When one thinks of the stock market, mostly one of these
two thoughts come in mind; Warren Buffet or Speculation! If a person possesses
knowledge of this field, he/she will be inclined to think about the Warren
buffet philosophy. Most of the other folks think that it is a speculative world
and if they’re lucky, they can make a fortune.
I too belonged to the second category of folks a few
years ago. I used to believe that one can become wealthy by practicing the
‘art’ of speculative trading. I had an opportunity to step into the world of
stock markets and started exploring the ‘how, what and when’ of trading. I soon
realized that the subject is a deep ocean of knowledge but practically lends
itself to human emotions of panic, fear and greed.
Cutting a long story short, here is a simple
understanding about stock market trading.
Trading can be categorized into:
Speculative trading, Fundamental-based trading and
technical trading
Speculative trading involves trading in a financial instrument involving high risk, in expectation of significant returns. The motive is to take maximum advantage of the price fluctuations in the market. Speculators, therefore, trade in securities which have highly volatile prices and are traded frequently. This type of trading was definitely not my cup of tea and led me to ponder on the other methods of playing the markets to ‘make some money’.
There are different philosophies / theories and each must
be right for certain set of people, of course, depending on their risk and
return preferences.
It’s a known fact that fundamentals of a company should
be the basis of its stock price and few, rather none can challenge ‘Buffetology’.
Warren Buffet strongly advocates
investing in fundamentally strong companies and identified the right stocks
using fundamental analysis. Fundamental analysis involves an analysis of the balance
sheet of the target company and of many more other parameters like turnover of assets,
profitability, quality of the management team, demand for their
products/services, future resilience/ vulnerability, state of the world
economy, trends, competition, innovations in that industry, etc.
Primarily, fundamental analysis helps define the target
security and prediction of the price or value. This method can lead to having a
very complex criteria for buying and selling stocks. It’s usually the experienced
and established market participants who use fundamental analysis techniques for
trading. It is used to make long term investments in the market. There are high
chances that human emotions like fear and greed play a big role while taking a
decision of entry or exit of the stocks.
And then there is this whole different world of technical
analysis.
Simply put, technical analysis is based on the philosophy
that trends and patterns repeat and that the stock prices can be predicted, with
a degree of accuracy, by analyzing the price patterns/trends.
Technical analysis today consists of several theories
around study of patterns / trends. There are many universities and institutes which
offer courses/certifications on technical analysis. You will find several certified
technical analysts employed in the industry and this skill is found to be
useful for individual traders, fund managers and investment bankers.
Technical analysis requires skills in mathematics, statistical
analysis and money management.
There primarily are two categories of technical analysis:
1. Chart theory - discretionary trading and
2. Trend following
The chart theory is based on price, volume and
indicators; - namely, support and resistance levels. It has a defined mechanism
of price determination. Though it is designed to avoid getting sentiment and
emotion in the equation, the nature (discretionary trading) of this business is
such that often emotions may play a bigger role in buy/sell decisions than rationale
and mathematics. Besides, the back testing of this system is a fairly complex exercise
and is often not required as pattern science is based on historical behavior. People
with knowledge and passion for mathematics prefer trading this style.
The trend following technique is purely based on price
theory. Frequently, trend followers say price is ‘GOD’. The technique doesn’t involve any prediction
of price. The trend following system can only be proven using historical data
analysis; technically known as back testing.
It gives a trader proven and consistence track record of
how a stock behaves in bullish, bearish and sideways market. The back testing
gives confidence as it shows how the stock has performed during major economic/political
events in the economy, natural calamities, economic cycles, etc. The concept is
really simple and is based on simple or exponential moving average or high-low
price theory.
The beauty of this trading method lies in the discipline
it lends to trading. The trader has to just be disciplined, once the rules in
the system are set up. The system rules are defined such that the scope of influence
of human emotions driving trading decisions is largely eliminated. Investors
who prefer simplicity and discipline will favor this technique for trading in the
capital market.
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