AVAIL TAX REBATE AND TAX-FREE INTEREST EVERY YEAR!
TABLE SHOWING THE MATURITY VALUE AND THE TAX REBATE AND TAX-FREE INTEREST ACCRUAL IF Rs.1000/- is deposited per month from 1st to 5th of April for 15 years in PPF account.
Compound Interest Rate 9 %
Year
Opening Balance
Amount of deposit
( Rs.1000 per month)
Tax free interest accrued
Closing Balance
Tax rebate earned @ rate of 20%
year-opening balance--depost--tax free intrest accrued--closing balanc--tax rebat
1---0-----------------12000---585-----------------------12585-----------2400
2--12585--------------12000---1718----------------------26303-----------2400
3--26303--------------12000---2952----------------------41255-----------2400
4--41255--------------12000---4298----------------------57553-----------2400
5--57533--------------12000---5765----------------------75318-----------2400
6--75318--------------12000---7364----------------------94686-----------2400
7--94686--------------12000---9106----------------------115788----------2400
8--115788-------------12000---11006---------------------138794----------2400
9--138794-------------12000---13076---------------------163870----------2400
10-163870-------------12000---15333---------------------191203----------2400
11-191203-------------12000---17793---------------------220996----------2400
12-220996-------------12000---20475---------------------253471----------2400
13-253471-------------12000---23397---------------------288868----------2400
14-288868-------------12000---26583---------------------327451----------2400
15-327451-------------12000---30056---------------------369507----------2400
16-369507-------------12000---33841---------------------415348----------2400
total-----------------192000--223348------------------------------------38400
thus for 12000 annual contribution interest is=RS223348
hence for 70000 annual contribution interest=
=70000*16*223348/192000=1302863.3
add contribution of RS 1120000.00
TOTAL-----------------RS2422863.3 TWENTY FOR LAKH TWENTY TWO THOUSAND EIGHT HUNDRED SIXTY THREE ONLY IF OUT OF INTREST OF RS 800000/ THE PPF CONTRIBUTION OF 70000/ PER YEAR IS PAID THEN TOTAL AMOUNT IN 16TH YEAR WILL BE =3222863. A 400% RISE IN 16 YEAR. SO PER YEAR YEILD 25%
Public Provident Fund Scheme is a boon to self employed professionals, business people and Executives
Invest in Public Provident Account and gift it to your Children. See the investment grows with your Children!
Table showing the maturity value of PPF accounts if Rs.10000/- is deposited as birthday gift every year —Rate of compound interest 9% p.a
Age Amount of deposit in Rs.
Maturity value
In Rs.
Quantum of growth (Gain to depositors)
AGE----AMOUNT OF DEPOSIT-MATURITY VALUE--QUANTUM OF GROWTH
16 YEARS-160000----------359737----------2.5 TIMES OF REPORT
21Years--210000----------618733----------2.95 TIMES OF REPORT
26 YEARS-260000----------1017232---------3.91 TIMES OF REPORT
At the age of 26 Rs. Ten thousand deposit every year earns the maturity amount of TEN LAKHS SEVENTEEN THOUSAND! At the end of 25 years.
Amount of monthly deposit per month in Rs.
Maturity value at the end ( in lakhs)
AMOUNT MONTHLY DEPOSIT IN RS-MATURITY VAALUE IN LAKH AT THE END OF
-------------------------AGE 16 YEARS--AGE 21 YEARS-AGE 26 YEARS
1-------500------------------2.07----------3.57---------5.87
2-------1000-----------------4.15----------7.14---------11.74
3.------1500-----------------6.21----------10.71--------17.61
4.------2000-----------------8.30----------14.28--------23.48
5.------2500----------------1035-----------17.85--------24.32
6.------3000----------------12.45----------21.42--------34.22
Public Sector Employees: Under this scheme there is a return of 9.5% payable half-yearly on 30th June and 31st December respectively. There is a minimum investment limitation of Rs.1000/- and the maximum limitation is the amount equal to total retirement benefit. It can be operated by retired PSU employees in his/her own name or with the spouse, jointly. In this scheme, there is a facility of premature encashment. Entire balance or part thereof can be withdrawn after the expiry of three years from the date of deposit. Maturity period of this scheme is 3 years. According to Income Tax Act, 1961 interest on this scheme is tax free.
To give an example of the power of compounding-
For those that know what a "covered call" is-
Professional covered call traders attempt a return of 2% per month. I have had traders laugh at that return as insignificant and have even seen traders call a return of that size "pointless."
Let's look at it-
Take a $200K account, and compound 2% monthly-
After 5 years, you would have over $500K. Not a bad return.
After 10 years, you would have over $1.7 Million. Looks like a pretty good retirement amount in a decade.
After 15 years, you would be up to almost 6 million. Retiring in a bit of style now.
After 20 years, you would have over 19 Million Hello Private Jet.
After 25 Years, you would have over $62 Million. Hamptons time!
After 30 years, you would have over $200 Million. I'd say that beats the heck out of a 401K.
$200 Million is insignificant and pointless?
Learn to Invest - The Power of Compound Interest
As you learn to invest compound interest is fundamental for long term success for investors and traders who wish to beat the market. According to various sources, Albert Einstein stated that compound interest is "the greatest mathematical discovery of all time." He is also attributed to have claimed that compounding is the eighth wonder of the world. We are not sure about that claim (though who are we to argue with Albert Einstein), but we believe that compound interest is key to long term success in the financial markets.
Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding. Compounding requires three things to be successful:
1.An investment that creates a positive return. Compounding works on investments that have negative returns as well, but that is a different story on risk and money management.
2.The reinvestment of the earnings.
3.Time for the reinvested earnings to generate more revenue. The more time you reinvest your earnings the more the value of your investment will accelerate.
For example, let's say your father was so happy that you graduated from college that he gave you $10,000. Since you know about compound interest (having read this article) you invest the $10,000 in a mutual fund that is able to return 10% in the first year. At the end of the year you would have earned $1,000 ($10,000*10%), and the value of your investment would now be $11,000. Now you invest the $11,000 for the second year in the same investment at the same 10%. At the end of year two you would have earned $1,100, $100 more than the first year. This additional $100 is due to compounding. The increase in the amount made each year continues until you close out of your investment.
Now let's say that another father was so happy that his twin children, T.J. and C.J., graduated from college that he gave each of them $20,000. (Some children are more fortunate than others.) T.J., the brother, had not learned about compounding from this site, so he spent $10,000 and kept the remaining $10,000 in his checking account. He did not want his father to claim he wasted all his money. Now C.J., the sister, had learned about compounding from this site and she invested her $20,000 in a fund that earned 10% compounded annually. After five years she had $32,210. That year the twins talked about investing and she suggested that her brother learn about compounding. He followed her advice and visited Trading Online Markets to learn the power of compounding. T.J. then invested his $10,000 he had in his checking account in a fund that earned 10% compounded annually.
Ten years after the twins had received their $20,000 they got together to compare their investments. C.J. had $51,875 and her brother had $16,105. Getting together again twenty years after they had received their money they again compared their results. C.J. had $134,500 and T.J. had $41,772. Thirty years after receiving their money T.J. had $108,347. He was hoping he might be getting close to what his sister had. Well when they got together to compare results he found out just how powerful compounding really is, for she had $348,988.
This example shows how the power of compounding can work for you. The secret is to invest wisely, save as much as you can and minimize your losses. In summary:
•Invest early, since you generate the benefits of compounding and it is very hard, if not impossible to catch up.
•Reinvest your income to generate more income. Time works in your favor.
•Leave your principle in place so you can continue to generate income to compound.
Using compounding is not a get rich quickly scheme. Rather it is one of the key principle to get rich over time. All successful investors take advantage of compounding. You should as well.
HOW TO EARN RUPEES ONE CRORE IN TEN YEARS
SUPPOSE YOU ARE HAVING RS 60 LAKH AS ON 1/4/2012.
INVEST THE ENTIRE AMOUNT IN F.D. YUO WILL GET INTEREST OF RS 6,00,000 ON 31/3/2013
1.REINVEST INT RS 5LAKH + PTINCIPAL OF 60 LAKH , GET INT OF RS6,50,000 ON 31/3/2014
2.REINVEST INT RS5 LAKH+ PRINCIPAL OF 65 LAKH, GET INTEREST RS7,00,000 ON 31/3/2015
3REINVEST INT RS 5 LAKH+ PRINCIPAL 70 LAKH, GET INT OF RS7,50,000 ON 31/3/2016
4.REINVEST INT RS 5LAKH+PRINCIPAL 75 LAKH, GET INT OF RS 8,00,000 ON 31/3/2017
5.REINVEST INT RS 5LAKH+PRINCIPAL 80 LAKH, GET INT OF RS 8,50,000 ON 31/3/2018
6.REINVEST INT RS 5 LAKH+ PRINCIPAL 85LAKH, GET INT OF RS 9,00,000 ON 31/3/2019
7.REINVEST INT RS 5 LAKH+ PRINCIPAL 90 LAKH, GET INT OF RS 9,50,000 ON 31/3/2020
8 REINVEST INT RS 5 LAKH+ PRINCIPAL 95 LAKH, GET INT OF RS 10,00,000 ON 21/3/2021
9. REINVEST INT RS 5 LAKH+ PRINCIPAL 100LAKH, GET INT OF RS 10,50,000 ON 31/3/2022
THUS IN TEN YEARS YOU WILL GET RS ONE CRORE 15 LAKH BY REINVESTMENT OF INTEREST AND YOU WILL EARN RS 10 LAKH INTEREST PET MONTH. YOU CAN SPEND RS 5LAKH PER YEAR AND CONTINUE REINVESTMENT OF RS 5 LAKH PER YEAR.
Top Five Reasons To Sell Covered Calls
.Investors who sell covered calls know it's a proven strategy that every-day investors as well as large hedge funds use to generate income on a monthly basis. It's not unrealistic to generate 3% to 5% per month.
An experienced investor who knows the ins and outs of selling options (also called writing covered calls) can earn 4% a month without taking much risk; that's a return 48% annualized, and if compounded, meaning no money is withdrawn and all profits reinvested, 60%! Higher returns in the 5% to 8%, and sometimes 10% a month are certainly possible if you get a stock in an uptrend and are capturing premiums as well as stock appreciation.
1. When you sell a call option you create CASH FLOW! If you are a "buy and holder", then collect some easy monthly rent and super size your returns!
2. Selling covered calls is lucrative; you can earn 3% to 5% per month.
Related CoverageSelling OTM Covered Calls
Selling covered calls is a great way to gain a monthly income from a stock that you already own. Selling out of the money calls can benefit you in two ways.
Steps to Selling Covered Calls
Selling covered calls is a very effective strategy in the stock market. It lets you make continuous cash flow from a stock that you already own and can have a huge effect on your annual return. So how do you set up a covered call trade?
Advantages of Selling Covered Calls
Selling Covered calls is a great strategy to help you create consistent cash flow from the stock market. It can significantly help you to increase the return of just buying and holding.
Selling Covered Calls For Extra Income
Do you need to squeeze more cash out of your portfolio? Selling covered calls is a conservative strategy that many income investors use to create extra passive income. This short term strategy will also give you some extra downside protection, by lowering the breakeven cost on your stocks.A $50,000 portfolio compounded at 4% monthly yields $524,288 in 5 years!
3. You can sell options in any market; there are strategies for bull markets, bear markets and sideways markets.
4. Covered calls are conservative with limited risk; they can be combined with puts for the ultimate in downside protection or sell at-the-money or in-the-money calls for fatter premiums that lower your cost basis.
5. The process is not time consuming; no staring at your computer for hours a day.
The Rules of the Game
* Successful sellers/writers depend on quality stocks. Pick rock-solid stocks with strong earnings per share (EPS) and know where the stock's support and resistance points are located. There are some high quality covered call screeners available.
* DO NOT be seduced by fat, juicy call premiums! This is where many inexperienced investors go wrong; they see a whopper of a premium and go for it. If you pick a stock that is incredibly volatile, you could be down $5.00 on the stock before you know it.
* Plan your trade and execute. Know the current stock market trend, your stock's trend, any upcoming news like earnings that may make things a little unpredictable.
* Consider dividend-paying stocks to help offset margin interest or just boost returns. Stocks like Merck pay almost a 5% dividend and are volatile enough to have nice call premiums. This is the best of both worlds.
* Use a protective put strategy for the ultimate in protection. If the stock tanks, you still make money!
What does it take to write covered calls profitably month after month?
* Successful covered call writing requires knowledge and skill; all of which can be acquired.
* You need to be focused to learn about the process, ask questions, and get help where needed.
Fortunately, there are a lot of resources. As a trader, it's important to really understand that we can no nothing to control or beat the market. That may sound odd; the market is there every day doing its thing. If a surfer is on a wave and it's not going his / her way, they get off and find another one!
That's what experienced investors do. If for some reason the trade is not performing, then you mange it accordingly, either using a covered call writing repair strategy or just closing out and live to trade again. "Hanging in there" doesn't earn a trader anything but a stomach ache!
Understanding these basics can bring you a huge peace of mind; the ability to create your "paycheck" every month no matter what without worrying about the economy, your job, social security or the world for that matter
Personal Finance and Investments.
Best Dividend Paying Stocks in India - highest dividend payout ratio
Dividend yield versus Dividend payout ratio.
In this post I will list some of the best stocks in india which have highest dividend payout ratio. Whenever a company earns profit, it distributes part of the profit as dividend to stock holders.
The amount of dividend paid out by the company is best measured by "Dividend Payout Ratio" which is defined as the ratio of dividend distributed by the company to PAT - the total profit earned (after tax). Companies with a dividend payout ratio of over 50% can be considered as those who distribute the dividend generously.
However, there is an alternative way of measuring how much dividend you get on a stock - called the "Dividend Yield". This is nothing but the amount of dividend you get per stock divided by the price you pay. Note that dividend yield changes as the price of the stock changes. A dividend yield of a stock can be high, either because the company has a high dividend payout ratio, or simply because its price is very low.
Best Dividend Paying stocks with highest dividend yield
In any case, if what matters to you is how much dividend you get per amount of money invested, then you should look at 'Dividend yield'. Here are some good stocks which have good dividend yields as of July 2010. I have also made sure that the stocks have some good fundamentals like ROE of 15%+, high interest cover, and good future prospects.
Dividend yields, at the time of writing this post (july 2010). I will update this list every quarter.
Name of the Company / Stock
Dividend Yield
SRF Ltd. 6%
HCL Infosystems 4.6%/7.2%
chennai petro-5.7%
hinduja global-5.7%
kothari products-5%
lkp finance-5.3%
mac charles india-5.1%
NIIT Technologies 4%
Tamil Nadu Newsprint and papers 4%
J K Lakshmi Cement 3.9%
Ballarpur Chini Mills 3.5%
Graphite India 3%
Castrol India 2.9%
Tata Steel 2.8%
GE Shipping 2.8%
My personal choice (also considering the future growth prospects of the company, and not just dividend yield)
1.Graphite India
2.Tamil Nadu Newsprint and Paper ltd.
3.NIIT Technologies (this stock will be risky if debt crisis in Europe worsens).
List of best, highest dividend paying stocks in India with not just highest dividend payout ratio, but strong fundamentals
As mentioned above, Dividend yield is price dependent, and you must check the latest price to get correct idea of dividend yield in the above list. However, a dividend payout ratio is something which is price independent and reflects the policy of the company in paying dividends. Below is a list of stocks with high dividend payout ratio.
In compiling the list below, I have not just focused on the dividend payout ratio, but also on other key financial ratios which ensure that the company is sound and safe, and has good growth prospects. Here are some of the factors that have been considered.
1.Dividend payout ratio of at least 30%. This is the ratio of dividend distributed by the company to the total amount of profit after tax earned.
2.Market capitalization of 500 crore+
3.Interest cover of 3 or above.
4.ROE of 15% or above.
5.Qualitative factors which focus on future growth and prospects for the company.
So here is the list. I think these stocks really make a good investment option.
Typically, well established FMCG companies top the list of high dividend paying stocks, as can be seen in the list below. However the list of good dividend paying stocks mentioned below also includes companies from other sectors like Pharma, IT, consumer durables, Power/Energy, etc.
1.Hindustan Unilever (HUL) - This is the biggest FMCG company in India. It has a dividend pay out ratio of about 65% - 85% ! one of the highest in the industry. Other positives for this stock include - less sensitive to economic downturns, low debt, highest ROE (over 120% - indicating a highly efficient business model), and decent growth. However, note that recently HUL has been losing market share to Godrej Consumer Products, especially in rural areas. So although I wouldn't put all my money on this stock, this is definitely a stock you want to have in your portfolio if you are focusing on dividend.
2.Tata tea - Again, one of the good FMCG stocks to have in your portfolio. Dividend payout ratio of over 75%.
3.Castrol India - This is a debt free company with a dividend payout ratio of over 75% on average. Other attractive numbers - ROE of over 70%, almost debt free. The company has been growing at modest pace of 10% in the past 3 years (due to recession), however bottom line has grown by over 30%.
4.Nestle India - Again, a good FMCG stock with average dividend payout ratio of over 70%.
5.Godrej Consumer Products Limited (GPCL) - Godrej has better growth prospects than Hindustan Unilever, I think. It is also a good dividend paying stock, with dividend payout ratio of over 65%.
6.ITC - Indian Tobacco Company - average dividend payout ratio of about 65%, in 2009, it was 94%!.
7.Glaxo Smithkline Pharma (GLAXO) - a good pharmaceutical company, with dividend payout ratio of over 60%. I had mentioned this stock in the list of best stocks to invest in 2009, and it has indeed given over 2 times the index returns.
8.HCL Technologies - A good IT stock. Dividend payout ratio of over 60%. However, note that IT stocks are in general vulnerable to slowdown in Europe, US.
9.Clariant Chemicals - This is also a good value stock. Dividend payout ratio of over 60%.
10.Alstom Projects India - This is one stock I am planning to put my money on, not just for its high dividend payout ratio of 35%-40%, but also because this is one company which is going to benefit by the possible 'nuclear energy boom' in the country. With the Indo-US nuclear deal passed, India will see lot of investments in building Nuclear reactors. Alstom is one (of the several other) players to be benefited by this.
11.CRISIL - Crisil is the leading credit rating agency in India with a market share of over 60%. Crisil has a dividend payout ratio of around 45%. Must have stock in your portfolio.
12.Blue Star - Blue star is the market leader in India in commercial air conditioner business. It has a dividend payout ratio of over 35% and a highly efficient business model with ROE of nearly 50%. Moreover, with increasing summer temperatures throughout india, Air conditioners is something you can bet a portion of your money on.
The above is not an analysis or recommendation to buy the stocks, but it is certainly a good list from which you can pick your 'best dividend paying stocks'. I myself own several of the above stocks. Especially the last 3 stocks in the list are not exactly 'best dividend paying',
Monday, February 16, 2009
High Dividend Stocks
Dividend is a tax-free income in the hand of shareholders. Dividends are far more profitable today than it would have been in the last four years. ET Intelligence dug deep to find out companies, which are consistent in paying dividends and in some cases have also increased the payout ratio.
This is because the stock prices have crashed in last one year, as result the dividend yield (dividend per share divided by price per share) has gone up. Therefore, the dividend per rupee of investment is much more today than it was earlier. However, investors should not aim at accumulating stocks with high dividend yield because such high yields may not be sustainable in case profit falls due to economic slowdown.
ET Intelligence dug deep to find out companies, which are consistent in paying dividends and in some cases have also increased the payout ratio. A high payout ratio means a higher percentage of profits are distributed among shareholders as dividends.
The payout ratio has come down for most of the companies in the table. For instance, Great Eastern Shipping paid 38.6% of its profits as dividend in FY 2003, which came down to 17.3% in FY 2008.
The drop in payout ratio has to be seen in the light of high growth in profits. When profits rise at astronomical rates, the dividend growth tends to be a bit lesser because the company prefers to retain some amount with it for further investment.
Investors interested in earning dividends should steer clear of companies with high fluctuations in profits. For instance, Tata Motors had incurred losses in FY 2001 and FY 2002.
Though the company is incurring losses, it can still pay dividend from its past cash flows. But sustaining dividend payment will become extremely difficult in near future. Similarly, other auto manufacturers, like Ashok Leyland, were also excluded from the sample because they operate in highly cyclical industry.
Checkout: Time To Invest For High Dividend Stocks
As we all know that investing in stocks is a risky affair, so, an investor should always try to balance his investments between stocks and fixed interest instruments, which are less risky. We did a simulation (taking the stocks mentioned in the table) to calculate the return purely from the dividend the stocks have been paying.
We assume that an investor had put in Rs 1,000 in each of the 10 stocks on April 01, 2003, taking his total investment to Rs 10,000. The amount invested in all stocks was same to make a portfolio with equal proportions invested in different stocks. At the end of first financial year on April 01, 2004, the investor would have received dividends from the companies amounting to Rs 1,264.
To minimise risk, we assume that the investor had invested the dividend in a fixed deposit for one year at the interest rate of 5.25% and then kept on rolling the fixed deposit every year for another one year. This is called ‘hybrid strategy’ , wherein the income from risky investments (in this case equity) is routed to relatively less risky investments (in this case fixed deposit).
Similarly, every year on the first day of April, the investor would have got dividends, which he would have routed to fixed deposit of one year. Following this strategy, the investor would have made Rs 8,970 from dividend and interest on those dividends in five years.
It is noteworthy that adopting this hybrid strategy the investor would have almost recovered 90% of his entire investment in five years time. This translates to annual return of 13.7% per annum from dividends only.
The most interesting part of the result is that the investor would have made a much higher return on his investments than offered by any fixed rate instrument. On the top of it, that return would have had been entirely free from taxes. The interest on fixed deposit is taxed.
As the interest earned formed a lesser part of the return; the tax incidence would also had been much lesser. Moreover, we have not considered the capital gains. The value of the total portfolio stands at Rs 46,302 today— close to five times of the principal amount of Rs 10,000—though the market has crashed by more than 50% since its peak
but they
Being Jhunjhunwala: Bull of bourses
Anuradha SenGupta
CNN-IBN
Rakesh Jhunjhunwala has made his fame and fortune by calling the markets right. How he has gone with a starting capital of Rs 5,000 to a net worth of a few thousand crore rupees is now the stuff of urban legend.
One of the big bulls of the stock market, Jhunjhunwala is quick to point out that he is bullish first and foremost on India's growth story. For the chartered accountant who bet big with the Madhu Dandavate budget of 1989, Bombay Stock Exchange is where it all started.
Anuradha SenGupta: It's 9 o'clock in the morning and we are outside Bombay Stock Exchange (BSE). Do you feel sentimental, when you pass by this road? This is where you started your career about 20 years ago.
Rakesh Jhunjhunwala: I can tell you Anuradha, I started here in 1985.
Anuradha SenGupta: You have been saying hello to a lot of people here.
Rakesh Jhunjhunwala: I know a lot of people here. I had no office here; I used to come here with a bag. We used to get a ticket to enter the ring. I couldn't get the permission, so I used to stand outside the ring and see trading take place. And that's how I learnt. And I remember how I struggled and how I raised money. It's a moment of great happiness. There was a samosa-wala here, right there in the garden and we used to eat samosas. Lovely samosas he used to make.
There was a bomb blast in the BSE and I was in the ring on the day of the blast. And two of the samosa-walas died here. We had 12 exits from the ring. There was such panic after the bomb-blast. And I was afraid of a stampede and kept shouting, "Don't worry, if we die, we'll die together. Don't try to save only yourself." And I saw a view in the gallery ring. Glass broke off and a person's head got cut in the ring. Very vivid and tragic memories of that day. But this street really reminds me of how I used to come here.
Anuradha SenGupta: Everyone saw how Mumbai, how the stock exchange, was back to its feet so quickly after the blast. Now is there something about making money, about trading and business that is linked with this survival instinct?
Rakesh Jhunjhunwala: You know, trading always keeps you on your feet, it keeps you alert. That's one of the reasons why I like to trade.
Anuradha SenGupta: What are these attitudes in life that you have got from your profession?
Rakesh Jhunjhunwala: First thing I've learnt is that markets work. They are the best mechanism to build societies.
Anuradha SenGupta: You are philosophical about what you do, isn't it?
Rakesh Jhunjhunwala: I am passionate, I don't know whether I am philosophical or not. I am observant surely.
Anuradha SenGupta: The India shining story, are you the face of that story, Rakesh Jhunjhunwala?
Rakesh Jhunjhunwala: Well, that's not for me to say. I entered the market at Index 150. Today, the index is at 12, 000. It's eighty times. And you know, I too could have gone abroad, I am a qualified chartered accountant. I could have practiced. It’s a fact that a person who started in 1985 in India in stock markets, could meet with success. Which speaks for the volume of opportunities available here.
Anuradha SenGupta: Today, every move you make, every investment you make, every stock you put your money on is tracked, there are people who jump into the bandwagon, whether you like it or not. Does that pressurise you?
Rakesh Jhunjhunwala: See Ma'm, I've no clients except my wife because I don't want to be answerable to anybody. But with her, I've no choice.
Anuradha SenGupta: Does it pressurise you, this performance anxiety? Like if I am a cricketer or a soccer player, and if I start performing well, there's always an expectation that every time I go into the batting field, I'll score a 100. Look at what's happening to Sachin Tendulkar?.
Rakesh Jhunjhunwala: But Ma’m, whether anyone's watching or not, I'm always paranoid about all my actions. And the likelihood of my actions being successful, say five years ago, or ten years ago or today, is only better to the extent of what better experiences I've had. I am fearless. I am not concerned about what people think. I am only concerned about my deeds.
Anuradha SenGupta: You are an icon, when it comes to someone who's successful at the stock market. Are there lot of Bunties and Bablis who want to become Rakesh Jhunjhunwala, you think?
Rakesh Jhunjhunwala: I do get mail from a lot of people, who say they want to invest in markets, and follow my career path. What did I do, they want to know.
Anuradha SenGupta: Ordinary investors, retired people. Do you think there's an understanding that they want to be educated or they just want to make a quick buck?
Rakesh Jhunjhunwala: See, markets are about money, but markets are also about knowledge. Markets are also about egos; markets are also about the satisfaction of having been proved right. Especially, when that right is from an original thought and not from a guided source or following somebody. So I feel the anxiety, curiosity and the anxiousness to know about the market; it's quite general. But markets being markets, the ability is quite limited in my opinion.
Anuradha SenGupta: Greed and fear, you said, are the two traits that have to be balanced. How does one balance them? Give us an anecdote, where you had to balance it.
Rakesh Jhunjhunwala: Anuradha, it's like this. Suppose I invest in Titan. I bought 'x' number of shares, I was extremely bullish, right? And you know, I would have been greedy if I had put in more than certain percentage of my wealth into Titan. And I didn't do it out of fear that Titan might not do well. I might lose my principal.
Anuradha SenGupta: What about ACC? You sold ACC at lot less than what it actually went on to be?.
Rakesh Jhunjhunwala: Ma’m, about markets, they say, either don't come to markets or don't regret what you have done. Right? Naya gilli, naya dao. I think the second quarter 1991 result was the best ACC produced for the next 10 years. And after those results came, I sold the shares. I bought them for 300 and within three months, I'd sold them for 3,500. And the price went to 10, 000. I've no regrets.
Anuradha SenGupta: You have no regrets, but what principle drove you at that point, fear or greed?
Rakesh Jhunjhunwala: I think I was neither being greedy nor being fearful, I was just being rational.
Anuradha SenGupta: Celebrating three years of the bull run, the BSE Index has gone from 3000 plus to 12,000 plus in just three years. And this investor says, it's going to continue that way.
Rakesh Jhunjhunwala: You know, Sensex has gone from 3000 to 12,000 in the last three years. You know people are excited, everybody's making money and that's why markets are making headlines. As they say Teji me sab ka bol bala, mandi me sab ka muh kala.
Anuradha SenGupta: Every time the markets run up, people get extremely euphoric and they get very very nervous, isn't it? And you are the guy whom they run to defend the bull run?
Rakesh Jhunjhunwala: There's no question of defending the bull run. See, we forget what markets are. Markets reflect economic truth and fundamentals. And I think India is going into a lot of unprecedented economic growth, I think the markets are only recognising that.
Anuradha SenGupta: Why is it so difficult to believe what you are saying? Why is there this fear psychosis, that if things are good, then they are bound to go bad?.
Rakesh Jhunjhunwala: I think for two reasons - past experiences and the inertia of the mind that India can have continued economic growth. And also because we've had two scams in the stock market, this also made people very suspicious of the markets. I think there is a combination of reasons.
Anuradha SenGupta: Are you saying that we should not be suspicious at all this time round?
Rakesh Jhunjhunwala: Well, I don't think there's a need to be suspicious, although I think you need to be alert. I don't think there's any scam in the market.
Anuradha SenGupta: Now, in the past, in the secondary markets, where we've seen these two scams happen, the primary market has been a safer place for retail investors. Now it looks like the primary markets are also a suspect, isn't it?
Rakesh Jhunjhunwala: Let us understand one thing that misuse of mechanisms is part of every market. All markets have to evolve. So therefore, we've to go to a stage of evolution where people are going to take advantage of the law. But law will catch up, right?
Anuradha SenGupta: You have always defended the regulator very strongly saying that the regulator is in place and that regulator systems and processes are just fine. Do you stand by that?
Anuradha SenGupta: See Ma'm, we may be critical of some mistakes that the regulator might have made, but we should realise that in the Indian stock markets, we have gone from the wild west to being one of the most modern trading system in the world. And in a very short span of time. Every regulator has to evolve. And mistakes are going to be made during evolution. So I think it's a matter of a glass being half full or half empty.
Anuradha SenGupta: Ironically, while Jhunjhunwala has all the trappings of success, he still clings to his middle-class south Mumbai roots. Proud to be a self-made man, he can’t help spouting Jhunjhunwala-isms.
Anuradha SenGupta: What I want to know, how important is it for you that people are always guessing how much you are worth? It's important, isn't it, that people don't really know?
Rakesh Jhunjhunwala: What irritates me, is how does it matter to them. And see, I am not running any relay race, I am not in any rat race with somebody and I want to be richer than somebody or I want to be the richest man. My purpose in life is to do what I enjoy and enjoy what I do, right? And wealth is a bi-product of what I do. Why do people want to know what my wealth is. How is it relevant?
Anuradha SenGupta: Maybe only because your claim to fame is the money you made on your own, the first generation from scratch starting with Rs 5,000?
Rakesh Jhunjhunwala: I think what is more needed to be appreciated is not the wealth I have as such but, how I made it. By God's grace, I am a rich man. How rich I am, how is it important? I can tell you one thing, I am rich enough for my wealth to matter internationally.
Anuradha SenGupta: You just mentioned that you are not in the rat race, how do you react when you see these lists that come out - 100 richest men in the world, 100 richest Indians, 50 most powerful Indians? Because you have figured in some, haven't you?
Rakesh Jhunjhunwala: Well, I have no press agent and I have no press agency, right? And I am not seeking any publicity. But as long as any list is a recognition of human effort and human achievement, then I would be lying if I said I don't like to be in that list. So, I like it to be there, but I am not making any special effort to be on this list. Being on the list is coincidental and not the purpose of my work.
Anuradha SenGupta: Then obviously there's no ambition to be on any other list and on higher number on any list?
Rakesh Jhunjhunwala: Not at all.
Anuradha SenGupta: You have often and emphatically pointed out that there's a lot of research, a lot of data gathering and a lot of knowledge accumulation that goes into this business of yours. What do you read?
Rakesh Jhunjhunwala: See, I read Economist and India Today, which I read cover to cover every week. In the Economist, I read the entire business section and the science and technology section. These are my constant reads. Then I read broker reports and go through balance sheets.
Anuradha SenGupta: There are five screens here, could you quickly tell us which one does what?
Rakesh Jhunjhunwala: Well, these are all of the BSE NSE live screens, where I track the prices. The first one right here is my investments. These are the futures.
Anuradha SenGupta: There are 31 scripts there?
Rakesh Jhunjhunwala: Yeah, except CL, all of them are my investments. These are all my shares in which I have some short-term positions. These are just some companies whose prices I want to follow. And these are the futures that I trade, right? This is the live Reuters screen, from where I get information. And this is the Internet. And there's the television.
Anuradha SenGupta: Can you go through a single day without having, if you want to, conversations with anybody outside.
Rakesh Jhunjhunwala: There are a certain people whose views I value, some friends with whom I discuss matters, so I talk to them. Essentially, the decisions in trading and investment are very lonely decisions. And I, of course, can trade without talking to anybody. But I do tend to talk to people.
Anuradha SenGupta: You know I have spoken to a few people, who say there's a contradiction in Rakesh Jhunjhunwala. There's this long time view he has on some shares and he stays and he stays and he stays. Hangs in there, tight. And here on his trading screen, he can make and lose 20 crores or 50 crores in a blink. As we talk, can you do that?
Rakesh Jhunjhunwala: Well, I don't do that kind of trading. I hold investments for a long time because I read somewhere and time has taught me that we should be greedy, but long term greedy. So, when you have something good, stick to it.
Anuradha SenGupta: What about the other screen?
Rakesh Jhunjhunwala: Ma'm, I had no capital when I came to the markets, and no father gifts and no father-in-law gifts. So I had to earn the capital to invest. How do you invest if you don't have the capital? And I got the capital by doing all this future trading.
Anuradha SenGupta: And you can lose and make up to how much, say as we are talking?
Rakesh Jhunjhunwala: I would not like to quote figures. I only make mistakes, which I can afford, where I can lift to begin again.
Anuradha SenGupta: You get in actually before the trends start, isn't it? For the investment decisions?.
Rakesh Jhunjhunwala: By God's grace, I think from 1985-86 to 2006, I had been able to catch most; say if there are 10 cycles in the market, then I have been able to catch 9 right. So investment wise, the cycles have been good. In trading, we make mistakes everyday. You know one author once said beautifully, that it's important that you are right or wrong in trading; it's important how much you lose when you are wrong and how much you make when you are right.
Anuradha SenGupta: If you lose money, do you feel stressed?
Rakesh Jhunjhunwala: No, never. I feel it for five minutes. Because Ma'm, I am not staking more than two or three percent of my wealth in these. I always remember Churchill's words.
Anuradha SenGupta: You've quoted Churchill. You quote very regularly. Do you read anything else that these people have written? The non-investing legends.
Rakesh Jhunjhunwala: Well, Churchill was not an investing legend at all.
Anuradha SenGupta: Exactly. So, do you read beyond the quotes that have come in the books?
Rakesh Jhunjhunwala: I am very fascinated by the Second World War. I have seen so many movies on the Second World War. I saw 25 CDs on the war and that gives you lot of quotes. Now, my non-market, non-economic reading is much lesser. I was a voracious reader before 35.
Anuradha SenGupta: Even by international standards, your good wealth is what you sell. Does that mean you are ready to trade and to invest in international markets? What's stopping you? Is it legality or is it scale?
Rakesh Jhunjhunwala: There are two to three reasons. First, even if I desire, I cannot do it because all my wealth is in India. By 2010, we will have capital ready. That's my guess. Second, the opportunity in India itself is so huge. And, so nascent. When we are getting good food at home, why think of a restaurant? And third, to invest at international scale, I need to build a bigger and broader organisation. I think I will have all the three by 2010.
Anuradha SenGupta: What in terms of capital you need to invest to be considered of a notable investor?
Rakesh Jhunjhunwala: I don't want to go into any market to be noted, I want to go there to make money.
Anuradha SenGupta: So, capital is not a limitation?
Rakesh Jhunjhunwala: No, capital is never a limitation.
Anuradha SenGupta: You work with money. To put it very simplistically, where do you save your money?
Rakesh Jhunjhunwala: Where do I save my money? Well, whatever I earn, less my expenses is my saving.
Anuradha SenGupta: Away from the stock markets, are there any areas you would save your money - art, real estate?
Rakesh Jhunjhunwala: No art really. I bought one painting last month. I have a house apart from this office, so no real estate either. I've invested in some real estate funds.
Anuradha SenGupta: So what is saving for Jhunjhunwala?
Rakesh Jhunjhunwala: My wealth is a valuable portfolio, that's my saving.
Anuradha SenGupta: Can that be notional also because today depending on the markets, it's x today and goes down tomorrow?
Rakesh Jhunjhunwala: I wouldn't say it's notional, it's fluctuating.
Anuradha SenGupta: Doesn't it bother you sometimes that you are not the guy with the ideas; you are the guy who is backing the guys with the ideas?
Rakesh Jhunjhunwala: I don't think so. There are various parts of creating anything. So when I invest in a company at an initial stage, I am handling with that company. I distinguish between my chairmanship of Aptech and my directorship of other companies. In Aptech, we are under management control of the company. So we are exactly running it.
Anuradha SenGupta: What's the experience like? For you it's a new experience, isn't it?
Rakesh Jhunjhunwala: It's a challenge, Ma'm. I don't know whether I will be successful. I will know in five years. But I love a challenge. Funds worldwide have made billions of dollars by taking over management control of companies. Now I had never taken management control of any company prior to Aptech. I think it will take 4 or 5 years. I still come to the year 2010.
Anuradha SenGupta: Is 2010 a year when a lot of things will happen to Rakesh Jhunjhunwala?
Rakesh Jhunjhunwala: Yes. I will be fifty that year.
Anuradha SenGupta: So you set a lot of milestones for yourself?
Rakesh Jhunjhunwala: I never said that. They are very flexible milestones. In a stock market, people come on CNBC and give targets. I think of targets but they are very flexible. If I succeed in reviving Aptech and we get a very good profitable company then I will get courage to buy management control of larger companies.
Anuradha SenGupta: We talked about how markets are all the time on a bull run. And when Sensex keeps climbing, there is great excitement and fear. Does it bother you that people like you are scrutinised very intently at these times?
Rakesh Jhunjhunwala: Ma'm, I am concerned about one thing. I follow the law in letter and spirit and we live in a democracy. I act in accordance with the laws in government institutions. Now if the government has a right to examine everything, whether we like it or not, we have to accept it. And that's part of life.
Anuradha SenGupta: But this suspicion that comes up every time, especially in this business, does that bother you?
Rakesh Jhunjhunwala: Not at all. Whatever I have done in life, people have looked on with suspicion. Imagine a chartered accountant in 1985 coming from a bureaucratic family, going to this stock market and standing on the streets. My father is a member of the Wellington club from 1973. I am a qualified chartered accountant. I don't think culturally I have done anything wrong. But they don't want to make me a member of Willington club. It's their choice. Initially, I used to react to this with anger. Now I react to it with maturity. People will have any opinion; time will change their opinion.
Anuradha SenGupta: If you have made your money as a trader or investor in the stock market, somehow it is not as respectable as the captains of the industry? Does that bother you? Because you are putting in huge amounts of education and knowledge to make the kind of investments you are making?
Rakesh Jhunjhunwala: Ma'm let me tell you one thing. Let me be very candid. For the kind of recognition I have got, I don't think it's not respected. It's now not respected in antique minds. If capitalism is the only method of government, then the only temples of that form of government are the stock markets. And believe me, I am not doing anything to be recognised by anybody. The recognition is incidental. I am doing what I enjoy to do.
Anuradha SenGupta: But Rakesh, it bothers you enough today to remember the incident of Willington club not giving you membership?
Rakesh Jhunjhunwala: But that maybe was 10-12 years ago when I might have felt a little pinch. Now I don't feel it.
Jhunjhunwala chooses to live in a joint family. Without the economic and emotional support of his parents, he is clear that he would not have managed to throw a conventional career to the winds. His family including his sisters and brothers are the only people who benefit from his stock tips.
Rakesh Jhunjhunwala: My dad is the person who has taught me the most in my life. And I think whatever I am in life, he has a very substantial contribution in it. He's the most democratic father. I had a curiosity and he has nurtured that curiosity.
Anuradha SenGupta: So you are not a mummy's boy; you are a daddy's boy?
Rakesh Jhunjhunwala: No, I am both mummy and daddy's boy. I am the baby of the family at 46. And the youngest tend to be both. I live with my parents and we are a very close-knit family.
Anuradha SenGupta: You have a daughter, Nishtha. I remember hearing you say that you have several challenges in front of you; the first challenge is to be able to look after your health i.e., cut down on drinking, smoking, so that you can spend a minimum of 35 years with your daughter Nishtha. How are you doing on that challenge?
Rakesh Jhunjhunwala: Well, I am just starting to work on it.
Anuradha SenGupta: What I am quoting is what I heard two years ago. And you are still trying to work on it?
Rakesh Jhunjhunwala: I think it's better late than never.
Anuradha SenGupta: You are still trying to work on it?
Rakesh Jhunjhunwala: Yes, and I will eventually.
Anuradha SenGupta: But you are talking about 2010, you are talking about Nishtha, about parents who've supported you in your career choice and with who you live today out of choice. Surely it bothers them that you are not dealing with this challenge upfront and with the kind of effort that's needed? What do you have to say to them?
Rakesh Jhunjhunwala: Well, I have no face to face them. Here I have lost a battle but I have not lost the war.
Anuradha SenGupta: Ok, Rakesh Jhunjhunwala, on one of those stock quotes. I am going to wish you all the very best in this battle. And I hope that the markets continue to rise and nobody pays a price for it.
Rakesh Jhunjhunwala: Well, that's a hope which may not be very legitimate, because in markets, some are going to win, some are going to lose. My hope would be to let India's economy prosper, let all Indians have at least basic needs. Let us build a society, which is egalitarian, where we allow people's skills to flow.
In-The-Money Covered Call
Writing in-the-money calls is a good strategy to use if the options trader is looking to earn a consistent moderate rate of return.
Covered Call (ITM) Construction
Long 100 Shares
Sell 1 ITM Call
Profit is limited to the premium earned as the writer of the call option will not be able to profit from a rise in the price of the underlying security.
Offers more downside protection as premiums collected are higher than writing out-of-the-money calls.
Covered Call (ITM) Payoff Diagram
Limited profit
As the striking price is lower than the price paid for the underlying stock, any upward price movement will not benefit the call writer since he has agreed to sell the shares to the option holder at the lower striking price. Therefore, the maximum gain to be made writing in-the-money calls is limited to the time value of the premium at the time of writing the call.
The formula for calculating maximum profit is given below:
Max Profit = Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Greater downside protection
As the premiums received upon writing in-the-money calls is higher than writing out-of-the-money calls, downside protection is greater as the higher premium can better offset the paper loss should the stock price go down.
The formula for calculating loss is given below:
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying < Purchase Price of Underlying - Premium Received
Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the covered call (itm) position can be calculated using the following formula.
Breakeven Point = Purchase Price of Underlying - Premium Received
Example
Suppose the stock XYZ is currently trading at $50 in June. An options trader decides to write a JUL 45 covered call for $7. He pays $5000 for the 100 shares of XYZ and receives $700 in premium giving a net investment of $4300.
The stock then rallies to $55 at expiration and the call gets assigned. As per the options contract, the trader has to sell the 100 shares of XYZ at the striking price of $45 and so he receives $4500 for the shares sold. Since his original investment is $4300, his net profit for the entire trade is only $200.
However, should the stock price go down to $45 instead, he still makes a profit since the $700 in premiums received more than offset the $500 in paper loss of the 100 shares he held which has lost $5 a share in value.
At $45, the call most likely will not get assigned since there is no intrinsic value left in the option. Since the shares did not get called away, the call writer can either sell the shares for $4500 giving him a net profit of $200 for the entire trade or write another call against the shares held.
Note: While we have covered the use of this strategy with reference to stock options, the covered call (itm) is equally applicable using ETF options, index options as well as options on futures.
Commissions
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
Covered Calls
The covered call is a strategy in options trading whereby call options are written against a holding of the underlying security.
Covered Call (OTM) Construction
Long 100 Shares
Sell 1 Call
Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.
However, the profit potential of covered call writing is limited as the investor had, in return for the premium, given up the chance to fully profit from a substantial rise in the price of the underlying asset.
Out-of-the-money Covered Call
This is a covered call strategy where the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered call is a popular strategy as the investor gets to collect premium while being able to enjoy capital gains (albeit limited) if the underlying stock rallies.
Covered Call Payoff Diagram
Limited Profit Potential
In addition to the premium received for writing the call, the OTM covered call strategy's profit also includes a paper gain if the underlying stock price rises, up to the strike price of the call option sold.
The formula for calculating maximum profit is given below:
Max Profit = Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Unlimited Loss Potential
Potential losses for this strategy can be very large and occurs when the price of the underlying security falls. However, this risk is no different from that which the typical stockowner is exposed to. In fact, the covered call writer's loss is cushioned slightly by the premiums received for writing the calls.
The formula for calculating loss is given below:
Maximum Loss = Unlimited
Loss Occurs When Price of Underlying < Purchase Price of Underlying - Premium Received
Loss = Purchase Price of Underlying - Price of Underlying - Max Profit + Commissions Paid
Breakeven Point(s)
The underlier price at which break-even is achieved for the covered call (otm) position can be calculated using the following formula.
Breakeven Point = Purchase Price of Underlying - Premium Received
Example
An options trader purchases 100 shares of XYZ stock trading at $50 in June and writes a JUL 55 out-of-the-money call for $2. So he pays $5000 for the 100 shares of XYZ and receives $200 for writing the call option giving a total investment of $4800.
On expiration date, the stock had rallied to $57. Since the striking price of $55 for the call option is lower than the current trading price, the call is assigned and the writer sells the shares for a $500 profit. This brings his total profit to $700 after factoring in the $200 in premiums received for writing the call.
It is interesting to note that the buyer of the call option in this case has a net profit of zero even though the stock had gone up by 7 points.
However, what happens should the stock price had gone down 7 points to $43 instead? Let's take a look.
At $43, the call writer will incur a paper loss of $700 for holding the 100 shares of XYZ. However, his loss is offset by the $200 in premiums received so his total loss is $500. In comparison, the call buyer's loss is limited to the premiums paid which is $200.
Note: While we have covered the use of this strategy with reference to stock options, the covered call (otm) is equally applicable using ETF options, index options as well as options on futures.
Commissions
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
Collars
As the covered call writer is exposed to substantial downside risk should the stock price of the underlying plunges, collars can be created to reduce this risk thru the use of put options.
The Collar Strategy
A collar is an options trading strategy that is constructed by holding shares of the underlying stock while simultaneously buying protective puts and selling call options against that holding. The puts and the calls are both out-of-the-money options having the same expiration month and must be equal in number of contracts.
Collar Strategy Construction
Long 100 Shares
Sell 1 OTM Call
Buy 1 OTM Put
Technically, the collar strategy is the equivalent of a out-of-the-money covered call strategy with the purchase of an additional protective put.
The collar is a good strategy to use if the options trader is writing covered calls to earn premiums but wish to protect himself from an unexpected sharp drop in the price of the underlying security.
Collar Strategy Payoff Diagram
Limited Profit Potential
The formula for calculating maximum profit is given below:
Max Profit = Strike Price of Short Call - Purchase Price of Underlying + Net Premium Received - Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Limited Risk
The formula for calculating maximum loss is given below:
Max Loss = Purchase Price of Underlying - Strike Price of Long Put - Net Premium Received + Commissions Paid
Max Loss Occurs When Price of Underlying <= Strike Price of Long Put
Breakeven Point(s)
The underlier price at which break-even is achieved for the collar strategy position can be calculated using the following formula.
Breakeven Point = Purchase Price of Underlying + Net Premium Paid
Example
Suppose an options trader is holding 100 shares of the stock XYZ currently trading at $48 in June. He decides to establish a collar by writing a JUL 50 covered call for $2 while simultaneously purchases a JUL 45 put for $1.
Since he pays $4800 for the 100 shares of XYZ, another $100 for the put but receives $200 for selling the call option, his total investment is $4700.
On expiration date, the stock had rallied by 5 points to $53. Since the striking price of $50 for the call option is lower than the trading price of the stock, the call is assigned and the trader sells the shares for $5000, resulting in a $300 profit ($5000 minus $4700 original investment).
However, what happens should the stock price had gone down 5 points to $43 instead? Let's take a look.
At $43, the call writer would have had incurred a paper loss of $500 for holding the 100 shares of XYZ but because of the JUL 45 protective put, he is able to sell his shares for $4500 instead of $4300. Thus, his net loss is limited to only $200 ($4500 minus $4700 original investment).
Had the stock price remain stable at $48 at expiration, he will still net a paper gain of $100 since he only paid a total of $4700 to acquire $4800 worth of stock.
Note: While we have covered the use of this strategy with reference to stock options, the collar strategy is equally applicable using ETF options, index options as well as options on futures.
Commissions
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).
Exclusive Promotion! Open a new account at OptionsHouse.com and get 100 Commission-Free Trades! (Make sure you click thru the above link and quote the promo code 'FREE100' during sign-up)
Summary
The beauty of using a collar strategy is that you know, right from the start, the potential losses and gains on a trade. While your returns are likely to be somewhat muted in an explosive bull market due to selling the call, on the flip side, should the stock heads south, you'll have the comfort of knowing you're protected.
Similar Strategies
The following strategies are similar to the collar strategy in that they are also bullish strategies that have limited profit potential and limited risk.
Costless Collar (Zero-Cost Collar)
Bull Put Spread
Bull Call Spread
The Costless Collar
If capital protection rather than premium collection is the main focus, a bullish investor can establish an alternative collar strategy known as the costless collar.
Costless Collar (Zero-Cost Collar)
The costless collar, or zero-cost collar, is established by buying a protective put while writing an out-of-the-money covered call with a strike price at which the premium received is equal to the premium of the protective put purchased.
Costless Collar Construction
Long 100 Shares
Sell 1 OTM LEAPS Call
Buy 1 ATM LEAPS Put
Costless collars can be established to fully protect existing long stock positions with little or no cost since the premium paid for the protective puts is offset by the premiums received for writing the covered calls.
Depending on the volatility of the underlying, the call strike can range from 30% to 70% out of money, enabling the writer of the call to still enjoy a limited profit should the stock price head north. This strategy is typically executed using LEAPS® options as the striking price of the call sold can be rather high in relation to the price of the underlying stock.
Costless Collar Payoff Diagram
Limited Profit Potential
Profit is limited by the sale of the LEAPS® call. Maximum profit is attained when the price of the underlying asset rallies above or equal to the strike price of the short call.
The formula for calculating maximum profit is given below:
Max Profit = Strike Price of Short Call - Purchase Price of Underlying - Commissions Paid
Max Profit Achieved When Price of Underlying >= Strike Price of Short Call
Example
Suppose the stock XYZ is currently trading at $50 in June '06. An options trader holding on to 100 shares of XYZ wishes to protect his shares should the stock price take a dive. At the same time, he wants to hang on to the shares as he feels that they will appreciate in the next 6 to 12 months. He setups a costless collar by writing a one year JUL '07 60 LEAPS call for $5 while simultaneously using the proceeds from the call sale to buy a one year JUL '07 50 LEAPS put for $5.
If the stock price rally to $70 at expiration date, his maximum profit is capped as he is obliged to sell his shares at the strike price of $60. At 100 shares, his profit is $1000.
On the other hand, should the stock price plunge to $40 instead, his loss is zero since the protective put allows him to still sell his shares at $50.
However, should the stock price remain unchanged at $50, while his net loss is still zero, he would have 'lost' one year's worth of premiums of $500 that would have been collected if not for the protective put purchase.
Note: While we have covered the use of this strategy with reference to stock options, the costless collar is equally applicable using ETF options, index options as well as options on futures.
Commissions
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).
Exclusive Promotion! Open a new account at OptionsHouse.com and get 100 Commission-Free Trades! (Make sure you click thru the above link and quote the promo code 'FREE100' during sign-up)
Summary
Overall, writing out-of-the-money covered calls is an excellent strategy to use if you are mildly bullish toward the underlying stock as it allows you to earn a premium which also acts as a cushion should the stock price go down. So if you are planning to hold on to the shares anyway and have a target selling price in mind that is not too far off, you should write a covered call.
Does Sensex trace GDP growth?
The Sensex is currently hovering at 6,400 levels at the end of FY05. Where will it be four years down the line i.e. FY09? The answer is over 10,000 (10,071 to be precise)! It is not rocket science, but a simple mathematical calculation. But how easy is that?
Assume that the Indian economy will grow by 12% every year (to make it clear, this is nominal growth and not real growth. If the nominal growth is 12% and if average inflation during the fiscal was say, 5%, then the real rate of GDP growth is 7% (12 minus 5). Since corporate performance tends to trace GDP growth over the long-term (very important assumption) and 'if' stock market follows suit, compound the current Sensex level by 12% over the next four years and you get the Sensex target for the future!
But, before you buy this argument, we would like to highlight some pitfalls in these assumptions by presenting the last ten year (FY95-FY04) performance of the Indian economy, the corporates and the Sensex. The objective is to analyse whether there is any co-relation at all. Here are the facts to start of with.
History speaks for itself…
FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 CAGR**
Macro indicators
Nominal GDP
growth 17.4% 17.0% 15.9% 11.8% 15.0% 10.2% 8.0% 9.9% 7.8% 11.7% 11.9%
Real GDP
growth 7.3% 7.3% 7.8% 4.8% 6.5% 6.1% 4.4% 5.8% 4.0% 8.5% 6.1%
Quantum
sales growth 29.6% 23.3% 19.0% (4.3%) 14.2% 23.4% 23.5% 0.7% 11.9% 11.4% 11.9%
Stock market
BSE Sensex* (13.7%) 3.3% (0.2%) 15.8% (3.9%) 33.7% (27.9%) (3.7%) (12.1%) 83.4% 6.2%
BSE-100 (12.2%) (3.5%) (5.5%) 15.9% (2.7%) 75.8% (41.7%) 1.4% (12.5%) 97.6% 7.1%
BSE-200 NA (6.3%) (4.9%) 14.9% 0.8% 63.9% (41.1%) 7.4% (8.9%) 104.3% 8.0%
Source: RBI and Equitymaster database. *as on March 31st **9yrs
First the good news. If one takes the last nine years CAGR (compounded annual growth rate) of real GDP and the performance of the BSE Sensex, yes, there is a clear co-relation. While real GDP has grown at 6.1% during this period, the Sensex has also posted similar gains. More importantly, the consolidated net sales of Quantum Universe has risen by 11.9% in the last ten years, which is at par with the nominal GDP growth rate. So yes, the argument is good enough and we concur.
But look a little deeper and the finer picture emerges. Even as the real GDP growth has been growing at a steady rate on an annual basis in the last ten years, the BSE Sensex has had a very volatile trend. On a year-on-year basis, there seems to be no sync at all between these two factors. However, if one considers the growth in nominal GDP and the corporate performance at the topline level, there is a fair degree of co-relation. This is because, GDP of the economy is the collective output of the agriculture, industrial and services sector, which is fairly represented in the Quantum Universe. Given this backdrop, investors may be better off if some following aspects are borne in mind before venturing into such predictions.
In the long-term, may be: Economy goes through cycles of recovery, peak, slowdown and depression over the longer period of time. Similarly, stock markets also have cycles, depending on how the economy is performing. Therefore, even if India's GDP grows at 12% in one year, the Sensex may not gain a similar percentage during the year. However, the relationship may hold true over the longer-term. Even here, there have been periods in the US economy in the last century wherein there has been a very weak link between economy and stock market performance.
Sensex at over 10,000! So what? Even if the Sensex manages to achieve such targets, what does it mean in the end to the investor? It does not answer which company's share does one buy from a long-term perspective. It is only good if you are a buyer of an index fund and is happy with a 'probable' 12% return per annum. Besides, 'what is hot' and 'what is not' changes over a period of time. The erstwhile bluechips like Century Textiles, Arvind Mills, ACC, Bombay Dyeing are no longer 'preferred' by investors. So, it is pertinant to understand that the benchmark indices only reflect market sentiments and the overall state of the economy. Taking buying/selling decisions just based on an index level is fraught with risks.
There is something called as sentiment: Stock markets are not only influenced by fundamentals but also by sentiments. For instance, lowering of interest rates by the RBI (like until 2004) typically has an impact on the economy with a lag. But the signal that the RBI is reducing interest rates may prop up stockmarkets immediately and stock prices may react much faster. Another example of sentiments playing a key role is the interest level in Indian equites, like say between 2001 to 2003. Even when valuations were extremely attractive, markets lacked in depth because of weak sentiments. There are other risks like stock market scams (we have had three major ones in the last ten years) that impact markets.
What value to assign?: Like the stock price is a factor of EPS and value multiple (called as price to earnings ratio), the index is a function of combined earnings of index stocks multipled by the value multiple. What valuation the Sensex deserves is again subjective. One could take the growth in nominal GDP at 12% as a valuation multiple i.e. P/E, whereas a high risk investor would be willing to pay even 20 times for the combined earnings of Sensex companies. While there is no definite answer to this one, investors have to bear in mind that in a bear market, even if GDP grows, the stock market may not reward the performance. Here the co-relation may turn weaker.
To conclude, while we believe that fundamentals dictate stock market directions over the longer-term, there are pitfalls in such assumptions, which one has to acknowledge. This is perhaps one of the key reasons why investors could adopt a long-term strategy while investing in stocks. Assuming that a company 'X' is likely to grow earnings at a certain rate, the stock market may take time to reward adequately. But over a period of time, markets will catch up. Patience is the virtue of the game, as far as serious investors are concerned.
lowest PEG Ratio NSE BSE indian Stocks as on 08 jan 2010 most undervalued indian stocks in 2010
lowest PEG Ratio NSE BSE indian Stocks as on 08 jan 2010
most undervalued indian stocks in 2010
What is PEG ratio?
The PEG ratio (Price/Earnings To Growth ratio) is a valuation measure for the earnings generated per share (EPS) and the company’s growth.
In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates
The PEG ratio is considered to be a convenient approximation. It was popularized by Peter Lynch, who wrote in “One Up on Wall Street” that “The P/E ratio of any company that’s fairly priced will equal its growth rate”, i.e. a fairly valued company will have its PEG equal to 1.
Source: http://en.wikipedia.org/wiki/PEG_ratio
Link
For example you’re analyzing a stock trading with a P/E ratio of 20 . Suppose the company’s earnings per share (EPS) have been and will continue to grow at 15 percent per year.
Divide the P/E ratio (20) by the growth rate (15), the PEG ratio is computed to be 1.33
We have USED PREVIOUS YEARS PAT GROWTH AND CURRENT PE TO ARRIVE AT
most undervalued indian stocks in 2010
Please check the current PE and PAT growth rates at NSE BSE sites before taking investing decision as data may change due to splits/bonus.
STOCK----------September-09 PAT--September-08 PAT---YOY% Change PE--PEG RATIO
WELSPUN INDIA --- 392------------ 5----------------- 7740.00%--- 6.3-- 0.00
MARATHON NEXTGEN--292------------ 29---------------- 906.90%---- 4.6-- 0.01
ALLAHABAD BANK -- 3,336---------- 417--------------- 700.00%---- 4.3-- 0.01
APOLLO TYRES---- 1,021---------- 78---------------- 1209.00%--- 9.7-- 0.01
GAMMON INDIA---- 354------------ 27---------------- 1211.10%---13.8-- 0.01
EVEREADY IND.--- 194------------ 23---------------- 743.50%---- 9.4-- 0.01
CENTURY ENKA---- 345------------ 60---------------- 475.00%---- 6.8-- 0.01
HEXAWARE TECH--- 612------------ 115--------------- 432.20%---- 7 ----0.02
JK CEMENTS ------ 654------------ 177--------------- 269.50%---- 4.6-- 0.02
SHASUN CHEMICALS--91------------- 28---------------- 225.00%---- 4.4-- 0.02
SUPREMEINDUSTRIES199------------- 41---------------- 385.40%---- 7.7-- 0.02
CENTURY IND.---- 1,048----------- 195--------------- 437.40%---- 10.2- 0.02
MRPL ----------- 1,797----------- 249--------------- 621.70%---- 14.5- 0.02
AGRO TECH FOODS--54-------------- 4----------------- 1250.00%--- 29.6- 0.02
BANSW.SYNTEX --- 69-------------- 25---------------- 176.00%---- 4.4-- 0.03
GOODYEAR (I)--- 236------------- 64---------------- 268.80%---- 6.8-- 0.03
HEIDELBERGCEMENT 271------------- 101--------------- 168.30%---- 5.3-- 0.03
BIRLA CORP----- 1,520------------597--------------- 154.60%---- 5.0-- 0.03
COMPACT DISC--- 128------------- 90 ----------------42.20% -----1.4-- 0.03
WHIRLPOOL INDIA- 249------------- 42-----------------492.90%---- 16.4- 0.03
INDOCO REMEDIES- 93-------------- 21-----------------342.90%---- 13.6- 0.04
LLOYD ELECTRIC-- 95-------------- 32-----------------196.90%-----8.8-- 0.04
SHREE CEMENT---- 2,919----------- 1,172------------- 149.10%-----6.8 --0.05
PRISM CEMENT --- 349------------- 150----------------132.70%--- 6.7---0.05
MIRC ELEC.------ 57-------------- 8------------------612.50%--- 32.1--0.05
GOKALDAS EXPORTS 104------------- 31---------------- 235.50%----12.6--0.05
ANSAL PROP.---- 338------------- 243--------------- 39.10%----===.3--0.06
APAR INDUSTRIES -238------------- 61---------------- 290.20%--- 18.2--0.06
BALKRISHNA IND-- 484------------- 245--------------- 97.60% -----6.2- 0.06
ABG SHIPYARD --- 458------------- 260--------------- 76.20%------5.2- 0.07
NUCLEUS SOFT EXP 95-------------- 40 ----------------137.50%-----9.6- 0.07
M&M------------ 6,121----------- 1,754 -------------249.00%---- 18.2-0.07
GUJSTATE PETRO 1,101------------ 284--------------- 287.70%-----21.1-0.07
DS KULKARNI--- 130-------------- 46---------------- 182.60%---- 13.4- 0.07
MANGALAM CEMENT 354-------------- 245 ----------------44.50%----- 3.3- 0.07
CANARA BANK --- 9,105------------ 5,294---------------72.00%------5.5- 0.08
BALRAMPUR CHINI 427 --------------145-----------------194.50%---- 15.1-0.08
STERLITE TECH.--546-------------- 220---------------- 148.20%-----11.6-0.08
IFCI---------- 1,905------------ 1,016-------------- 87.50%------7.4 -0.08
JINDAL DRILL-- 206-------------- 65 -----------------216.90%---- 19-- 0.09
BAJAJ ELEC.--- 291-------------- 123-----------------136.60% ----12.1-0.09
TRIVENI ENG.-- 726-------------- 270-----------------168.90%---- 15 --0.09
FINANCIAL TECH--2,183------------ 770---------------- 183.50%---- 17 --0.09
STOCK-----------03/10 PAT---------03/09 PAT----------YOY% CHANGE--PE--PED RATIO
CAIRN INDIA-----2452--------------262-----------------839%--------54.3--0.04
ASHOK LEYLAND---2230--------------569-----------------291%--------19.5--0.07
KARUR VYAS BANK-990---------------391-----------------153%--------8.3---0.05
VARDHMANTEXTILE-548---------------154-----------------255%--------7.6---0.03
ADHUNIKMETTALICK207---------------22------------------840%--------23.8--0.03
GABRIEL---------64----------------7-------------------814%--------16.6--0.02
RAJESH EXPORT---986---------------94------------------948%--------10.6--0.01
ESCRT-----------444---------------38------------------1068%-------12.0--0.01
FINOLAX CABLE---186---------------25-------------------644%-------5.5---0.01
KAZARIA CERAMIC-127---------------6-------------------2066%-------12.7--0.01
BARTONICS INDIA-254---------------23------------------1109%-------6.4---0.01
JSW STEEL-------7170--------------314-----------------2183%-------9.6---0.01
TN NEWSPRINT---572---------------18------------------3077%-------6.2---0.00
Warren Buffett: How He Does It
Did you know that a $10,000 investment in Berkshire Hathaway in 1965, the year Warren Buffett took control of it, would grow to be worth nearly $30 million by 2005? By comparison, $10,000 in the S&P 500 would have grown to only about $500,000. Whether you like him or not, Buffett's investment strategy is arguably the most successful ever. With a sustained compound return this high for this long, it's no wonder Buffett's legend has swelled to mythical proportions. But how the heck did he do it? In this article, we'll introduce you to some of the most important tenets of Buffett's investment philosophy. (For more on Warren Buffett and his current holdings, check out Coattail Investor.)
Buffett's Philosophy
Warren Buffett descends from the Benjamin Graham school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. When discussing stocks, determining intrinsic value can be a bit tricky as there is no universally accepted way to obtain this figure. Most often intrinsic worth is estimated by analyzing a company's fundamentals. Like bargain hunters, value investors seek products that are beneficial and of high quality but underpriced. In other words, the value investor searches for stocks that he or she believes are undervalued by the market. Like the bargain hunter, the value investor tries to find those items that are valuable but not recognized as such by the majority of other buyers.
Warren Buffett takes this value investing approach to another level. Many value investors aren't supporters of the efficient market hypothesis, but they do trust that the market will eventually start to favor those quality stocks that were, for a time, undervalued. Buffett, however, doesn't think in these terms. He isn't concerned with the supply and demand intricacies of the stock market. In fact, he's not really concerned with the activities of the stock market at all. This is the implication this paraphrase of his famous quote : "In the short term the market is a popularity contest; in the long term it is a weighing machine."(see What Is Warren Buffett's Investing Style?)
He chooses stocks solely on the basis of their overall potential as a company - he looks at each as a whole. Holding these stocks as a long-term play, Buffett seeks not capital gain but ownership in quality companies extremely capable of generating earnings. When Buffett invests in a company, he isn't concerned with whether the market will eventually recognize its worth; he is concerned with how well that company can make money as a business.
Buffett's Methodology
Here we look at how Buffett finds low-priced value by asking himself some questions when he evaluates the relationship between a stock's level of excellence and its price. Keep in mind that these are not the only things he analyzes but rather a brief summary of what Buffett looks for:
1. Has the company consistently performed well?
Sometimes return on equity (ROE) is referred to as "stockholder's return on investment". It reveals the rate at which shareholders are earning income on their shares. Buffett always looks at ROE to see whether or not a company has consistently performed well in comparison to other companies in the same industry. ROE is calculated as follows:
= Net Income / Shareholder's Equity
Looking at the ROE in just the last year isn't enough. The investor should view the ROE from the past five to 10 years to get a good idea of historical performance.
2. Has the company avoided excess debt?
The debt/equity ratio is another key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money. The debt/equity ratio is calculated as follows:
= Total Liabilities / Shareholders' Equity
This ratio shows the proportion of equity and debt the company is using to finance its assets, and the higher the ratio, the more debt - rather than equity - is financing the company. A high level of debt compared to equity can result in volatile earnings and large interest expenses. For a more stringent test, investors sometimes use only long-term debt instead of total liabilities in the calculation above.
3. Are profit margins high? Are they increasing?
The profitability of a company depends not only on having a good profit margin but also on consistently increasing this profit margin. This margin is calculated by dividing net income by net sales. To get a good indication of historical profit margins, investors should look back at least five years. A high profit margin indicates the company is executing its business well, but increasing margins means management has been extremely efficient and successful at controlling expenses.
4. How long has the company been public?
Buffett typically considers only companies that have been around for at least 10 years. As a result, most of the technology companies that have had their initial public offerings (IPOs) in the past decade wouldn't get on Buffett's radar (not to mention the fact that Buffett will invest only in a business that he fully understands, and he admittedly does not understand what a lot of today's technology companies actually do). It makes sense that one of Buffet's criteria is longevity: value investing means looking at companies that have stood the test of time but are currently undervalued.
Never underestimate the value of historical performance, which demonstrates the company's ability (or inability) to increase shareholder value. Do keep in mind, however, that the past performance of a stock does not guarantee future performance - the job of the value investor is to determine how well the company can perform as well as it did in the past. Determining this is inherently tricky, but evidently Buffett is very good at it.
5. Do the company's products rely on a commodity?
Initially you might think of this question as a radical approach to narrowing down a company. Buffett, however, sees this question as an important one. He tends to shy away (but not always) from companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity such as oil and gas. If the company does not offer anything different than another firm within the same industry, Buffett sees little that sets the company apart. Any characteristic that is hard to replicate is what Buffett calls a company's economic moat, or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.
6. Is the stock selling at a 25% discount to its real value?
This is the kicker. Finding companies that meet the other five criteria is one thing, but determining whether they are undervalued is the most difficult part of value investing, and Buffett's most important skill. To check this, an investor must determine the intrinsic value of a company by analyzing a number of business fundamentals, including earnings, revenues and assets. And a company's intrinsic value is usually higher (and more complicated) than its liquidation value - what a company would be worth if it were broken up and sold today. The liquidation value doesn't include intangibles such as the value of a brand name, which is not directly stated on the financial statements.
Once Buffett determines the intrinsic value of the company as a whole, he compares it to its current market capitalization - the current total worth (price). If his measurement of intrinsic value is at least 25% higher than the company's market capitalization, Buffett sees the company as one that has value. Sounds easy, doesn't it? Well, Buffett's success, however, depends on his unmatched skill in accurately determining this intrinsic value. While we can outline some of his criteria, we have no way of knowing exactly how he gained such precise mastery of calculating value. (To learn more about the value investing strategy of selecting stocks, check out our Guide To Stock-Picking Strategies.)
Conclusion
As you have probably noticed, Buffett's investing style, like the shopping style of a bargain hunter, reflects a practical, down-to-earth attitude. Buffett maintains this attitude in other areas of his life: he doesn't live in a huge house, he doesn't collect cars and he doesn't take a limousine to work. The value-investing style is not without its critics, but whether you support Buffett or not, the proof is in the pudding. As of 2004, he holds the title of the second-richest man in the world, with a net worth of more $40 billion (Forbes 2004). Do note that the most difficult thing for any value investor, including Buffett, is in accurately determining a company's intrinsic value.
by Investopedia Staff (Contact Author | Biography)
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.
Market Strength: S&P 500 FuturesPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
If you've ever watched financial television before or after the markets open you will probably notice that they often quote the latest index futures price on the "bug" in the bottom corner. The futures market is an important concept and can be used to gauge the trend of the market.
Futures
There are two types of futures contracts, financial and commodities. No matter which type of contract you buy the basic premise is the same. The buyer of the contract agrees to deliver the product (or cash for financial futures) at the contract price on the expiry date. A contract can be on anything from corn, wheat, oil or, in our case, a stock index. It should be noted that a majority of futures contracts get "closed out" before the delivery date and so no physical delivery actually takes place.
The Standard and Poor's 500 index (S&P 500) contains many of the largest companies in the world, so it only makes sense that movement in the direction of the S&P futures is one of the best indicators of overall short-term market direction (Note: The Nasdaq futures are considered a good indicator of technology stocks). The word futures might make this indicator sound confusing but it really isn't. If S&P futures are up, it's an indication that there is upward pressure on the market and the stock market will tend to rise. On the other hand, if S&P futures are down, it's a sign that there is downward pressure on the market and it will likely trend lower.
This rise or decline in the futures contract is usually calculated as a change from fair value. Fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest and dividends lost because the investor owns the futures contract rather than the physical stocks. This price is determined over the period of the futures contract.
Arbitrageurs
Part of the reason that the markets follow the trend of futures contracts is because of arbitrageurs. An arbitrageur is someone who simultaneously purchases and sells a security (or index) in order to profit from a differential in the price, usually on different exchanges or marketplaces. For S&P futures contracts here is what happens: Suppose the futures contract is trading above fair value (higher), before the market is about to open. An arbitrageur will sell (short) the S&P futures contract and go long (buy) on the underlying stocks within the S&P 500 index. Therefore, the stock prices will increase until the S&P 500 index reaches fair value with S&P futures contract. This sounds like a lot of work but really isn't because of program trading. Using software that monitors both a stock index and futures contracts on the index, traders can be notified when there is a larger than normal gap. This strategy is commonly referred to as index arbitrage.
Popularity
The main reason that S&P futures are so popular for detecting strength is because this contract trades 24 hours a day on financial exchanges around the world. It allows traders and brokers to gauge the futures level before the actual stock markets open for trading which gives a sense of where the market is likely trend at the start of trading.
Market Strength: Advancers to DeclinersPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
The advance/decline line (A/D) is a technical analysis tool and is considered the best indicator of market movement as a whole. Stock indexes such as the Dow Jones Industrial Average (DJIA) only tell us the strength of 30 stocks, whereas the A/D line provides much more insight. The formula is quite simple: it is the ratio between advancing stocks and declining ones. If the markets are up but there are more declining stocks than advancing ones it's usually a sign that the markets are losing their breadth or momentum. If the number of advancing issues are dominating the declining issues, the market is said to be healthy.
Unlike the S&P futures contract, this indicator is not necessarily short term. Looking at the A/D line (not just the advance decline ratio) shows us the cumulative trend of advancers to decliners over a particular period of time. Most of the time the stock market does not turn around in an instant. Instead, the markets shift slowly, just as economic, business and market cycles would. This is why the general overall trend of the A/D line is important when determining the strength of the market.
Even so, the advancers to decliners is a tool and not a crystal ball. Sudden market shocks that result from interest rate movements, war, or other drastic events can't be detected by the A/D.
Next: Market Strength: Relative Strength Index and Arms
RSI: Calculation Underlies Meaningful Interpretation
--------------------------------------------------------------------------------
RSI is probably J. Welles Wilder Jr.'s best-known indicator. It can be found on virtually every technical analysis website and is included with almost all software packages. RSI stands for Relative Strength Index, but the name is misleading. Most relative strength calculations compare a stock against an index -- such as comparing Intel (INTC) to the Semiconductor or $SOX index. Wilder's RSI compares a stock's gains to its losses over a set period of time. The result is an RSI graph usually presented as a panel above or below the price chart.
When Wilder first articulated RSI in his 1978 book, New Concepts in Technical Analysis (ISBN 0-894959-027-8), his methodology involved the use of a Hewlett-Packard programmable calculator. The swing trader of that time would have had to follow the logic of a 10-column spreadsheet to understand how the indicator was constructed. The swing trader of 2004 has a noticeable advantage. With a stroke of the computer key, presto, RSI appears above or below the price chart.
On reflection, however, this ability to effortlessly conjure up RSI can also be a disadvantage. Without understanding the mathematical construction of the indicator, it is easy to use it mechanically. Worse, its implications can be misinterpreted, which may lead to poor trading decisions. In future articles I will devote attention to a detailed discussion of how RSI can:
-- Serve as a leading indicator of an upcoming reaction or reversal by limning out "a failure swing."
-- Trace out price patterns difficult to detect on the underlying price chart.
-- Signal bearish or bullish momentum divergence and therefore the probability of trend reversal.
-- Mimic trendlines on the underlying price chart by establishing key support and resistance levels.
Many times during these discussions, I will refer back to the mathematical reasoning behind RSI and I will now explain that calculation.
The formula for RSI is:
RSI = 100 – [100/1 +RS]
RS = Average of n periods closes up/Average of n periods closes down.
RSI provides meaningful information on a chart of any length, and I have used it on 5 minute, hourly, daily, weekly and monthly charts. "N" in the RS formula is the number of periods used in the calculation. Wilder himself suggested 14 periods as the default, but a 9 and 21 period RSI are also commonly used by traders.
If you're not mathematically inclined, finding RS can sound daunting, but is actually simple. The first step is to assemble 14 periods of data for any stock or index. In the example below of Intel, I started my RSI calculation on November 1st and collected 14 days of closing prices, since I wanted to do a daily RSI computation.
The next step was to total all the up closes, or daily gains, during the 14 days. As the spreadsheet below shows, Intel gained 17 cents on November 2nd, 6 cents on November 3rd, 21 cents on November 4th etc. The sum of these gains for all fourteen days was $2.77. To find out the average gain for the period, one simply divides $2.77 by 14 to get 19.8 cents.
The same process is repeated for the down days. Total declines in the 14-day period were 50 cents, making the average decline 3.6 cents.
Next, you need to figure out RS. RS is calculated by dividing the average up closes (19.8) by the average down closes
(3.6). This simple calculation (19.8/3.6) yields a result of 5.50.
The formula asks us to then add 1.0 to 5.5, giving us a result of 6.5. To resolve the brackets we divide 100/6.5 and find that the answer is 15.38.
The final step is to subtract 15.38 from 100. The 100 is included in the formula to insure that the final result always oscillates between zero and 100. When 15.38 is deducted from 100, we have calculated the RSI of 84.62. That RSI indicates Intel is extremely overbought and is prone to profit taking or a "reaction." (Note that Stockcharts further smoothes this raw RSI number by adding additional data points so its RSI and the one you calculate will be slightly different.)
One of Wilder's goals in creating RSI was to eliminate unnecessary calculations. Once the 14th day's numbers were established, he used a 10-column spreadsheet to compute subsequent RSI values. An example of the 10- column spreadsheet with RSI calculations is provided below. The math takes some practice. The logic itself, however, doesn't change. RSI for days 15-19 (November 19-26) is presented in the spreadsheet.
A----- B---- C-- D-------E------ F------- G------ H------- I----- J
Date- Close- Up- Down- Up Avg.Down Avg-Cell E/F-1.1+"G"-100/"H"(100-Cell I) = RSI
11/1 $22.44
11/2 $22.61 0.17
11/3 $22.67 0.06
11/4 $22.88 0.21
11/5 $23.36 0.48
11/8 $23.23 ----0.13
11/9 $23.08 ----0.15
11/10 $22.86 ----0.22
11/11 $23.17 0.21
11/12 $23.69 0.52
11/15 $23.77 0.08
11/16 $23.84 0.08
11/17 $24.32 0.48
11/18 $24.80 0.48
14-Day-Totals 2.77-0.50 - 0.198-0.036--5.50--6.50--15.38-- 84.62
11/19 $24.16 -0.64 0--- 0.184- 0.079- 2.33- 3.33- 30.00-- 70.00
11/22 $24.10 -0.06 ------0.171--0.078- 2.19- 3.19-- 31.55--68.65
11/23 $23.37 -0.73 -----0.158--0.124- 1.28- 2.28-- 43.86--56.14
11/24 $23.61 0.24 ------- 0.164- 0.115- 1.42- 2.42-- 41.32--58.68
11/26 $23.21 -0.40----- 0.152- 0.135- 1.12- 2.12-- 47.16- 52.84
Below is a chart of Intel covering the period of the spreadsheet, November 1st -26th. In addition to RSI, I have also placed parabolic SAR and ADX, two of Wilder's other popular indicators, on the chart. Note that on November 12th RSI went above the overbought 70 level. That warned the swing trader INTC was significantly overbought. By itself, it was not a sell signal, because a stock can get and stay overbought for a long period of time when a strong uptrend is in place. It did caution, however, to be very alert for a reaction and be prepared to nail down profits.
Intel stayed overbought for several days and reached a closing peak of $24.80 on November 18th. RSI at that point was an extreme 84.62. Note how the large series of up days and the very small number of down days led to this extreme reading.
On November 19th, Intel declined 64 cents, creating a large black candle. RSI gave a sell signal as it declined from above 70 to below that level. The slower moving ADX, while remaining on a buy signal, saw +DI fall below the black ADX line, often signaling a peak. The following day INTC lost another 6 cents. The parabolic SAR dots switched from below the share price to above it, signifying that profits should immediately be taken on INTC (the Swing Trader exited its position in INTC on this day with an 8.1% gain). According to Wilder's indicators, however, since ADX was on a buy signal, INTC should not be shorted.
Note how the RSI declined on subsequent days as the price fell. As the average gains in the last fourteen days approached the average losses, RSI trended down toward the 50 level, the point at which gains and losses over the 14 days are in perfect balance.
Understanding how RSI is constructed leads to more effective use of the indicator.
--------------------------------------------------------------------------------
Market Strength: Relative Strength Index and Arms
Relative Strength
When talking about the strength of a stock or overall market, one great tool is the relative strength index (RSI) which is a comparison between the days a stock finishes up against the days it finishes down. It is a big tool in momentum trading. Depending on the type of investor, the RSI can be used to detect strength over a couple hours or over several months. Obviously, the longer trends are more valuable to long-term investors, whereas short-term trends in the RSI are popular with traders.
RSI = 100 - [100/(1 + RS)]
where:
RS = (Avg. of n-day up closes)/(Avg. of n-day down closes)
n= days (most analysts use 9 - 15 day RSI)
The RSI ranges from 0 to 100. A stock is considered overbought around the 70 level - a reason to consider selling. This number is not written in stone, in a bull market 80 is a better level because stocks often trade at higher valuations. Likewise, if the RSI approaches 30, a stock is considered oversold - a cause consider buying it. Again, make the adjustment to 20 in a bear market.
A long-term RSI is more rolling and it fluctuates a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks of some industries will go as high as 75-80 before dropping back and others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (one year or more) to determine at what level the RSI has traded in the past.
This chart was supplied by Barchart.com
Here we have an RSI chart for AT&T (T). The RSI is the green line and its scale is the numbers that go from 0 to 100. Notice that the RSI was approaching the 60-70 level and then the stock (blue line) sold off, both in December and January. Also notice around October when the RSI dropped to 25 the stock climbed up nearly 30% in just a couple of weeks.
Divergence Trading
What if there was a low risk way to sell near the top or buy near the bottom of a trend?
What if you were already in a long position and you could know ahead of time the perfect place to exit instead of watching your unrealized gains, a.k.a your potential Aston Martin down payment, vanish before your eyes because your trade reverses direction?
What if you believe a currency pair will continue to fall but would like to short at a better price or a less risky entry?
Well guess what? There is a way! It's called divergence trading.
In a nutshell, divergence can be seen by comparing price action and the movement of an indicator. It doesn't really matter what indicator you use. You can use RSI, MACD, the stochastic, CCI, etc.
The great thing about divergences is that you can use them as a leading indicator, and after some practice it's not too difficult to spot.
When traded properly, you can be consistently profitable with divergences. The best thing about divergences is that you're usually buying near the bottom or selling near the top. This makes the risk on your trades are very small relative to your potential reward.
Cha-ching!
Higher Highs and Lower Lows
Just think "higher highs" and "lower lows".
Price and momentum normally move hand in hand like Hansel and Gretel, Batman and Robin, Serena and Venus Williams, salt and pepper...You get the point.
If price is making higher highs, the oscillator should also be making higher highs. If price is making lower lows, the oscillator should also be making lower lows.
If they are NOT, that means price and the oscillator are diverging from each other. And that's why it's called "divergence."
Divergence trading is an awesome tool to have in your toolbox because divergences signal to you that something fishy is going on and that you should pay closer attention.
Using divergence trading can be useful in spotting a weakening trend or reversal in momentum. Sometimes you can even use it as a signal for a trend to continue!
There are TWO types of divergence:
1.Regular
2.Hidden
In this grade, we will teach you how to spot these divergences and how to trade them. We'll even have a sweet surprise for you at the end.
Regular Divergence
A regular divergence is used as a possible sign for a trend reversal.
If price is making lower lows (LL), but the oscillator is making higher lows (HL), this is considered to be regular bullish divergence.
This normally occurs at the end of a down trend. After establishing a second bottom, if the oscillator fails to make a new low, it is likely that the price will rise, as price and momentum are normally expected to move in line with each other.
Below is an image that portrays regular bullish divergence.
Now, if the price is making a higher high (HH), but the oscillator is lower high (LH), then you have regular bearish divergence.
This type of divergence can be found in an uptrend. After price makes that second high, if the oscillator makes a lower high, then you can probably expect price to reverse and drop.
In the image below, we see that price reverses after making the second top.
As you can see from the images above, the regular divergence is best used when trying to pick tops and bottoms. You are looking for an area where price will stop and reverse.
The oscillators signal to us that momentum is starting to shift and even though price has made a higher high (or lower low), chances are that it won't be sustained.
Did you get all of that? Pretty simple eh?
Now that you've got a hold on regular divergence, it's time to move and learn about the second type of divergence - hidden divergence.
Don't worry, it's not super concealed like the Chamber of Secrets and it's not that tough to spot. The reason it's called "hidden" is because it's hiding inside the current trend.
Hidden divergence
Divergences not only signal a potential trend reversal; they can also be used as a possible sign for a trend continuation. Always remember, the trend is your friend, so whenever you can get a signal that the trend will continue, then good for you!
Hidden bullish divergence happens when price is making a higher low (HL), but the oscillator is showing a lower low (LL).
This can be seen when the pair is in an uptrend. Once price makes a higher low, look and see if the oscillator does the same. If it doesn't and makes a lower low, then we've got some hidden divergence in our hands.
Lastly, we've got hidden bearish divergence. This occurs when price makes a lower high (LH), but the oscillator is making a higher high (HH). By now you've probably guessed that this occurs in a downtrend. When you see hidden bearish divergence, chances are that the pair will continue to shoot lower and continue the downtrend.
Let's recap what you've learned so far about hidden divergence.
If you're a trend follower, then you should dedicate some time to spot some hidden divergence.
If you do happen to spot it, it can help you jump in the trend early.
Sounds good, yes?
Okay, now you know about both regular and hidden divergence.
We hope you got it all down pat. Keep in mind that regular divergences are possible signals for trend reversals while hidden divergences signal trend continuation.
How To Trade Divergences
Now it's time to put those Jedi-divergence mind tricks to work and force the markets to give you some pips!
Here we'll show you some examples of when there was divergence between price and oscillator movements.
First up, let's take a look at regular divergence. Below is a daily chart of USD/CHF.
We can see from the falling trend line that USD/CHF has been in a downtrend. However, there are signs that the downtrend will be coming to an end.
While price has registered lower lows, the stochastic (our indicator of choice) is showing a higher low.
Something smells fishy here. Is the reversal coming to an end? Is it time to buy this sucker?
If you had answered yes to that last question, then you would have found yourself in the middle of the Caribbean, soaking up margaritas, as you would have been knee deep in your pip winnings!
It turns out that the divergence between the stochastic and price action was a good signal to buy. Price broke through the falling trend line and formed a new uptrend. If you had bought near the bottom, you could have made more than a thousand pips, as the pair continued to shoot even higher in the following months.
Now can you see why it rocks to get in on the trend early?!
Before we move on, did you notice the tweezer bottoms that formed on the second low?
Keep an eye out for other clues that a reversal is in place. This will give you more confirmation that a trend is coming to an end, giving you even more reason to believe in the power of divergences!
Next, let's take a look at an example of some hidden divergence. Once again, let's hop on to the daily chart of USD/CHF.
Here we see that the pair has been in a downtrend. Notice how price has formed a lower high but the stochastic is printing higher highs.
According to our notes, this is hidden bearish divergence! Hmmm, what should we do? Time to get back in the trend?
Well, if you ain't sure, you can sit back and watch on the sidelines first.
If you decided to sit that one out, you might be as bald as Professor Xavier because you pulled out all your hair.
Why?
Well the trend continued!
Price bounced from the trend line and eventually dropped almost 2000 pips!
Imagine if you had spotted the divergence and seen that as a potential signal for a continuation of the trend?
Momentum Tricks
While using divergences is a great tool to have in your trading toolbox, there are times when you might enter too early because you didn't wait for more confirmation. Below are a couple of tricks that you can make use of so that you have more confirmation that the divergence will work out in your favor.
Wait for a crossover
This ain't so much a trick as it is a rule. Just wait for a crossover of the momentum indicator. This would indicate a potential shift in momentum from buying to selling or vice versa. The main reasoning behind this is that you are waiting for top or bottom and these can't be formed unless a crossover is made!
In the chart above, the pair showed lower highs while the stochastic already made higher highs. Now that's a bearish divergence there and it sure is tempting to short right away.
But, you know what they say, patience is a virtue. It'd be better to wait for the stochastic to make a downward crossover as confirmation that the pair is indeed headed down.
A couple of candles later, the stochastic did make that crossover. Playing that bearish divergence would've been pip-tastic!
What's the main point here? Just be patient! Don't try to jump the gun because you don't quite know when momentum will shift! If you aren't patient, you might just get burned as one side keeps dominating!
Moving out of overbought / oversold
Another trick would be to wait for momentum highs and lows to hit overbought and oversold conditions, and wait for the indicator to move out of these conditions.
The reason for doing this is similar to that of waiting for a crossover - you really don't have any idea when momentum will begin to shift.
Let's say you're looking at a chart and you notice that the stochastic has formed a new low while price hasn't.
You may think that it's time to buy because the indicator is showing oversold conditions and divergence has formed. However, selling pressure may remain strong and price continues to fall and make a new low.
You would have been pretty bummed out as trend didn't continue. In fact, a new downtrend is probably in place as the pair is now forming lower highs. And if you were stubborn, you might have missed out on this down move too.
If you had waited patiently for more confirmation that the divergence had formed, then you could have avoided losing and realized that a new trend was developing.
Draw trend lines on the momentum indicators themselves
This might sound a little ridiculous since you would normally draw trend lines only on price action. But this is a nifty lil' trick that we wanna share with you. After all, it doesn't hurt to have another weapon in the holster right? You never know when you might use it!
This trick can be particularly useful especially when looking for reversals or breaks from a trend. When you see that price is respecting a trend line, try drawing a similar trend line on your indicator.
You may notice that the indicator will also respect the trend line. If you see both price action and the momentum indicator break their respective trend lines, it could signal a shift in power from buyers to sellers (or vice versa) and that the trend could be changing. Oh yeah! Break it down like a Michael Jackson video
9 Rules for Trading Divergence
Before you head out there and start looking for potential divergencr, here are 9 rules for trading divergence.
1. Make sure your glasses are clean
In order for divergence to exist, price must have either formed one of the following:
•Higher high than the previous high
•Lower low than the previous low
•Double top
•Double bottom
Don't even bother looking at an indicator unless ONE of these four price scenarios have occurred. If not, you ain't trading a divergence, buddy. You're just imagining things. Immediately go see your optometrist and get some new glasses.
2. Draw lines on successive tops and bottoms
Okay now that you got some action (recent price action that is), look at it. Remember, you'll only see one of four things: a higher high, a flat high, a lower low, or a flat low.
Now draw a line backward from that high or low to the previous high or low. It HAS to be on successive major tops/bottom. If you see any little bumps or dips between the two major highs/lows, do what you do when your significant other shouts at you - ignore it.
3. Do Tha Right Thang - Connect TOPS and BOTTOMS only
Once you see two swing highs are established, you connect the TOPS. If two lows are made, you connect the BOTTOMS.
Don't make the mistake of trying to draw a line at the bottom when you see two higher highs. It sounds dumb but really, peeps regularly get confused.
4. Eyes on the Price
So you've connected either two tops or two bottoms with a trend line. Now look at your preferred indicator and compare it to price action. Whichever indicator you use, remember you are comparing its TOPS or BOTTOMS. Some indicators such as MACD or Stochastic have multiple lines all up on each other like teenagers with raging hormones. Don't worry about what these kids are doing.
5. Be Fly like Pip Diddy
If you draw a line connecting two highs on price, you MUST draw a line connecting the two highs on the indicator as well. Ditto for lows also. If you draw a line connecting two lows on price, you MUST draw a line connecting two lows on the indicator. They have to match!
6. Keep in Line
The highs or lows you identify on the indicator MUST be the ones that line up VERTICALLY with the price highs or lows. It's just like picking out what to wear to the club - you gotta be fly and matchin' yo!
7. Ridin' the slopes
Divergence only exists if the SLOPE of the line connecting the indicator tops/bottoms DIFFERS from the SLOPE of the line connection price tops/bottoms. The slope must either be: Ascending (rising) Descending (falling) Flat (flat)
8. If the ship has sailed, catch the next one
If you spot divergence but the price has already reversed and moved in one direction for some time, the divergence should be considered played out. You missed the boat this time. All you can do now is wait for another swing high/low to form and start your divergence search over.
9. Take a step back
Divergence signals tend to be more accurate on the longer time frames. You get less false signals. This means fewer trades but if you structure your trade well, then your profit potential can be huge. Divergences on shorter time frames will occur more frequently but are less reliable.
We advise only look for divergences on 1-hour charts or longer. Other traders use 15-minute charts or even faster. On those time frames, there's just too much noise for our taste so we just stay away.
So there you have it kiddos - 9 rules you MUST follow if you want to seriously consider trading using divergences. Trust us, you don't wanna be ignoring these rules. Your account will take more hits than BabyPips.com's Facebook fan page.
Follow these rules, and you will dramatically increase the chances of a divergence setup leading to a profitable trade.
Now go scan the charts and see if you can spot some divergences that happened in the past as a great way to begin getting your divergence skills up to par!
Divergence Cheat Sheet
Let's review!
There are two types of divergences:
1.Regular divergence
2.Hidden divergence
Each type of divergence will contain either a bullish bias or a bearish bias.
Since you've all be studying hard and not been cutting class, we've decided to help y'all out (cause we're nice like that) by giving you a cheat sheet to help you spot out regular and hidden divergences quickly.
Type----- Bias------ Price -----Oscillator------ Description----------- Example
Regular-- Bullish--- Lower Low-- Higher Low--- Indicates underlying
--- strength. Bears are exhausted.
------------------------------------------------Warning of possibletrend
direction change from
downtrend to uptrend.
--------------------------------------------------------------------------------
Bearish-- Higher High--Lower High-----Indicates underlying weakness
. Bulls are exhausted.
Warning of possible trend
direction change from
uptrend to downtrend.
----------------------------------------------------------------------------------
Hidden---Bullish--- Higher Low----Lower Low----- Indicates underlying strength.
Good entry or re-entry. Occurs
during retracements in an
uptrend. Nice to see during
price retest of previous
lows. "Buy the dips"
----------------------------------------------------------------------------------
Hidden--Bearish--- Lower High--- Higher High-----Indicates underlying weakness.
Found during retracements in
a downtrend.Nice to see during
price resets of previous
highs.Sell the rallies.
----------------------------------------------------------------------------------
Whew! That's quite a lot to remember, isn't it? We'll give you two options:
1.You can write this all down in your palm and look back on it while trading. If you're the type who gets sweaty palms when you're nervous, we wouldn't recommend this.
2.You can simply bookmark this page and just revisit it when you mix up those higher lows, lower highs, lower lows, and higher highs. You don't want to make a wild guess while coming up with a trade, do you?
Summary: Divergences
Please keep in mind that we use divergence as an indicator, not a signal to enter a trade!
It wouldn't be smart to trade basely solely on divergences since too many false signals are given. It's not 100% foolproof, but when used as a setup condition and combined with additional confirmation tools, your trades have a high probability of winning with relatively low risk.
There are a bunch of ways to take advantage of those divergences.
One way is to look at trend lines or candlestick formations to confirm whether a reversal or continuation is in order.
Another way is to make use of momentum tricks by watching out for an actual crossover or waiting for the oscillator to move out of the overbought/oversold region. You can also try drawing trend lines on the oscillator too.
With these nifty tricks, you can guard yourself against false signals and filter out those that'll be very profitable.
On the flip side, it is just as dangerous trade against this indicator.
If you're unsure about which direction to trade, chill out on the sidelines.
Remember that taking no position is a trading decision in itself and it's better to hold on to your hard-earned cash than bleed Benjamins on a shaky trade idea.
Divergences don't appear that often, but when they do appear, it'd behoove you to pay attention.
Regular divergences can help you collect a big chunk of profit because you're able to get in right when the trend changes.
Hidden divergences can help you ride a trade longer resulting in bigger-than-expected profits by keeping you on the correct side of a trend.
The trick is to train your eye to spot divergences when they appear AND choose the proper divergences to trade.
Just because you see a divergence, it doesn't necessarily mean you should automatically jump in with a position. Cherry pick your setups and you'll do well.
What does it mean to use technical divergence in trading?
--------------------------------------------------------------------------------
In technical analysis, most indicators can give three different types of trading signals: crossing over a major signal line, crossing over a center line and indicator divergence.
Of these three signals, divergence is definitely the most complicated for the rookie trader. Divergence occurs when an indicator and the price of an asset are heading in opposite directions. Negative divergence happens when the price of a security is in an uptrend and a major indicator - such as the moving average convergence divergence (MACD), price rate of change (ROC) or relative strength index (RSI) - heads downward. Conversely, positive divergence occurs when the price is in a downtrend but an indicator starts to rise. These are usually reliable signs that the price of an asset may be reversing. When using divergence to help make trading decisions, be aware that indicator divergence can occur over extended periods of time, so tools such as trendlines and support and resistance levels should also be used to help confirm the reversal.
The chart below shows an example of divergence:
Chart by MetaStock
The security shown is experiencing a prolonged uptrend; an observant trader would realize that the price ROC is sloping down while the price continues to climb. This type of negative divergence can be an early sign that the price of the underlying security may be reversing. If the price of the security breaks below the upward trendline, this will complete the confirmation and the trader will take a short position.
Divergence: The Trade Most Profitable by Candy Schaap
Because trends are composed of a series of price swings, momentum plays a key role is assessing trend strength. As such, it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal, but it does signal that something is changing, and that the trend may consolidate or reverse.
Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum. Here, we'll take a look at how to evaluate price momentum and show you what divergence in momentum can tell you about the direction of a trend.
Defining Price Momentum
The magnitude of price momentum is measured by the length of short-term price swings. The beginning and end of each swing is established by structural price pivots, which form swing highs and lows. Strong momentum is exhibited by a steep slope and a long price swing. Weak momentum is seen with a shallow slope and short price swing (Figure 1).
Figure 1: Momentum
For example, the length of the upswings in an uptrend can be measured. Longer upswings suggest that the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength. Equal length upswings means the momentum remains the same. (For related reading, see Momentum Trading With Discipline and Riding The Momentum Investing Wave.)
Price swings are not always easy to evaluate with the naked eye - price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price.
Momentum Stock Trading System
New: FREE this week: "The 7 Steps to Become a Highly Successful Stressfree Trader" + our DailyStock Picks
- Our New 8-chapter E-book on the best and most overlooked ways to trade without investing tons of time and stress, priced at $49, is FREE to you right now as a special introductory promotion. Download it now, because this is *HOT* - Click here to download
Momentum trading seems to have many followers and equally many skeptics and cynics but we must first define exactly what momentum trading is and its advantages and disadvantages in order to form an educated opinion.
Momentum trading merely says every year there are a small number of stocks that go on to gain 500%- 1000%+ moves in the stock market. This can easily be seen by going to one of the many free stock screeners and typing in the parameter that displays stocks that have gained at least 500% over the year. Depending on the state of the overall stock market will depend how many stocks show up in this search. Even during the worse bear market I can recall (2000 –2001) there are still dozens of small cap, unknown stocks, going on to make 500%+ moves.
Let's go right back to some good old common sense. Let's say every year there are 30 stocks that go onto make a 700% move in the stock market. What if we can jump on these stocks when they have put in a 400% move for the year? So to jump on board a momentum stock simply identify which stocks have already put in a sterling performance for the year. Buy into them and hope they keep powering on. Some will and some will not. Simply cut your losses quickly on the losers and ride the winners for as long as they keep heading in the right direction.
For many they will look at a stock, which has already gained 400%, and say it has gone too far. They would rather get in at the bottom and ride the stock from 0 to 400%. They have been taught buy " stock guru" to buy low and sell high. This sounds great but in practice it is a losing strategy. Why? You have no way of knowing which stocks the market will or will not fall in love with. All the fundamentals in the world cannot give you a better chance than flipping a coin. You can pick two equally great looking stocks. Both with fantastic earnings and prospects. One will languish the other will go no to make stellar returns. Are you willing to take this risk?
Trying to pick a bottom is greed. You are not happy with making a 200,300%+ gain but you want more. You want it all. Greed and fear are the emotions that always have and always will destroy your stock market profits.
Another advantage with momentum trading and one severely overlooked is the speed at which profits are made. It's all very well making a 800% return on a stock you made but it's that great a return if it took six years to make it. Did you know the fastest movement in a trend is in the last quarter? You do now. Trends start slowly and gather momentum as they continue. A stock, which rises from $10 to $300, will see its fastest move from about $70 onwards. The movement from $70 to $300 will be in about 1/10 of the time it took for the stock to go from $10 to $70. Think about this. It is much better to jump into the tale end of a large trend than catch the smaller, slower moving start of trends and this is exactly what momentum stock trading is all about.
Momentum Indicators
Common momentum indicators for measuring price movements include the relative strength index (RSI), stochastics and rate of change (ROC). Figure 2 is an example of how RSI is used to measure momentum. The default setting for RSI is 14. RSI has fixed boundaries with values ranging from 0-100.
For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also swings down. (For related reading, see Getting Confirmation With The Momentum Strategy.)
Figure 2: Indicator swings generally follow the direction of price swings (A). Trendlines can be drawn on swing highs (B) and lows (C) to compare the momentum between price and the indicator.
Source: TDAmeritrade Strategy Desk
The study of momentum simply checks whether price and the indicator agree or disagree.
Figure 3: Compare price and indicator to make better trading decisions.
Source: TDAmeritrade Strategy Desk
Momentum Divergence
Disagreement between the indicator and price is called divergence and it can have significant implications for trade management. The amount of agreement/disagreement is relative, so there can be several different patterns that develop in the relationship between price and the indicator. For this article, the discussion will be limited to the basic forms of divergence. (For more, see What does it mean to use technical divergence in trading?)
It is important to note that there must be price swings of sufficient strength to make momentum analysis valid. Therefore, momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable, as shown in Figure 4.
Figure 4: In range conditions the indicator does not add to what we see from price alone. Variable pivot highs and lows show range.
Source: TDAmeritrade Strategy Desk
Divergence in an uptrend occurs when price makes a higher high, but the indicator does not make a higher high. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not make a lower low. When divergence is spotted, there is a higher probability of a price retracement. Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways. (For more insight, check out Retracement Or Reversal: Know The Difference.)
Figure 5: Momentum divergence and a pullback. Higher pivot highs (small orange arrows) signal price support.
Source: TDAmeritrade Strategy Desk
Divergence helps the trader recognize and react appropriately to a change in price action. It tells us something is changing and that the trader must make a decision about the trade, such as tighten the stop-loss or take profit. Seeing divergence increases profitability by alerting the trader to protect profits.
Take note of the stock from Figure 5, Chesapeake Energy Corp. (NYSE:CHK), in which shares pulled back to the support. The chart of CHK in Figure 6 (below) shows that trends do not reverse quickly or often. Therefore, we make the best profits when we understand trend momentum and use it for the right strategy at the right time.
Figure 6: Trend continuation. Agreement between price and the indicator give an entry (small green arrows).
Source: TDAmeritrade Strategy Desk
Managing Divergence
Divergence is important for trade management. In Figure 5, taking profit or selling a call option were fine strategies. The divergence between the price and the indicator lead to a pullback and then the trend continued. If you look at the pivot the price makes below the lower trendline, this is often referred to as a bear trap, where the false signal draws in shorts and then price quickly reverses. We can see that the signal to enter appeared when the higher low in price agreed with the higher low of the indicator in Figure 6 (small green arrows).
Divergence indicates that something is changing, but it does not mean the trend will reverse. It signals that the trader must consider strategy options: holding, selling a covered call, tightening the stop, or taking partial profits. The glamor of wanting to pick the top or bottom is more about ego than profits. To be consistently profitable is to pick the right strategy for what price is doing, not what we think price will do. (For more, see Divergences, Momentum and Rate Of Change.)
Figure 7: Divergence results in range.
Source: TDAmeritrade Strategy Desk
Figure 7 shows divergence that leads to sideways price action. Notice the weakening momentum in moving average convergence divergence (MACD) as price enters a range. This signals that the trader should consider strategy options. When price and the indicator are inconsistent relative to each other, we have disagreement, or divergence. We are not in control of what price will do; we control only our own actions.
Figure 8: Divergence and then reversal of trend.
Source: TDAmeritrade Strategy Desk
Sometimes divergence will lead to a trend reversal, as shown in Figure 8. The Utilities Select Sector ETF (AMEX:XLU) shown in Figure 9 pays a dividend and has options. Understanding trend momentum gives a profit edge as there are three ways to profit here: capital gains, dividends and call premium. This example shows trend continuation after a sideways move, which translates into profit continuation.
Figure 9: Go with the trend when the price and the indicator agree.
Source: TDAmeritrade Strategy Desk
Conclusion
The most useful way to use a momentum indicator is to know what strategy to use. Price will lead the way but momentum can indicate a time to preserve profits. The skill of a professional trader lies in his or her ability to implement the correct strategy for price action.
Arms Index (TRIN)
The Arms Index is commonly referred to on financial television and short-term trading websites. Arms is a market performance indicator that varies from the A/D and RSI because instead of simply looking at the number of up and down ticks (or stocks) the Arms Index weighs each stock by the volume traded for each issue. A ratio of one means that the market is in balance. A ratio above one indicates that more volume is moving into declining stocks. A ratio below one indicates that more volume is moving into advancing stocks.
Both the RSI and Arms are great little indicators that can help you detect the overall strength of the market. Most investors agree that the RSI and Arms is most effective in "backing up" or increasing confidence before making an investment decision.
Next: Market Strength: Oil and Bonds
Market Strength: Oil and BondsPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
The price of oil and bonds as they relate to market strength is a wide topic, but these are two areas tend to have a large influence over the markets. In this section, we will address the basics of using the prices of these vehicles to determine market strength.
Oil
Energy is one commodity that affects every company in one way or another. For example, the price of wheat makes a greater impact on agriculture stocks, but oil influences everything from the cost of electricity and heating, to the cost of production and transportation. When the price of commodities, and particularly oil, is on the rise it signals that inflation is starting to become apparent. The day-to-day price fluctuations won't cause inflation fears, but the long-term trend will. If the price of oil has been steadily increasing, it could cause investors to be fearful that inflating energy prices will slow company profits.
The price of oil has an opposite effect on those stocks directly influenced by the price of oil. Drilling, pipeline and retail distribution of energy stocks tend to have an extremely high correlation to the price of oil.
Bond Prices
Ten and 30 year bonds, along with interest rate futures are another indicator used by many investors to gauge the strength of the stock market. As you may already know, if bond prices are going up, then yields are decreasing. This decrease in yields causes investors to search for other areas in which to invest their money at a higher return - this usually means the stock market. On the other end of the equation, lower bond yields means that interest rates are low and companies will find it much cheaper to borrow money and finance expansion or growth.
While bond and oil prices might not be as accurate and current as the S&P 500 futures, they are the useful when looking at the overall condition of the economy and, more importantly, at the trend of the stock market.
Next: Market Strength: Conclusion
At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
The usefulness of these indicators depends on what type of investor you are. Long-term investors shouldn't care too much if the S&P futures are up or down before the markets open, whereas traders and short-term investors find this type of information key.
Regardless of what type of investor you are, knowing the overall trend of the market over several months is beneficial. It doesn't mean you should trade on the basis of this trend, but if you are informed you may be able to protect your assets.
Here's a quick recap of what we've learned:
•The S&P 500 index contains many of the largest companies in the world, making it a good indicator of overall, short-term market direction
•If S&P futures are up, this indicates an upward trend in the stock market. If S&P futures are down, it's a sign that the market will trend lower.
•This rise or decline in a futures contract is usually calculated as a change from fair value, or the equilibrium price for a futures contract.
•An arbitrageur is someone who simultaneously purchases and sells a security (or index) in order to profit from a differential in the price - they are part of the reason that the market follows the trend in futures contracts.
•Index arbitrage is an investment strategy that attempts to profit from the differences between actual and theoretical futures prices of the same stock index. This is done by simultaneously buying (or selling) a stock index future while selling (or buying) the stocks in that index.
•The A/D line is a technical analysis tool. It is the ratio between advancing stocks and declining ones.
•The A/D line is not a short-term indicator; it shows us the cumulative trend of advancers to decliners over a particular period of time.
•Relative Strength Index (RSI) is a technical analysis indicator that compares the days that a stock finishes up against when it finishes lower.
•The RSI ranges from 0 to 100, but a stock is considered overbought if it reaches the 70 level, meaning that you should consider selling. When it is a true bull market, an RSI of 80 might be a better level since stocks often trade at higher valuations. Likewise, if the RSI approaches 30, it is a strong buying indicator (20 in a strong bear market).
•The Arms index is a market performance indicator that weighs each stock by the volume traded for each issue. A ratio of one means the market is in balance. A ratio above one indicates that more volume is moving into declining stocks. A ratio below one indicates that more volume is moving into advancing stocks.
•Oil is an energy commodity; its price can affect many companies.
•The day to day price fluctuations in oil won't cause inflation fears, but if its price increases steadily it could cause investors to be fearful that inflating energy prices will slow company profits.
•The price of oil has an opposite effect on those stocks directly influenced by the price of oil such as drilling, pipeline and retail distribution of energy stocks.
•Bond prices can also be used to gauge the strength of the stock market.
•An increase in bond prices means a decrease in yields, which may cause more investors to move their money to the stock market for higher returns.
•Lower bond yields also tends to lead to lower interest rates, making it cheaper for companies to borrow money to finance growth.
On-Balance Volume (OBV)
Devised by Joseph Granville, on-balance volume is a running total, which rises or falls every trading day, based on whether prices close higher or lower than on the previous day. OBV is a leading indicator, so it typically rises or falls before that of the actual prices. A new OBV high indicates the power of bulls, the weakness of bears and the likely resultant rise of prices. A new OBV low indicates an opposite pattern: the power of bears, weakness of bulls and a possible decrease in value. When OBV shows a signal differing from that of actual prices, it indicates that volume (emotion of the market) is not consistent with consensus of value (actual prices) - a shift in price, which would alleviate this imbalance, is imminent. (For additional reading on volume, see Gauging Support And Resistance With Price By Volume.)
Filed Under: Active Trading
Many say that charting is nothing more than predicting the direction of a price between significant support and resistance levels. We know that a support level is a price level which a stock has had difficulty falling below. This is where a lot of buyers tend to enter the stock. Similarly, we know that resistance is a price level above which a stock has difficulty climbing. This is where a lot of buyers take profits and shorts enter. Typically, a stock's price will range between these levels until it breaks out or breaks down. Hundreds of different methods can be used to locate these areas of support and resistance, but one of the most underrated methods is simply using price by volume (PBV) charts. In this article, we explain what PBV charts are and explore techniques that you can use to make effective trades using these charts. (For additional reading on volume, see Volume Oscillator Confirms Price Movements, Volume Rate of Change and Gauging The Market's Psychological State.)
Trendlines, chart patterns, pivot points, Fibonacci lines and Gann lines are among the most popular methods used to identify areas of support and resistance. But the less commonly used PBV charts, which illustrate volume using a vertical volume histogram, can be invaluable when determining not only the location of key support and resistance levels, but also the strength of these levels. (For further reading, see Support And Resistance Zones - Part 1 and Part 2.)
What Are PBV Charts?
A price by volume chart is simply the standard volume histogram reapplied to price instead of time (price is seen on the Y axis and time on the X axis). So, instead of being able to determine when a stock is going in and out of favor (indicated by increasing volume levels over time), PBV enables you to determine the level of buying or selling interest at a given price level. PBV charts can be created in many different charting applications, as well as by using free online charting services from websites like BigCharts.com and StockCharts.com.
Using PBV Charts
PBV charts are relatively easy to use and understand. There are three major elements involved:
•Volume strength indicates the amount of shares that traded at the given price level. This is indicated by the horizontal length of the PBV histogram.
•Volume type refers to the number of shares sold compared to the number of shares bought. This is indicated by the two different colors seen on each bar.
•Successful reactions or tests means the number of times a stock successfully tests and "bounces off" a given level.
Together, these three factors will allow you to determine the strength of a particular price level. Once you have a good idea of price strength, you can combine this information with trendlines and other studies to determine support and resistance levels, find support bases and even play gaps.
Finding Support Bases
Support bases are simply instances in which a stock ranges before continuing a trend, or reversing. To determine when a stock is basing, simply follow these steps:
Draw two parallel, horizontal lines that connect parallel highs and lows in a trading range after a trending move.
Then, use the PBV histogram to see if these parallel lines are located near key price levels.
Finally, note the buying or selling pressure (colors) as well as the total volume to determine in which direction a breakout is likely to occur.
Figure 1 shows Hudson City Bancorp (HCBK) along with the price by volume histogram. Looking at this chart, we can see that the longer blue bars indicate buying pressure or support, while a longer red bar indicates selling pressure or resistance. Meanwhile, the larger overall bar indicates that that particular price level is of interest to traders. In this case, we note that $12.50 appears to be a level at which we can watch for a breakout to the upside.
Source: StockCharts.com
Figure 1
Locating Support and Resistance Levels
Support and resistance levels are simply areas beyond which the price has difficulty moving due to large buying or selling interests. To determine areas of support or resistance, simply do the following:
Identify areas where the PBV histogram shows significant buying or selling interest.
Determine whether these large interests are buying or selling interests.
Draw horizontal trendlines parallel to these PBV bars, giving preference to those that also connect highs and lows on the chart.
Let's take a look at Google (GOOG) for an example:
Source: StockCharts.com
Figure 2
Trending between these support and resistance levels should be immediately apparent. These areas are known as "soft areas", where only short volume bars exist between two long bars. One common strategy is to buy and sell based on the trends between these "soft areas". In the chart for Google (Figure 2), for example, we'd look to short GOOG when it breaks Support 1 and cover when it hits Support 2.
Playing Gaps
Gaps occur when an asset's price rapidly moves from one point to another, creating a visible gap or break between prices in the chart. You can use PBV charts to help predict when a gapping stock will find support simply by looking for an area where there was a lot of prior interest. Also, gaps themselves can produce areas of future support and/or resistance, which can be reinforced by the PBV histogram. Let's take a look at a few examples:
Source: StockCharts.com
Figure 3
In the case of DHB Industries (Figure 3), a PBV trader would look to buy a breakout from Resistance 2 and sell when Resistance 1 is reached. Notice that the gap down creates an area of very little resistance to upward movement - this tells us that it is likely that the second target will be reached.
Source: StockCharts.com
Figure 4
In the case of Elan Corp. (Figure 4), we can see that a trader who bought on a break above $7.60 (the long PBV bar) would have already realized a gain of nearly 100%. Notice that once the key resistance was broken, there was very little resistance to the upside.
Clearly, PBV can be extremely useful when combined with gaps if you are attempting to buy rebounds or retracements after gaps occur. (To learn more, see Playing The Gap and Retracement Or Reversal: Know The Difference.)
Conclusion
PBV charts can be an invaluable tool in your stock analysis arsenal. When you combine it with other methods such as trendline analysis and Fibonacci, it is easy to see how much additional insight can be gained from this charting method. Here are some key points to remember:
•The first color represents volume on days when the price moved higher.
•The second color represents volume on days when the price moved lower.
•When one color of the bar is significantly longer than the other, strong support or resistance is present.
•Horizontal trendlines connect the top of the PBV bar for resistance and the bottom of the PBV bar for support.
•PBV bars are used for support and resistance levels, trading bases and gap areas.
Accumulation/Distribution (A/D)
Accumulation/distribution is also a leading indicator pertaining to volume, but it takes opening and closing prices into account. A positive A/D indicates that prices were higher when they closed than when they opened; a negative A/D indicates the opposite. But the bull or bear winners are only credited with a fraction of each day's volume, depending on the day's range and the distance from opening to closing price. Obviously, a wide range between open and close produces a stronger signal A/D, but the pattern of A/D highs and lows is most important. If a market opens higher and closes lower, thereby causing A/D to turn down, an upward-trending market may be weaker than it initially appears.
The significance of accumulation/distribution lies in its insight into the activities of the distinct groups of professional and amateur traders. Amateurs as a group are more likely to influence the opening price of the market since these amateurs base their first trades on the financial news they have read overnight as well as on the corporate news that was issued by their favorite companies after market close. But as the trading day wears on, the professionals determine the day's ultimate results. If the professionals disagree with the amateurs' bullishness at the open, the professionals will drive prices lower for the close. When the pros are more bullish than amateurs, the pros will drive prices higher all day and into the close. As indicators for future trends, the activities of professionals are generally more important than that of the amateurs. (For more, see Trend-Spotting With The Accumulation/Distribution Line.)
Filed Under: Active Trading, Forex
The accumulation/distribution line was created by Marc Chaikin to determine the flow of money into or out of a security. It should not be confused with the advance/decline line. While their initials might be the same, these are entirely different indicators, and their uses are different as well. Whereas the advance/decline line can provide insight into market movements, the accumulation/distribution line is of use to traders looking to measure buy/sell pressure on a security or confirm the strength of a trend. Read on to learn how to use accumulation/distribution to analyze a security. (Read more about Marc Chaikin in Discovering Keltner Channels And The Chaikin Oscillator.)
Close Location Value
The first step in creating the accumulation/distribution (A/D) line is finding the close location value (CLV), which looks at the location of the close and compares it to the range for a given period (one day, week or month). The CLV will have a value from +1 to -1:
•A value of zero would mean that the price closed halfway between the high and low of the range.
•A value of +1 means the close is equal to the high of the range.
•A value of -1 means the close is equal to the low of the range.
The CLV can be calculated as follows:
CLV = ([(C-L) - (H - C)] / (H - L))
Where:
C = the closing price
H = the high of the price range
L = the low of the price range
The CLV is then multiplied by the corresponding period's volume, and the total will form the A/D line. (For a look at the CLV's precursor, the on-balance volume, read Introduction To On-Balance Volume.)
Benefits and Drawbacks of Using the A/D Line
In some instances, using the A/D line can give traders a clear advantage:
•Monitor General Money Flow - The A/D line can be used as a gauge for the general flow of money. If the A/D line is moving higher, this signals that there is buying pressure that is starting to prevail. On the flip side, if the A/D line is moving downward, this signals that increased selling pressure is beginning to gain a foothold.
•Confirmation - You can also use the A/D line to confirm the strength, and possibly the longevity, of a current move.
There are also a few drawbacks to keep in mind when analyzing a security using the A/D line:
•Trading Gaps - The A/D line does not take trading gaps into consideration, so these gaps, when they occur, may not be factored into the A/D line at all. Therefore, if a stock's price has gapped upward but closes around the midpoint, that gap will be ignored because the A/D line is formulated using closing prices. (To learn about profiting from trading gaps, read Playing The Gap.)
Playing The Gap by Justin Kuepper,
Gaps are areas on a chart where the price of a stock (or another financial instrument) moves sharply up or down with little or no trading in between. As a result, the asset's chart shows a "gap" in the normal price pattern. The enterprising trader can interpret and exploit these gaps for profit. Here we'll help you understand how and why gaps occur, and how you can use them to make profitable trades.
Gap Basics
Gaps occur as a result of underlying fundamental or technical factors. For example, if a company's earnings are much higher than expected, the company's stock may gap up the next day. This means that the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.
Gaps can be classified into four groups:
•Breakaway gaps are those that occur at the end of a price pattern and signal the beginning of a new trend.
•Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit new highs or lows.
•Common gaps are those that cannot be placed in a price pattern - they simply represent an area where the price has "gapped".
•Continuation gaps occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock's future direction.
To Fill or Not to Fill
When someone says that a gap has been "filled", that means that the price has moved back to the original pre-gap level. These fills are quite common and occur as a result of the following:
•Irrational Exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction.
•Technical Resistance: When a price moves up or down sharply, it doesn't leave behind any support or resistance.
•Price Pattern: Price patterns are used to classify gaps; as a result, they can also tell you if a gap will be filled or not. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend, while continuation and breakaway gaps are significantly less likely to be filled since they are used to confirm the direction of the current trend.
When gaps are filled within the same trading day on which they occur, this is referred to as fading. For example, let's say a company announces great earnings per share for this quarter, and it gaps up at open (meaning it opened significantly higher than its previous close). Now let's say that, as the day progresses, people realize that the cash flow statement shows some weaknesses, so they start selling. Eventually the price hits yesterday's close, and the gap is filled. Many day traders use this strategy during earnings season or at other times when irrational exuberance is at a high. (For more on this subject, read The Madness Of Crowds.)
How To Play the Gaps
There are many ways to take advantage of these gaps. Here are a few popular strategies:
•Some traders will buy when fundamental or technical factors favor a gap on the next trading day. For example, they'll buy a stock after-hours when a positive earnings report is released, hoping for a gap up on the following trading day.
•Traders might buy or sell into highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continued trend. For example, they may buy a currency when it is gapping up very quickly on low liquidity and there is no significant resistance overhead.
•Some traders will fade gaps in the opposite direction once a high or low point has been determined (often through other forms of technical analysis). For example, if a stock gaps up on some speculative report, experienced traders may fade the gap by shorting the stock.
•Traders might buy when the price level reaches the prior support after the gap has been filled. An example of this strategy is outlined below.
Here are the key things you will want to remember when trading gaps:
•Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
•Exhaustion gaps and continuation gaps predict the price moving in two different directions - be sure that you correctly classify the gap you are going to play.
•Retail investors are the ones who usually exhibit irrational exuberance; however, institutional investors may play along to help their portfolios - so be careful when using this indicator, and make sure to wait for the price to start to break before taking a position.
•Be sure to watch the volume. High volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.
Example
To tie these ideas together, let's look at a basic gap trading system developed for the forex market. This system uses gaps in order to predict retracements to a prior price. Here are the rules:
The trade must always be in the overall direction of the price (check hourly charts).
The currency must gap significantly above or below a key resistance level on the 30-minute charts.
The price must retrace to the original resistance level. This will indicate that the gap has been filled, and the price has returned to prior resistance turned support.
There must be a candle signifying a continuation of the price in the direction of the gap. This will help ensure that the support will remain intact.
Note that because the forex market is a 24-hour market (it is open 24 hours a day from 5pm EST on Sunday until 4pm EST Friday), gaps in the forex market appear on a chart as large candles. These large candles often occur as a result of the release of a report that causes sharp price movements with little to no liquidity. In the forex market, the only visible gaps that occur on a chart happen when the market opens after the weekend.
Let's look at an example of this system in action:
Figure 1 - The large candlestick identified by the left arrow on this GBP/USD chart is an example of a gap found in the forex market. This does not look like a regular gap, but the lack of liquidity between the prices makes it so. Notice how these levels act as strong levels of support and resistance.
We can see in Figure 1 that the price gapped up above some consolidation resistance, retraced and filled the gap, and finally, resumed its way up before heading back down. Technically, we can see that there is little support below the gap, until the prior support (where we buy). A trader could also short the currency on the way down to this point, if he or she were able to identify a top.
Conclusion: Minimizing Risk
Those who study the underlying factors behind a gap and correctly identify its type can often trade with a high probability of success. However, there is always a risk that a trade can go bad. You can avoid this by doing the following:
•Watching the real-time electronic communication network (ECN) and volume: This will give you an idea of where different open trades stand. If you see high-volume resistance preventing a gap from being filled, then double check the premise of your trade and consider not trading it if you are not completely certain that it is correct.
•Being sure that the rally is over: Irrational exuberance is not necessarily immediately corrected by the market. Sometimes stocks can rise for years at extremely high valuations and trade high on rumors, without a correction. Be sure to wait for declining and negative volume before taking a position.
•Using a stop-loss: Always be sure to use a stop-loss when trading. It is best to place the stop-loss point below key support levels, or at a set percentage, such as -8%. (To learn more, see The Stop-Loss Order - Make Sure You Use It.)
Remember, gaps are risky (due to low liquidity and volatility), but if properly traded, they offer opportunities for quick profits
•Minor Changes - Sometimes it can be difficult to detect minor changes in volume flows. The rate of change in a downtrend could be slowing, but this would be difficult (if not impossible) to detect until the A/D line turned upward. (To learn how to monitor trends in volume, read Volume Rate Of Change.)
Bullish and Bearish Signals
The A/D line creates both bullish and bearish signals. These signals rely on divergence and confirmation.
Bullish Signals
Bullish signals occur when the price of a security is moving down or is in a downtrend, but A/D line is trending upward (see Figure 1). This divergence signals increased buying pressure, which can indicate weakening seller strength. It is usually followed by a change in the trend of the security from downward to upward.
Figure 1: A chart of Goldman Sachs (NYSE:GS) clearly shows that the current A/D line has moved positively while the stock continues to be in a downward trend.
Source: StockCharts.com
Bearish Signals
A bearish signal is formed when the A/D line is trending downward, but the price of the security is in an uptrend (see Figure 2). Selling pressure is beginning to increase, which usually signals a future downtrend in the price.
Figure 2: A chart of AT&T (NYSE:ATT) shows the A/D line moving downward while the stock price continues its uptrend. While the divergence is early, what you are looking for is a separation between the price and the A/D line.
Source: StockCharts.com
Spotting a Divergence
In order to spot bearish and bullish signals, you need to have a trend in the underlying security. Once this has been established, you can begin to look for a divergence from that trend. When spotting these divergences, either bullish or bearish, it is best to allow a week or two for the signals to develop. When it comes to bearish patterns, you want to keep an eye out for signals that are flat or do not have a sharp divergence – these can also signal that no future change is probable. (For more information, see Divergence: The Trade Most Profitable.)
Other Indicators
There are other indicators that can be used along with the A/D line.
Money Flow Index
1.Money Flow Index
2.Money Flow Index Divergences
The Money Flow Index (MFI) uses price and volume and the concept of accumulation distribution to create an overbought and oversold indicator that is helpful in confirming trends in prices and warning of potential reversals in prices. The inputs to the Money Flow indicator are given below:
1.Typical Price: (High + Low + Close) / 3
2.Money Flow: Typical Price x Volume
3.Positive Money Flow: The Money Flow on days where the Typical Price is greater than the previous day's Typical Price.
4.Negative Money Flow: The Money Flow on days where the Typical Price is less than the previous day's Typical Price.
5.Money Ratio: Positive Money Flow / Negative Money Flow
6.Money Flow Index: 100 - [100 / (1 + Money Ratio)]
The chart below of Google (GOOG) stock shows the Money Flow Index in action:
Interpreting the Money Flow Index
•Below 20 is considered oversold; look for buying opportunities.
•Above 80 is in overbought territory; look for sell signals.
In the chart above of GOOG, the downtrend in price was confirmed by the downtrend in the Money Flow Index. Once the MFI entered the oversold area, traders would be advised to begin to reduce their short sell positions and buy to cover.
Later, the price of Google increased, and the MFI indicator confirmed that increase. This is a signal that the trend in Google still has buying pressure and that the stock trader should continue holding their long position in the stock.
In additon to being an excellent confirmation tool, the Money Flow Index can warn of potential price reversals. Money Flow Index divergences is next.
The money flow index (MFI) is a volume-weighted momentum indicator. This indicator compares positive money flow to negative money flow and creates an indicator that can then be compared to the price of the security to identify the current strength or weakness of a trend. It is calculated using a 14-day period.
The MFI has a scale from 0-100. This scale is a range:
•A security that is close to 100 usually signals an overbought position. In reality, an overbought position can be signaled by an MFI value around 80.
•A security that is near zero will signal an oversold position. A value of around 20 usually qualifies a position as oversold. (For further reading, see The Basics Of Money Flow.)
Money Flow Index Divergences
Money Flow Index
1.Money Flow Index
2.Money Flow Index Divergences
Since the Money Flow Index uses volume in its calculation, this indicator can prove effective as a divergence indicator. The theory is as follows:
•If price is rising, and the volume on up days is greater than the volume on down days, then this is confirming of the price rise.
•Likewise, if price is falling and the volume on down days is greater than the volume on up days, then the recent downward trend in stock prices is confirmed.
•In contrast, if prices rise, yet the volume on the up days is less than the volume transacted on down days, then money is secretly pouring out of the stock; this is a bearish divergence.
•And similarly, when prices fall, but the volume on the down days is less than the volume on up days, then money is flowing back into the stock, a bullish divergence.
The chart below of Microsoft (MSFT) shows the effectiveness of the Money Flow Index in detecting bullish and bearish divergences:
In the chart above, beginning on the left, Microsoft's stock price is in a downtrend; however, the Money Flow Index is not going downwards, in fact, it is sloping upwards. This is a good illustration of a bullish divergence.
On the second half of the chart, Microsoft is making new highs, yet the Money Flow Index is making lower highs, a bearish divergence. Stock traders of MSFT would be advised to scale out of their position because money is flowing out of Microsoft stock.
Later, the price of Google increased, and the MFI indicator confirmed that increase. This is a signal that the trend in Google still has buying pressure and that the stock trader should continue holding their long position in the stock.
The Money Flow Index is a valuable technical analysis tool due to its ability to incorporate both price and volume into its calculations. The Money Flow Index is very effective in confirming price action and warning of future price reversals.
Other technical analyis tools similar to the Money Flow Index, is the On Balance Volume indicator (see: On Balance Volume) and the Chaikin Oscillator (see: Chaikin Oscillator).
Relative Strength Index
Another indicator that can be used with the A/D line is the relative strength index (RSI), a momentum oscillator. The RSI is calculated by taking the magnitude of a stock's recent gains and comparing it to the magnitude of a stock's recent losses. The RSI has a number range from 0-100. Like the MFI, it is used primarily to highlight overbought and oversold conditions. The RSI is best used as a complement to another technical tool to analyze a security. (To learn more, read Ride The RSI Roller coaster.)
Combining Indicators and Oscillators
While using the A/D line by itself is indeed feasible, it is even more advantageous to add either the MFI, the RSI, or both. Since the MFI and RSI both give a range, they can be used to spotlight extreme conditions that the A/D line was not designed to spotlight.
While the RSI and MFI both attempt to highlight overbought or oversold positions, they go about it in different ways:
•The MFI measures the flow of money into a security, whether that money is positive or negative.
•The RSI compares the magnitude of a stock's recent gains to its recent losses.
Neither of these technical tools overlaps, so they can indeed be used in conjunction with the A/D line. (For more information, see our Exploring Oscillators And Indicators tutorial.)
The A/D Line in Action
The following is a three-month chart of Kellogg Co. (NYSE:K). This is a perfect example of the A/D line showing us that the strength of the uptrend is indeed sound. As the trend continues upward, the A/D shows that this uptrend has longevity. Even after a minor drop in the stock price starting August 11, 2008, the A/D line continued to signal strength. The stock had then begun to turn around again.
Figure 3
Source: StockCharts.com
The next example is Pfizer Inc. (NYSE:PFE). This is a two-month chart, and the A/D line confirmed both the uptrend and the downtrend. At the right of the chart, the stock looks like it is beginning to follow the lead that the A/D line signaled early on in August 2008.
Figure 4
Source: StockCharts.com
The following is a two-month chart of Apple Inc. (Nasdaq:AAPL). The A/D line and stock price have gone hand in hand. Apple has been on a downtrend, and the A/D line has been confirming existing selling pressure on the stock, forcing it to go down. The A/D line is confirming a downtrend at the latest date on the chart.
Figure 5
Source: StockCharts.com
Conclusion
The accumulation/distribution line is an effective tool for spotlighting buying and selling pressure on a security. It is also a fantastic way to confirm an existing trend. Using the A/D line alone is one way to analyze a security, but it can also be used with either the MFI or the RSI to refine the analysis. Since both the RSI and MFI work well with the A/D line, using them together can help you get a better sense of overbought or oversold situations. In the end, the A/D line is an effective tool in any trader's arsenal.
The Madness Of Crowds by Jason Van Bergen
The incessant intraday struggle between the bulls and the bears to wrest power away from each other drives market rallies and precipitates market declines. Regardless of the style of analysis or system employed by a trader, one primary aim of his or her trading endeavors is to understand the degree of control held by the bulls or bears at any given time, and to predict who should hold power in the near to distant future.
The Force of Emotion
One way to see the market is as a disorganized crowd of individuals whose sole common purpose is to ascertain the future mood of the market (the balance of power between bulls and bears) and thereby profit from a correct trading decision today. However, it's important to realize that the crowd is comprised of a variety of individuals, each one prone to competing and conflicting emotions. Optimism and pessimism, hope and fear - all these emotions can exist in one investor at different times or in multiple investors or groups at the same time. In any trading decision, the primary goal is to make sense of this crush of emotion, thereby evaluating the psychology of the market crowd. (To read more on behavioral finance, see Taking A Chance On Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)
Charles Mackay's famous book, "Extraordinary Popular Delusions and the Madness of Crowds", is perhaps the most often cited in discussions of market phenomena, from the tulipmania in 17th-century Holland to most every bubble since. The story is a familiar one: an enduring bull market in some commodity, currency or equity leads the general public to believe the trend cannot end. Such optimistic thinking leads the public to overextend itself in acquiring the object of the mania, while lenders fall over each other to feed the fire. Eventually, fear arises in investors as they start to think that the market is not as strong as they initially assumed. Inevitably, the market collapses on itself as that fear turns to panic selling, creating a vicious spiral that brings the market to a point lower than it was before the mania started, and from which it will likely take years to recover.
The Nature of Crowds
The key to such widespread phenomena lies in the nature of the crowd: the way in which a collection of usually calm, rational individuals can be overwhelmed by such emotion when it appears their peers are behaving in a certain universal manner. Those who study human behavior have repeatedly found that the fear of missing an opportunity for profits is a more enduring motivator than the fear of losing one's life savings. At its fundamental level, this fear of being left out or failing when your friends, relatives and neighbors seem to be making a killing, drives the overwhelming power of the crowd.
Another motivating force behind crowd behavior is our tendency to look for leadership, in the form of the balance of the crowd's opinion (as we think that the majority must be right) or in the form of a few key individuals who seem to be driving the crowd's behavior by virtue of their uncanny ability to predict the future. In times of uncertainty (and what is more uncertain than the multitude of choices facing us in the trading universe?), we look to strong leaders to guide our behavior and provide examples to follow. The seemingly omniscient market guru is but one example of the type of individual who purports to stand as all-knowing leader of the crowd, but whose façade is the first to crumble when the tides of mania eventually turn.
Choices, choices, choices …
Due to the overwhelming power of the crowd and the tendency of trends to continue for lengthy periods of time on the basis of this strength, the rational individual trader is faced with a conundrum: does he or she follow the strength of the rampaging hordes or strike out defiantly with the assumption that his or her individually well-analyzed decisions will prevail over the surrounding madness? The solution to this problem is actually quite simple: follow the crowd when its opinion jives with your analysis and cut your losses and get out of the market when the crowd turns against you! Both following the crowd and getting out present their own unique challenges:
Following the crowd - The key to enduring success in trading is to develop an individual, independent system that exhibits the positive qualities of studious, non-emotional, rational analysis and highly-disciplined implementation. The choice will depend on the individual trader's unique predilection for charting and technical analysis, and so forth. If market reality jives with the tenets of the trader's system, a successful and profitable career is born (at least for the moment). (For more on some of these systems, see our Active Trading archive.)
So the ideal situation for any trader is that beautiful alignment that occurs when the market crowd and one's chosen system of analysis conspire to create profitability. This is when the public seems to confirm your system of analysis and is likely the very situation where your highest profits will be earned in the short term. Yet this is also the most potentially devastating situation in the medium to long term, because the individual trader can be lulled into a false sense of security as his or her analysis is confirmed. The trader is then subtly and irrevocably sucked into joining the crowd, straying from his or her individual system and giving increasing credence to the decisions of others.
Inevitably, there will be a time when the crowd's behavior will diverge from the direction suggested by the trader's analytical system, and this is the precise time at which the trader must put on the brakes and exit his position. This is also the most difficult time to exit a winning position, as it is very easy to second guess the signal that one is receiving, and to hold out for just a little more profitability. As is always the case, straying from one's system may be fruitful for a time, but in the long term, it is always the individual, disciplined, analytical approach that will win out over blind adherence to those around you.
Getting out - A trader's best decisions will be made when he or she has a written plan that spells out exactly under what conditions a trade will be entered and exited. These conditions may very well be driven by the crowd, or they may occur regardless of the direction in which the crowd is moving. And there will be times when the trader's system issues a signal that is exactly opposite to the direction in which the crowd is moving. It is the latter situation of which a trader must be extremely wary.
The crowd is never wrong. When the crowd is moving in a direction that is contrary to what a trader's system maintains, the trader's best decision is to get out! In other words, the trader should take his or her profits or realize losses and wait on the sidelines until such time as a positive signal is once again issued by the system. It is better to relinquish a certain amount of potential profit than to lose any amount of one's hard-earned principal.
Conclusion
Remember, the feeling that you are missing out on a surefire opportunity for profit is the most psychologically trying and dangerous situation that you are likely to face in your trading career. Indeed, the feeling of missed opportunities is more taxing than realizing losses - an inevitable eventuality if you stray from your chosen path. This is perhaps the ultimate paradox of trading, that our innate human instinct and desire to fit in with the crowd is also the situation that has led many an individual trader to financial ruin. Never fight the power of the crowd, but always be aware of how your individual decisions relate to the power of those around you. (Learn more in Leading Indicators Of Behavioral Finance.)
Open Interest
Shifting from our discussion of volume, we find open interest as the next major indicator of crowd psychology. Open interest applies to the futures market and refers to a reading of future contracts or options expiring at a certain time in the future. Open interest adds the total long and short contracts in the market on a given day, and the absolute value of open interest corresponds to a cumulative long or short position. Open interest only rises or falls when a new contract is created or destroyed - one long and one short seller must enter the market to increase the open interest, and one long and one short seller must close their positions for open interest to fall.
Open interest is only of interest (pun intended) when it deviates from its norm. An absolute value is of no interest (bad pun again intended). Open interest reflects the psychology of the market by way of the market's inherent conflict between bulls and bears. To move the open interest indicator up or down, both bulls and bears must be equally confident that their long or short position is correct (or incorrect). A rising open interest demonstrates that bulls are confident enough to enter into contracts with bears, who are equally confident in their bearishness to enter into the position. One group will inevitably lose, but as long as potential losers (either bulls or bears) enter contracts, the rise or fall in open interest will continue. But there is more to the open interest picture than immediately meets the eye. (For more, see Discovering Open Interest.)
Filed Under: Active Trading, Futures, Options, Technical Analysis
Open interest, the total number of open contracts on a security, applies primarily to the futures market. Open interest is a concept all futures traders should understand, because it is often used to confirm trends and trend reversals for futures and options contracts. Although this number often gets lost as traders focus on bid price, ask price, volume and implied volatility, paying attention to open interest can help options traders make better trades. Here we take a look at what information open interest holds for a trader and how traders can use that information to their advantage.
Tutorial: Futures Trading 101
Futures Fundamentals: How The Market WorksPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity.
What Exactly Is a Futures Contract?
Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year. This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.
That's how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.
So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). We will talk more about the outlooks of the long and short positions in the section on strategies, but for now it's important to know that every contract involves both positions.
In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.
Profit And Loss - Cash Settlement
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their futures contract of $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the future price at which he is obliged to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obliged to pay is less than what the rest of the market is obliged to pay in the future for wheat.
On the day the change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.
As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the futures contract and the bread maker would have made $5,000 on the contract.
But after the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in actuality buy his wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel but because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging.
Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000 while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires.)
Economic Importance of the Futures Market
Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators.
Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.
Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market.
Futures Fundamentals: CharacteristicsPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities. In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.
When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.
The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.
Let's say that you had to deposit an initial margin of $1,000 on a contract and the maintenance margin level is $500. A series of losses dropped the value of your account to $400. This would then prompt the broker to make a margin call to you, requesting a deposit of at least an additional $600 to bring the account back up to the initial margin level of $1,000.
Word to the wise: when a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf.
Leverage: The Double-Edged Sword
In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.
Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question (which is part of the reason why the futures market is useful but also very risky). The smaller the margin in relation to the cash value of the futures contract, the higher the leverage. So for an initial margin of $5,000, you may be able to enter into a long position in a futures contract for 30,000 pounds of coffee valued at $50,000, which would be considered highly leveraged investments.
You already know that the futures market can be extremely risky and,therefore, not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: great profits or greater losses.
As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin. However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy a futures contract with a margin deposit of $10,000, for an index currently standing at 1300. The value of the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every point gain or loss, $250 will be gained or lost.
If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor earned a profit of $16,250 (65 points x $250); a profit of 162%!
On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250 - a huge amount compared to the initial margin deposit made to obtain the contract. This means you still have to pay $6,250 out of your pocket to cover your losses. The fact that a small change of 5% to the index could result in such a large profit or loss to the investor (sometimes even more than the initial investment made) is the risky arithmetic of leverage. Consequently, while the value of a commodity or a financial instrument may not exhibit very much price volatility, the same percentage gains and losses are much more dramatic in futures contracts due to low margins and high leverage.
Pricing and Limits
As we mentioned before, contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on).
Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges and are known as “ticks.” For example, the minimum sum that a bushel of grain can move upwards or downwards is a quarter of one U.S. cent. For futures investors, it's important to understand how the minimum price movement for each commodity will affect the size of the contract in question. If you had a wheat contract for 5,000 bushels, the minimum price movement would be $12.50 ($0.0025 x 5,000).
Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day.
Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per ounce closed at $5. Today's upper price boundary for silver would be $5.25 and the lower boundary would be $4.75. If at any moment during the day the price of futures contracts for silver reaches either boundary, the exchange shuts down all trading of silver futures for the day. The next day, the new boundaries are again calculated by adding and subtracting $0.25 to the previous day's close. Each day the silver ounce could increase or decrease by $0.25 until an equilibrium price is found. Because trading shuts down if prices reach their daily limits, there may be occasions when it is NOT possible to liquidate an existing futures position at will.
The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or “spot” month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract.
In order to avoid any unfair advantages, the CTFC and the futures exchanges impose limits on the total amount of contracts or units of a commodity in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity.
Futures Fundamentals: How To TradePrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
At the risk of repeating ourselves, it's important to note that futures trading is not for everyone. You can invest in the futures market in a number of different ways, but before taking the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader, you should have a solid understanding of how the market and contracts function. You'll also need to determine how much time, attention, and research you can dedicate to the investment. Talk to your broker and ask questions before opening a futures account.
Unlike traditional equity traders, futures traders are advised to only use funds that have been earmarked as pure "risk capital"- the risks really are that high. Once you've made the initial decision to enter the market, the next question should be “How?” Here are three different approaches to consider:
Do It Yourself - As an investor, you can trade your own account without the aid or advice of a broker. This involves the most risk because you become responsible for managing funds, ordering trades, maintaining margins, acquiring research and coming up with your own analysis of how the market will move in relation to the commodity in which you've invested. It requires time and complete attention to the market.
Open a Managed Account - Another way to participate in the market is by opening a managed account, similar to an equity account. Your broker would have the power to trade on your behalf, following conditions agreed upon when the account was opened. This method could lessen your financial risk because a professional would be making informed decisions on your behalf. However, you would still be responsible for any losses incurred as well as for margin calls. And you'd probably have to pay an extra management fee.
Join a Commodity Pool - A third way to enter the market, and one that offers the smallest risk, is to join a commodity pool. Like a mutual fund, the commodity pool is a group of commodities which can be invested in. No one person has an individual account; funds are combined with others and traded as one. The profits and losses are directly proportionate to the amount of money invested. By entering a commodity pool, you also gain the opportunity to invest in diverse types of commodities. You are also not subject to margin calls. However, it is essential that the pool be managed by a skilled broker, because the risks of the futures market are still present in the commodity pool.
Futures Fundamentals: StrategiesPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.
Going Long
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.
For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September.
By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit!
Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.
Going Short
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.
Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market.
Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.
By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss.
Spreads
As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called “spreads.”
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts.
There are many different types of spreads, including:
Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates.
Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, the investor may take Short June Wheat and Long June Pork Bellies.
Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).
Futures Fundamentals: ConclusionPrinter friendly version (PDF format)Sponsor: At last, an easy way to predict stock trends – get your FREE copy of 5 Chart Patterns You Need to Know.
Buying and selling in the futures market can seem risky and complicated. As we've already said, futures trading is not for everyone, but it works for a wide range of people. This tutorial has introduced you to the fundamentals of futures. If you want to know more, talk to your broker.
Let's review the basics:
•The futures market is a global marketplace, initially created as a place for farmers and merchants to buy and sell commodities for either spot or future delivery. This was done to lessen the risk of both waste and scarcity.
•Rather than trade in physical commodities, futures markets buy and sell futures contracts, which state the price per unit, type, value, quality and quantity of the commodity in question, as well as the month the contract expires.
•The players in the futures market are hedgers and speculators. A hedger tries to minimize risk by buying or selling now in an effort to avoid rising or declining prices. Conversely, the speculator will try to profit from the risks by buying or selling now in anticipation of rising or declining prices.
•The CFTC and the NFA are the regulatory bodies governing and monitoring futures markets in the U.S. It is important to know your rights.
•Futures accounts are credited or debited daily depending on profits or losses incurred. The futures market is also characterized as being highly leveraged due to its margins; although leverage works as a double-edged sword. It's important to understand the arithmetic of leverage when calculating profit and loss, as well as the minimum price movements and daily price limits at which contracts can trade.
•“Going long,” “going short,” and “spreads” are the most common strategies used when trading on the futures market.
•Once you make the decision to trade in commodities, there are several ways to participate in the futures market. All of them involve risk - some more than others. You can trade your own account, have a managed account or join a commodity pool.
What Open Interest Tells Us
A contract has both a buyer and a seller, so the two market players combine to make one contract. The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
8 Rules of Open Interest
There are certain rules to open interest that futures traders must understand and remember. They have been written in many different publications, so here I have included an excellent version of these rules written by chartist Martin Pring in his book "Martin Pring on Market Momentum":
1. If prices are rising and open interest is increasing at a rate faster than its five-year seasonal average, this is a bullish sign. More participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature.
2. If the open interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top.
3. High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many weak longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.
4. An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway.
5. A breakout from a trading range will be much stronger if open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move.
6. Rising prices and a decline in open interest at a rate greater than the seasonal norm is bearish. This market condition develops because short covering, not fundamental demand, is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course, prices will decline.
7. If prices are declining and the open interest rises more than the seasonal average, this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover, it turns bullish.
8. A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.
Figure 1: 2002 chart of the COMEX Gold Continuous Pit Contract
Source: TradeStation
For example, in the 2002 chart of the COMEX Gold Continuous Pit Contract, shown above, the price is rising, the open interest is falling off and the volume is diminishing. As a rule of thumb, this scenario results in a weak market.
If prices are rising and the volume and open interest are both up, the market is decidedly strong. If the prices are rising and the volume and open interest are both down, the market is weakening. If, however, prices are declining and the volume and open interest are up, the market is weak; when prices are declining and the volume and open interest are down, the market is gaining strength.
The Bottom Line
Open interest can help futures traders get a sense of whether the market is gaining strength or getting weaker. When analyzing futures, avoid the common mistake of failing to take this number into account. As an investor, the more you know, the less likely you are to be caught off guard in a losing trade. Remember, it's your money, so invest it wisely.
Reading Open Interest Signals
A rising open interest points to an increase in the supply of potential losers, propelling the trend forward. Open interest that increases during an uptrend reveals that a certain number of bears believe the market is too high; but, if the uptrend increases, their short positions will be squeezed, and their subsequent buying will propel the market even higher; however, open interest that remains relatively constant during a market uptrend indicates that the supply of losers has stopped growing as the only potential candidates to enter into a contract are previous buyers who are looking to make a profit from their position. In this case, the uptrend is likely nearing its end.
During a downtrend, shorts are selling aggressively while the only participants that are buying are bottom pickers. But even value investors exit their positions when prices fall too far, so prices will go even lower. If open interest rises in a declining market, the downtrend is likely to continue. If open interest remains flat in a downtrend, there are few remaining bottom pickers, and the only remaining candidates for the contract are additional bears that shorted earlier and now want to cover and leave the market. Bears that exit with a profit cause a flat open interest in a downtrend, meaning that the best gains from the downtrend have probably already been had.
Falling Open Interest
Finally, a falling open interest shows that losers are exiting positions while winners are taking profits. It also shows there are no additional losers to take the place of those who have given up. The falling open interest is a clear signal that winners are taking their profits and running for the border while losers are giving up hope. A loss of a contract (and a declining open interest) points to the likely end of a trend.
The Bottom Line
There are times when reading the market trends and market psychology using specific metrics seems as effective as Roman soothsayers reading entrails. However, if you carefully pick the indicators, understand their limitations and use them in tandem, you will be much better positioned to spot the market's mood and adjust for what that mood means for your positions. (For more, check out Gauging Major Turns With Psychology.)
