A layman’s guide to 200 DMA and how to use it

When you write a blog that has readers from all over, it is sometimes a challenge to decide how you need to pitch a topic. On one hand you can assume that your readers know most of the things you are referring to and just get on with the blog post. On the other you may have to explain the basic details elaborately, before getting on with the main topic. I have referred to 200 DMA as a basic indicator for deciding on when to buy in some of my posts. It was pointed out to me by a few readers that many may not really know what is 200 DMA, leave alone it’s significance.

Well, let me get down to the basics then – DMA full form is Daily Moving Average and 200 DMA is the Daily Moving Average over a 200 day period. You calculate it for Nifty by adding all the closing Nifty levels for the last 200 days and then dividing the sum by 200. So, obviously unless we are having a flat market for long the current level of Nifty will normally be different from the 200 DMA of Nifty. The other point to understand is this – we can have 200 DMA for any stock or for any other index as well. So 200 DMA of ITC is possible and so is 200 DMA of Sensex or CNX Mid cap index. Also, while 200 DMA is used very popularly you do have other indicators like 50 DMA, 30 DMA etc. These are also calculated as I have explained for 200 DMA.

Why is the 200 DMA the most popularly used indicator? Historically at some earlier point in time, stock markets used to be in business for 200 days a year. The 200 DMA would then represent the average value of the stock or particular index over the past year on a rolling basis. What is the significance of this? Well, one year is a fairly substantial period and the 200 DMA value will give you an indication compared to what the current market price (CMP) is. For example if the stock has been trading with a downward bias then in general CMP will be less than 200 DMA. It may not be a very good idea to buy such a stock when the 200 DMA is in a declining trend, even though the CMP by itself may look attractive. Similarly in a rising market the 200 DMA will show an increasing trend and it may make sense to consider buying any stock only after the 200 DMA trend gets to be a decreasing one, or at least flattens out considerably.

Let me try to explain this with the example of Nifty in the year 2015. On 3rd November 2014, Nifty was at 8324 and 200 DMA of Nifty was at 7191. Based on how the market has performed over the last one year, we can note the following:-

  • On 12th February 2015, Nifty was at 8711 and 200 DMA for Nifty was 8312.
  • On 22nd April 2015, Nifty was at 8429 and 200 DMA for Nifty was 8254
  • On 23rd April  2015, Nifty was at 8398 and 200 DMA for Nifty was 8564.
  • On 7th May 2015, Nifty was at 8057 and 200 DMA for Nifty was 8289
  • On 12th June 2015, Nifty was at 7982 and 200 DMA for Nifty was 8360.
  • On 25th August 2015, Nifty was at 7880 and 200 DMA for Nifty was 8456.
  • On 7th September 2015, Nifty was at 7558 and 200 DMA for Nifty was 8430.
  • On 29th October 2015, Nifty was at 8111 and 200 DMA for Nifty was 8378.

It is easy to see from this that the 200 DMA Nifty has started to decline for the last few days and this needs to be confirmed as a trend. Obviously, if the trend is confirmed then we are entering the buying zone for some of the Nifty stocks as well as for the MF schemes that have a high percentage of holding in the Nifty stocks. The maximum gap between the Nifty level and the 200 DMA was on 7th September but the Nifty found support at that level. I would say the 200 DMA has a high chance of declining further, based on whether BJP loses the Bihar elections. Crystal ball gazing is a tough task for our markets but I do think there is a possibility of the 200 DMA for Nifty reaching a level of 8100 or so by December end.

This will clearly mean that the Nifty will probably achieve levels higher than 200 DMA for the first time since 18th August, some time in January 2016. From now till then we will probably be in a strong buying zone. Of course, for individual stock or MF schemes you must also look at the 200 DMA levels for that stock or relevant index and see those trends for the past year. There are several web sites which will supply you with the relevant data you need to make buying decisions.

I hope with this I have been able to clear up the way in which you can make use of 200 DMA figures and trends. I will do another post on price triggers for stocks in the near future. But before that, I will write one about how I intend to use these indicators for my MF purchase, now that I have finally got out of SIP.

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What’s in store for the markets this week?

Short term predictions of the markets are always fraught with danger as they can end up making you look rather silly. It is much more hazardous to try and do this for the immediate term like a week. However, investors who are into stocks seriously will recognize the value of understanding short term market movements and I thought I would take a shot at it for this week.

Since the upheavals of last Monday, the market seems to have some semblance of stability, both globally and in India. The factors in the global markets that will be most watched for in September are the Fed rates in the US on September 17th and the ongoing China story that is unfolding. If the interest rates are hiked and Chinese market continues to slide then it is quite likely that there can be short term panic. As our markets are largely dependent on FII investments, any large scale sell-off from their end can easily get our markets to crash. On the other hand, if the two events do not take place then there will be a lot of relief among global investors and, while this still will not be enough for a strong rally, global and Indian markets will be able to be in a range with a possible positive bias.

The domestic factors faced by our markets are more challenging at present. The following are worth considering:-

  • Earning for the last quarter was with mixed messaging and will not play a role in driving markets up. Even this quarter seems muted and all real hopes are pinned on the last 2 quarters of the FY.
  • Irrespective of the political spin that the Government wants to put on it, the backtracking on the land bill amendments is a huge negative, both as a signal and in real terms. The pace of infrastructure build-up is going to get adversely impacted by this, leading to much longer recovery in the stock prices of companies linked to such activities.
  • For all interest rate sensitive sectors, the wait for the rate cuts continue. However, the RBI Governor has not held out much promise on this front and my estimate is we will have a maximum of another 25 basis point cut this year and maybe 50 basis point cut in the FY. This will cause cheer for many stocks but it is still some time away.
  • Political situation is uncertain and chances of GST being passed and implemented by April 2016 is doubtful. Though this is more of a sentiment issue, the lack of progress is negative for the markets.

My assessment from a fundamental perspective is that there are possibilities for the markets to either move up slightly or have a more considerable down-move in this week. For the Nifty, the downside will probably be capped at 7700 or so, where it is likely to find support. On the upside 8200 will be difficult to cross. We will most likely see both days of strong gains and serious losses in the coming 5 days. I expect Nifty to end between 7900 and 8100 on Friday.

The mid-cap and the small-cap indices will have more pronounced movements and in all likelihood the bias there will be negative. Individual stocks may fluctuate rapidly based on news flows but most will trade in a range.

If you are into stocks then what should you be doing? For your existing portfolio, where you already have price triggers for buying, look at these carefully but continue with your plan. For new investors trying to start a portfolio, stay on the sidelines for now. There will be better times to buy, the volatility this week and possibly the next month is not a good starting point.

I plan to do a post at the start of every week, covering this topic and hope it will be useful for the readers.

I am happy to see many people have got started out here. Also, become a part of my Facebook group Market Musings where a lot more is discussed on the general market situation and also individual stocks.

Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.

A guide to understanding and investing in equity

Over the course of the last few weeks, I have written several posts on basic aspects of equity as well as investing in it. Based on some requests that I have received from the readers, I thought it will be a good idea to create a basic guide that people will be able to go through in a systematic manner. This post will fulfill that need. As before follow the hyperlinks in blue color to open up new tabs for the relevant posts.

To begin with you need to understand what exactly does equity mean. Read this post to understand how equity works. Next thing you need to understand is what are stock markets and indices. For people who are used to debt instruments and real estate understanding the nature of stock market returns is an important learning.

Many financial planners will ask you to invest in SIP with the implicit understanding that the returns can be looked as compounding. This is completely misleading and you need proper understanding of this to avoid serious mistakes with your finances. Read the post Equities and compounding to get a handle on this. We need to invest in equities not because of compounding but due to the fact that it gives us great potential for growth in our investments. Why this happens and how is elaborately explained in this post.

It is correct that equity is an asset that is best invested for the long term. However it is also right that returns in equity are non-linear in nature and can even be negative over a period of time. The post Fallacy of time dependence explains well what you need to know about this concept.

Pricing in equity is something that most people find mysterious and difficult to understand. This post will give you a basic understanding of equity pricing. The next post A more detailed look on pricing will help you understand price movements better. The obvious question most investors ask is which stocks should I buy and at what price – I have tried to answer this question through this post. As expected the post generated a lot of comments and I had written another post with explanation of my methodology.

The final two posts cover styles of investing that you can follow and mode of investing that you may use.

Read the above posts multiple times if you require to get a clear picture of how equity operates as an asset class. Your equity investments will benefit immensely once you have understood these concepts well and are able to apply them.

Investing in direct stocks is of interest to many readers and I will soon start writing a series on that.

Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.

Equity as an asset class #8 – Some notes on my methodology

I have got a good response and quite a few questions on my last blog post outlining how I select my stocks and at what price do I look at buying them. As getting back to each person individually is difficult, I have decided to look at the main issues raised, in this post along with some explanations.

On what basis do I select the market leaders?

  • As I said before the worth of a company is best proven by its market capitalization. However, it is enough for you to select 2 of the top 3-5 companies in a sector. For example in the IT sector, you cannot go wrong if you are selecting TCS, Infosys, Hcl Tech etc.
  • Which company to select can be on the basis of PE ratio and also your own knowledge gained from different sources. Note that there is no need for you to reas Balance Sheets etc for this.
  • It is not mandatory to select the top company in each sector though I see no harm in this at all.

How to select the Emerging companies in each sector?

  • This is a little more difficult and you will need to understand something about the business of the sector as well as how the companies in them are doing.
  • Try to look at companies that are trying to do something different. For example, in IT a few years back investing in companies that were focusing on product development would have been a good idea. In E-commerce today, look at companies that are creating logistical capabilities as part of their plans.
  • Read a lot about what the analysts and other people are recommending but make sure that you understand the basic issues and do not get swayed by the jargon.
  • If you are not comfortable that the company will be successful or are not sure whether you would like to be a customer yourself avoid investing in it.

Why PE and not other ratios like ROI, ROCE etc?

  • I believe that Market capitalization, Earnings and future outlook are the 3 most important parameters that need to be looked at to understand the health of the company.
  • ROI and ROCE will get covered by the first two of the above parameters.
  • While many other ratios can be considered, the ones I have recommended are enough to make a decision.

What is the logic of using PE and DMA as parameters for pricing?

  • PE will tell you whether you are buying the stock at a reasonable valuation or not.
  • The immediate price of the stock is a function of demand and supply as we have noted in an earlier post. I think the 200 DMA is a good reflection of the demand and supply for a particular stock. If the stock is something that I want to buy then any price lower than 200 DMA will be an attractive price.
  • Again, there can be many systems – I have only written about what I use for my investments.

I hope that gives some more clarity on what I had written about in my last post. At a later date when I do a series of posts on Stock investing, I will get into more details of sectors and individual stocks in those sectors. Do remember the caveat that you have to gain enough knowledge to be able to use the methods properly – a guide can only show the path but we still have to make the journey on our own.

Equity as an asset class #7 – Which stocks to buy at what price?

It is good that we now understand the broad logic of stock pricing based on the fundamental mechanism of supply and demand. However, for an individual investor what is more important is the right price at which he buys a stock. This can be made quite complicated due to the following reasons.

  1. The stock or the sector you are trying to buy into, may or may not follow the trend of the index. So it is possible that the index is falling and your stock is rising despite being a constituent of the index.
  2. The indices only cater to a few stocks and the stocks outside of these will have their own patterns of movement.
  3. Normally stocks within the same sector behave in a similar manner but there are exceptions to this rule. So two Pharma companies that you want to buy may be moving in the opposite directions.

Before we get into some mechanisms of getting to the price determination, let me point out some of the things that are absolutely of no use. You may have read them at many places and others may have told you so but avoid them anyway.

  1. While you do need to know about the industry and the specific business of a company you are trying to invest in, there is no real use of plodding through Balance sheets and trying to calculate all kinds of ratios for yourself. There are much more knowledgeable people than you who do this as a profession and you can simply use that data.
  2. When buying a stock it is important to understand that while you do want to buy it as low as possible, unless you are a trader and investing for a very short term, the price is not that crucial a deal.
  3. Review is important but once you have decided to buy a stock, stick with it for some time and don’t jump constantly.

So how do you decide on the price of a stock to buy it at? Well, there are several theories which you can read up yourself and as always I do not want to reinvent the wheel here. So, I will just point out some of the mechanisms that I use.

  • I first identify the sector that I want to invest in by looking into how they have done historically, but more importantly what is their near term and long term prospects. For example, Pharma companies have great near term and long term prospects both from a domestic consumption point of view as well as research potential they have.
  • In general, any consumption based theme is a good idea for a country as populous as India. Some of the industries to benefit will be FMCG, Tourism, Travel, Utilities, Construction etc.
  • I look at 2 sets of companies within the sector – first the market leaders in the sector and secondly the emerging companies that may not be doing very well but have a far greater potential for the future. Typically, I will select a minimum of 3 and a maximum of 5 companies from a sector.
  • The first indicator I look at is the PE ratio. While it can be misleading at times, I have found this to be the most logical way to judge the price. In general I try to avoid anything above 20 and would be keen to buy something below 15.
  • The second indicator to decide on what price to buy at can be decided by the Moving Average price. Typically, I look at 200 day DMA, though at times of serious volatility the time frame can be shortened. If the stock can be bought at a price less than 200 DMA, I would seriously consider buying it. If it is significantly higher I would wait.

Have I always done it like this? Absolutely not as my understanding and knowledge have improved over time and I do things in a much more systematic way now than before. Identifying the right sectors, deciding on a shortlist of leading and emerging companies in those sectors to invest in, finalizing the companies based on their PE ratios and trends and deciding on the appropriateness of the price by looking at 200 DMA etc is a pretty solid method to get started.

Are there other ways of doing this? Definitely yes. Is my way a guaranteed success? Definitely not. Has it worked for me most of the times in terms of the desired results? This one is a definite yes again.

If you are going to start a portfolio use this or some other methods without over complicating it. And no, I have not read the Balance sheets of all the companies that I have invested in, only their analysis. In fact, the only Balance sheets I have read are for companies where I was the CEO.

Equity as an asset class #5 – The basic logic of pricing

One of the things that had puzzled me greatly when I first started investing in equity was how drastic the price movements of a stock were at times. I remember a particular stock go from 30 Rs a share to about 200 Rs a share in a span of 3 months and another go from 300 Rs to about 65 Rs. In both cases nothing much had changed in the respective company performances or their prospects. I do not claim to be an expert on stock pricing – however, with my long experience in the equity markets I do have a better understanding of this now than before. Let me try and share it in this post.

The most important factor responsible for the stock price is the supply and demand for that particular stock. As we know from Economics when supply is exceeding demand prices tend to drop and when demand outstrips supply prices tend to rise. For a particular stock, the shareholders will either want to buy more of it or sell their holdings at some points in time. If there are more stocks to be sold than there is demand prices will drop. On the other hand, if there are a lot of buyers in the market and limited shares available for sale the price will rise.

Let me try and illustrate this by an example. I have 1000 shares of a company X which is a market leader in its sector. In one quarter the results are likely to be declared poor. As it so happens, I need money at this particular juncture for one of my goals. I want to sell it at 1000 Rs per share which is the current market value. However, in anticipation of poor results the demand for X is muted, so at 1000 Rs I find no buyers. Now like me there are several shareholders of X who are trying to sell. I and others will be forced to offer a lower price if we are very keen to dispose of the shares. At some point, buyers will start getting interested. Maybe at 1000 Rs there was no interest but at 900 Rs there may be some buyers. Depending on how strong are the selling needs of the shareholders and the strength of demand, the price can drop alarmingly at times.

Remember when the Satyam scam broke in early 2010? The stock went from 100 Rs to about 6 Rs in a matter of hours. The simple reason was that many people were desperate to sell the stock and no one wanted to buy it. Now this was a classic case of seller desperation as most shareholders believed that the shares will have no value whatsoever soon. In this scenario, they were prepared to sell almost at any price, irrespective of what price they may have bought it at. As the price kept dropping some buyers got interested – their logic may well have been that the company will reorganize in some manner after the existing promoters are out, so it will be a good idea to get it really cheap. In hindsight they have been proved to be correct !!

Almost the exact opposite happens when there is high demand for a stock. In the above case of Satyam, when the government got its act together and Tech Mahindra took over the company, the stock price recovered. This was because people started believing the company had a future and therefore were interested in investing in the same. As demand was more than supply, the stock price kept increasing. The recovery in the stock price was of course much more gradual when compared to the fall, as in this case the level of buyer desperation was not that high.

One important thing to understand at this point is that there is really no base price of floor price for a stock. Yes, every share has a face value but that is not really a support price, further it is normally a low value anyway. So depending on the demand and supply dynamics, the prices can really be almost anything in practice. You will thus find a Maruti sold at 125 Rs in IPO, quoting 4000 Rs now. You will also find Kingfisher Airlines at 1.5 Rs, from a high of 300 Rs and more ( For Deccan aviation, IPO was at 146 Rs).

So, we are now clear about one aspect. In order to understand the price movements of stocks we will have to understand what drives demand and supply in the markets and for a particular stock. I will address this in the next post.