How to Trade Stocks & Indices? – How to Invest.. series

Ref: 10-004    of 19 May, 2010 By Kalidas                      PDF Downlaod from Box.net

I am writing this article at the request of many readers who want to know how do I identify and select the stocks for trading and investment purpose. The methods I am going to share apply to almost all markets. However, I may give examples from US and Indian market with occasional reference to Hong Kong market.

I am covering stocks first and then the convertible bonds as this article series  progresses. The stock market is meant for masses. Even a small investor can dabble into the market with limited means. However, convertible bond is meant for mostly very knowledgeable investors of fairly good Net Worth (called High Net Worth or HNW) investors and Mutual Funds specializing in bonds.

First of all, let me give show you some facts of life or the eternal truth relating to Stock Market or for that matter – Capital market in general. Each of the following pronouncements is referenced later at appropriate stages to prove my point.

These are the 23 commandments of the stock market. They are not codified anywhere in the world. These are unwritten rules, always in force, never documented, always debated, always investigated, never proved, always commented on and yet never concluded.

Initially, my emphasis is to give you some trading rules on how to buy or sell the stock. Whether one is a long term, medium term or short-term investor, the fact is he must know how and when to buy and sell the stock. The real investment game will be discussed in second article after about 15 days, which will disclose my methods of identifying the stocks for various term investments. Convertible Bonds, a hybrid security between stock and bond, will be discussed in the third article.
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WHAT IS STOCK MARKET?
Rule-1
The stock market is a “Devil’s Game”.
•    God, Truth, righteousness, fairness etc. always take back seat.
•    Nevertheless, God (and Gold) always have last laugh when the crash arrives.
•    Stockbrokers, Fund Managers, Rating agencies, Regulators, Analysts and Politicians are “Devil’s Advocates”
•    Death, Accidents, new Customer and Market Crash always come without notice. Always be prepared to face such eventualities and seize outstanding opportunities.
•    No one knows when the bull market began or ended; no one also knows when the bear market began and ended. Analyst’s always double talk, they are more like red ringworms with face or mouth on either side. They always “go with the wind”.
•    The Devil’s advocates always concoct theories. One of them is “Discounted theory of actual events”. Another is “Better than Expected” or “Worse than expected” when they are proved wrong.

Rule-2
Bullish Markets are symbolized by SUN and bearish (market) by MOON.
•    The markets usually rise on “sunny day” and retract on “cloudy or rainy day”. It is very much true in city like Hong Kong.
•    Look out of the window and see how the day is in early morning. Moon or night brings in more rainfall. Even cloud does not hold water and throws it away as rain. If the day is heavy or rainy, one does not feel like working nor wants to buy anything. In fact he will feel like selling or throwing the stock away the way cloud does.
•    Sun denotes brain, which imparts certainty and intellects. This is why people feel like working on sunny day. Moon represents “Mind” which is always volatile, fickle or chanchal. Moon also denotes uncertain mind or uncertainty. This is why the markets usually fall during the period of uncertainty.

Rule-3
Future earnings determine the prospects of a stock, not underlying asset value (book value)
•    Earnings, earnings and earnings alone determine the market trend either on upside or downside.
•    Current earnings or P/E are the most inaccurate guide to the intelligent investor. The trend setting investors look only at future prospects to determine his actions (Buy, Add, Sell, Reduce or Hold)
•    Looking at the book value or NAV (for stocks) is the criteria of the old age. Such valuations were useful to determine the realizable asset value in case the company goes for bankruptcy. If the company were to go for bankruptcy, there was no question of investing into that company. Those who look at the asset value alone, regardless of earning power, are destined to lose big time. As a rule, when the Analysts start pitching Asset or Book Value of the company as attractive reason, it is time to get out of that stock.

Rule-4
Do not try to make small money all the time; it is enough if one makes big money at few times.
•    Most investors or speculators try to make small money (what I call “sandwich money”) in fast and furious trades; a smart and seasoned investor makes big money in few slow and steady trades.
•    Do not try to make money in every trade. It is enough if one makes money in 7 out of 10 trades.

RALLIES AND CORRECTIONS
Rule-5
Normal rallies and correction last for 2 and ½ days, good rallies and correction last for 3 and ½ days and speculative rally and correction (crash) last for 5 days or more.
•    When the stock rallies and closes near high, it means that unfilled orders will carry through on the following session (day). When it rises for 2 days, it will rise further for half day on third day and then profit taking sets in. It applies to all markets and investment products including commodities.
•    Similarly, when the stock closes near day low, it means that sell orders have not been filled and carried over. The stock continues its downward journey on following sessions.
•    Weekly high or low on good volume indicates bullish or bearish tone that is carried over to coming week. When the stock closes near week high on good volume, it determines its upward trend for the coming week.

THINGS TO NOTE
Rule-6
Never count percentages, rely on absolutes
•    Most business channels talk more of percentages, not absolutes. Watch CNBC, Bloomberg, CBS or others, the Anchors speak for percentages at least 3 times in any sentence.
•    % always look small when the base is high; similarly percentages look very high when the base is small.
•    It is the money in your pocket that counts, which is “absolute”. That is what you are going to spend.
•    When stock drops from say, 100 to 30, the % drop is 70%; when the same stock rebounds from 30 to 100 (original level) it is a jump of 233%. Absolute numbers remain same.
•    Only idiots rely on percentages; smart investors rely only on absolutes.

Rule-7
99% investors buy first and then sell; only smart 1% investors (short sellers) sell first and buy back later.
•    Stock market builds on hopes that the stock will go up so that they can make profit. This is why 99% of investors buy long (buy first and hold).
•    Smart investors (short sellers) work against such hopes and they sell first (short) and buy back later. They usually make more money than others.
•    When the short sellers sells and stock goes up, he should sell more to average up his sale price. The profit taking will set in and he will make money easily.
•    Selling first and buying (or covering later) is most businessmen do unconsciously. They get sale order first and confirm the sale. (Sold first). Then they go their suppliers to buy the goods (covering short)
•    It may not be possible for small investors to short sell due to restrictive exchange rules that normally favor the large brokers, mutual funds of hedge funds. For them, buying long is the only solution.

Rule-8
Round numbers and Beautiful girls never comes in one’s hand. Always be flexible in setting number target for sale or buy.
•    Most investors keep “round figures” as the buy or sale target which is not achieved most of the times wasting the time of investors and his brokers. 10, 20,30, 100, 500, 1000 are the round figure targets.
•    If an investor wants have his trade successfully executed, he should set the target about 10 to 15 points (or 0.5% to 1.5% depending on stock value) above or below the intended round number price. Say, if he wants to sell a stock at 30. He may write sell order at 29.85. Similarly, he wants to by at 30, he may write buy order at 30.10 or better 30.35.
•    The round number levels are as slippery as beautiful girls.  There are thousands of buyers and sellers at round numbers. Smart investors always accept lower than round number for sales or higher than round numbers for purchase.
•    Be a large hearted investor. Learn to leave something on table and do not become greedy to earn last dollar or rupee.

HOW THE STOCKS AND INDICES MOVE?
Rule-9
Indices above 5800 move in increments of 400 and 600 pts for critical levels. They move in increments of 200 pts at other intermediary levels. Those levels are supported or resisted by 35 points on either side.
•    Say, 9,800, 10,200, 10800, 11,200………..14,200, 14,800…16,200, 16,800, 17,200, 17,800, 18,200 and so on.
•    All intermediary levels are say, 10,400, 10,600 etc. where movement increments are 200 points on either side.
•    The market operators unconsciously test the upside and downside level by about 35 points on either side of critical level. Say, the indices are falling to 10,800. The index will still go down further to 10,765 from where it will rebound. Similarly, when the index is rising and hit 10,800 level, it may go a bit further by 35 points before deciding whether to go higher or go down in profit taking.
•    If one wants to buy the Index when it is falling, he may write limit order to buy at 10,765 (If the critical level breached is 10,800). Similarly, when the index is rising he may add 35 pts to write sell order for indices (10,800 +35  = 10,835)
•    If index rises above XX,200, it is possible it will rise to Xx,800. Similarly when it falls below XX,800 and stay below that level for 2 days, it is possible it may go down further by 600 pts to test the further support of XX,200 levels. Thus, if the stock falls below 10,800 and stays for 2 days, it will go down to 10,200 unless there are strong reasons to go above 10,800 level.
•    These are rules of thumb.

WHAT MOVES THE STOCKS?
Rule-10
When really bad news hit the stock or the market due to economic events, such as market crash overseas, debt crisis, exchange crisis, etc. – allow 3 days to 5 days before jumping in.
•    Over 80% of short term trades are margin based. That is, investors borrow from banks or brokers to leverage his trades. They glee in good times, and weep in bad times.
•    When the market tanks by 5% to 10% in single session, and closes near day low, the margin calls originate on following day. If the market goes down further, the margin call pick up momentum.
•    The broker or financier issue margin call to the investor and give him notice to make good the margin, If he does not, the financing banks or brokers sell the stock on 2nd or 3rd day of the margin calls.
•    Such forced sales usually take place at about one our later after market opening. Since they are forced sellers, they usually sell at the market or bid prices. The spread widens with the result that losses to investors mount at alarming rate. It is therefore good time to buy during the time of forced selling.
•    One may buy long term on margin if the stock or market has tanked over 50%. When the market drops 70% it is time to accumulate good index stocks on margin basis.
•    In market crash, the fundamentals do not work. Pick up whichever good stock has dropped most.

Rule-11
The stock moves on its own strength, industry’s strength, country’s market strength and global market strength. (Read strength = strength + weakness)
•    When the stock moves on its own strength, it invariably makes money.
•    When the stock moves on sectoral strength, it still makes money.
•    When the stock moves on Country’s market strength, it makes less money.
•    When the stock moves on global market strength, it makes least money.

Rule-12
When the earnings of the company can be easily worked out, they tend to trade at low P/E; Similarly, when the earnings of a company can not be anticipated, the stock usually trade at high P/E ratio.
•    Single product companies such as commodity companies usually trade at low P/E because their revenue can be figured out with reference to commodity mined and market price thereof.
•    Similarly, utility companies such as Power producers, Water distributors, telecom companies and energy companies tend to trade at low P/E.
•    Similarly, holding companies trade at low P/E because its earnings could be easily figured out by summing up the profit share in subsidiary companies. Unless the holding company has its own identity and business.
•    Stock market always ignores present earnings or P/E or EPS. It always seeks to anticipate the future earning prospects or things beyond.
•    A famous song “Choli ke pichhe kya hai…” sums up this section. Suspense creates excitement that moves the stocks and the markets.

Rule-13
Given a choice, go for the stocks of subsidiary companies rather than holding company. When a person wants to buy the stock of holding company because it has not moved (or cheaper) whereas other subsidiaries did (or became expensive), it is time to get out, not get in. It is the peak.
•    Again it is the earnings and its visibility. The stock of holding companies usually trade at lower level than other subsidiaries for the reason that the earnings of holding company do not hold surprises – they are just arithmetical sum total of all subsidiaries.
•    The subsidiaries may trade at 15 times P/E but holding company at 6 to 8 times because if there are not to be growth in the earnings of subsidiaries, the earnings of holding company would have peaked.
•    UNLESS of course, the holding company has own independent activities that may cover over 50% of its total earnings including subsidiaries.

Rule-14
The stocks usually move in a group regardless of fundamentals. Get out of less worthy ones.
•    This is especially true in Asian bourses where most of the leading companies are family controlled enterprises.
•    Say, there is good news about Birla group in India, all stocks in Birla group will move. Similarly for Tata, Ambanis (both Mukesh and Anil known as MDAG and ADAG), Jindals etc.
•    This is the time to lighten up on stocks on good news and load up on those stocks on bad news.

Rule-15
When the stock moves on non-financial news – such as political, social or anti social news, use the opportunities to load up or sell out after a few days.
•    Stock market relies mainly on financial fundamentals, not others.
•    When the political crisis hurts the stocks, treat as buy opportunities after 3 to 5 days.
•    If anti social events such as bomb blasts take place, treat as buy opportunity and jump in immediately.
•    Never anticipate political, social and judicial events and take anticipatory position immediately before those events.
•    Similarly, when the political events engineer rallies, such as outcome of election, get out of stocks within next 5 days of such euphoria.
•    Similarly, when the political events cause steep fall, such as outcome of election – hung parliament or coalition government – treat as buy opportunities.
•    Politicians may change – they come and go – but the bureaucrats remain same. It takes long time to change established policies.
•    Normally the bureaucrats rule the nation most of the time – the politicians are merely rubber stamps. Bureaucrats or so called experts’ advice the politicians and they have domineering effects on financial policies unless the Leadership is strong and imaginative.

WHEN TO ENTER OR REFRAIN FROM THE MARKET
Rule-16
One need not be in the market all the time; however, the market should be on his radar all the time.
•    A smart investor acts like a lion. Just as the lion kills its pray only when he is hungry (not otherwise), an intelligent investor is discreet enough to participate in the market for a kill only when the market is attractive.
•    The market is a dynamic force. It should be under the watch of an investor even if he does not participate.

Rule-17
Always be a player, not the bystander or spectator. It is the player who makes a run or a century, not the bystander.
•    There are 2 batsman in the field and 20,000 spectators. It is only those with the bat facing a ball make runs or a century.

HOW TO BUY, SELL AND TRADE THE STOCKS? – FUNDAMENTAL STRATEGY
Rule-18
Do not buy or sell after reading or watching business TV channels.
•    Many brokers or investment banks have financial journalists on their roll what they call PR exercise. They feed the information with definite intent.
•    Do not let your impulsive instinct to shroud your logic or judgment.
•    When every one knows what is read or watched on media, there is little room to make good money.

Rule-19
Buy or sell “Three Weeks” ahead of expectation of event, and reverse the bet “Three Working days” ahead of scheduled event.
•    It is similar to “Buy on rumors, sell on facts” and vice versa.
•    The stocks usually move ahead of events. The brokers start tipping around after taking proprietary position.  They usually get out a day before the scheduled event.

Rule-20
Do not try be a bottom pincher OR a peak picker.
•    Always remember very few people are found near the bottom or at the peak.
•    Start buying when the stock recovers by 8% from steep fall and start selling when the stock is within 15% of target price.
•    When you feel buying just buy, and when you want to sell, just sell without waiting in the line or Queue.
•    One never succeeds in bottom fishing or peak picking. Be practical


HOW TO BUY, SELL AND TRADE THE STOCKS? – STRATEGY TO ACTIONS
Rule-21
Always sell in first 15 to 30 minutes of market opening. Buy in next 60 minutes. Sell before lunchtime, and again buy back 30 minutes before close (provided there are no adverse international events)
•    The market makers or operators make two levels in the morning trades – low and high – within which they operate all day long.
•    Always sell in first 15 to 30 minutes of trades. The rise in price is mostly not so real trade based, but operator based.
•    The stock consolidates for 60 to 90 minutes after first 30 minutes. The market makers then buy back a little to cover their short position.
•    Some market makers or operators sell ahead of lunch hours. The broker crowd is thin during lunchtime, which helps smart operators to dictate trend. It is said that a smart broker never takes lunch. This is why most steep corrections take place during lunch time (1:00 PM to 2: 00 PM) and near the close (Last 15 minutes)
•    Last 15 minutes of trades reverses the morning bets. If the stock has risen, it will fall (due to bulls liquidation), and if it has fallen, it will rise (due to short recovering) during this period.
•    If the spread between Bid and Offer widens, it means that the market makers want to sell first and buy back only later at much lower price. The stock usually falls later in the day so that they can recover their short position.
•    If the spread between bids and offer narrows down, it means that the market makers are engaged in stock accumulating stage by forcing the level down. The stock usually gets higher later in the day.

Rule-22
Buy a stock after 45 minutes and before 90 minutes of opening trade.
•    Most people sell the stock in the morning after reading newspaper or watching business channels. Such selling is active after 45 minutes of opening. The market makers also recover their shorts when the real sellers rope in.
•    Most people buy the stocks only in the afternoon, saying they want to study the market. Even if they studied the market, it holds good for the day, not beyond. Anything can happen at night when dictating US market opens and closes before the world market opens from Australia to Arabia.
•    Study yourself. How many times you bought the stocks in the early morning hours? How many times you bought the stocks in the afternoon, especially after lunch hours?
•    Often, the market makers set two levels – high and low of the stock. The investor, trader or speculator – whatever name you call – will try to set these levels as his benchmark and try to get high price for his sale and low price for his buy. He rarely succeeds.
•    The stocks usually moves in first and last 30~45 minutes of a daily trading session. The stock usually hardly moves or moves sideways during intermediary 4 hours. Nothing usually happens during this time, and yet the daily trader glues to the screen doing also nothing.
•    A smart person would operate during first and last 30~45 minutes and then take time off to attend his normal work.
•    This rule does not apply when the market is in crash or deep correction mode due to other complex factors.

Rule-23
Always follow 35:85 rule while trading stocks.
•    Watch out interesting numbers 35 and 85 at all times. Study almost all active stocks for their daily pattern. One will notice day high and low around this level.
•    If the stock is valued at Rs 50, for instance, it is possible it may have fluctuated between 48.85 on downside and 51.35 in normal days.
•    When the stock goes to say 48.50, a round number, it is possible the traders might force it lower to 48.35 to see whether any support comes in. If it does, the trader recovers his short position quickly.
•    Look at today’s Gold prices – 1085, 1135, 1185, 1235 are the levels to which it touched and then either progressed or corrected.
•    It applies to any commodity, forex trades, bonds, CBs, property markets etc.

These are the 23 unwritten yet widely followed Commandments from the years long observations by the Kalidas (Anil Selarka). I am sharing this knowledge and experience with the readers of this blog.

Above are merely daily trading tactics. The real Long Term and Medium Term tactics will be discussed in next article – How to Select the Stocks and Bonds? However, the tactics as above will be used to time and control the purchase and sales activity

CAUTION: Kindly note that the contents of this article are “copyrighted”. General permission is granted to anyone only if they acknowledge the source as “this Article and the Author”. Ungrateful copycats are not welcome and will be proceeded against legally for violation of copyrights and intellectual property.

Kalidas (Anil Selarka)
Hong Kong, 19th May 2010