Volume on daily basis. It is observed that PCR 1 is neutral, 0.80 is oversold zone and 1.20 is overbought zone. If after a big fall, PCR reaches or goes below 0.80, chance of pullback is high. Similarly, if after a big rise, PCR reaches or goes above 1.20, chance of correction is high. Now imagine, if RSI goes close to 30 and PCR goes below 0.80, the chance of pullback gets higher. However, do keep in mind that any scrip could spend longer than expected time at oversold zone or overbought zone, which largely depends on the prevailing sentiment.

In the next series, we shall start a brief discussion on Technical Analysis.


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