Security Investment Analysis - Essay Example

SECURITY INVESTMENT ANALYSIS Table of Contents Topic 3 Introduction 3 Technical Analysis 4 Assumptions in Technical Analysis 5 Tools of Technical Analysis - Charts 5 Definition of Chart 5 Why Technical Analysts Favour Charts 5 Types of Chart 6 Chart Patterns 7 Topic 2: 13 Part (i) 13 Part (ii) 18 References 21 Topic 1: Introduction The share price movement is analysed broadly with two major approaches – The Fundamental Analysis and the Technical Analysis. The former analyses the share prices on the basis of economic analysis, industry analysis and then company analysis. If the price of shares of any stock is lower than its intrinsic value, then there is every possibility that the forces of demand and supply will drive share prices towards equilibrium. This means that the share price is expected to rise in future. In such situation, the investor will buy the stock. Consider the reverse situation when the intrinsic value of stock is lower than the market price of shares. In such case, there is a chance that the price of shares may fall in future and the investor will prefer to sell the shares. The buying and selling of shares by an investor depends on the movements of share prices and their intrinsic value. The factor which determines the decision regarding buy, hold, or sell of share depends on the analyst’s perception about stock price movement in future. The objective of the investor as a market participant is to make profit. The investor may buy shares at chap price and sell at high price and make a profit on transaction. Again an investor may hold the share when the intrinsic value of share is equal to the market price of share because in such case, buy or sell of shares is irrelevant. But when the investor finds that the intrinsic value of shares is lower than market price of shares, the shares will be sold to earn profits1. The Technical analyst mainly follows the stock price movement of security market and takes advantage from short term price fluctuations. If there is an uptrend in the movement of stock prices, the technical investor may buy the scrip. If he buys the stock whose price is expected to rise, then he will make profit by buying at a lower price and sell at high price in future. The transaction gives the investor an opportunity to make profit due to movement in prices. Conversely, with the beginning of fall in price, the investor may sell the scrip and avoid loses. Both the technical analysis and fundamental analysis aims to earn a good return to investor but their approaches are different. Technical Analysis It is the process of identifying stock price movement patterns at a prior stage and then to devise the buying and selling strategy. With the help of several indicators, a technical investor analyse the relationship between price – volume and demand – supply for the overall market as well as the individual stock. High volume is favourable on the upswings and consequently the numbers of shares are traded is greater than before and on the downside the number of share traded dwindles. So if the reciprocal is true, then there is a chance of trend reversals. The objective of technical analyst is to identify the trend reversal as early as possible and then gain from these movements. To put it more simply, if a technical investor can identify the two states of market – not trending or trending, the investor’s analysis is 80 % complete. A successful technical trader concentrates on two aspects – one, to find the trend and two, to find the trade2. Assumptions in Technical Analysis The technical analysis is based on three major assumptions about the stock market – one, the stock prices and the stock market factors in everything from natural calamities to psychological behaviours of the market participants; two, by carefully observing the movements in stock prices, it will be possible to identify distinct patterns in the stock price movements; three, the movement of stock prices in the stock markets are repetitive in nature. Tools of Technical Analysis - Charts Definition of Chart A chart or more precisely price chart is a series or a range of prices plotted against time period that provides an easy to read and summarise graphical representations of share price movements. The vertical axis of a chart depicts the prices of stock or exchange rate while the horizontal axis depicts the time frame under observation. Prices are plotted from left to right across the horizontal axis with most recent plots (current prices) being furthest3. Why Technical Analysts Favour Charts The charts provide visual assistance and they are the most appropriate tool to identify the changes in pattern of stock price movements. They also help to identify the resistance and support levels. Resistance is a point where the rising prices can be expected to stop in the short term due to concentration of supply. The support is a point where falling prices can be expected to stop for the time being due to concentration of demand4. Types of Chart 1. Line Chart 2. Bar Chart 3. Point & Figure Chart 4. Candlestick Charts Line Charts They are the most basic form of charting and are extensively used in the application of technical analysis. The line chart represents only the closing stock prices over a given time frame. The line is formed by connecting the closing prices over the time frame. They have the limitation that line charts do not provide visual information of trading. The price ranges cannot be defined by them. It also does not consider the open price, high and low prices for the given time5. Bar Charts They are easy to draw and they are also easy to interpret. In a daily price chart, each vertical line represents the range of each day’s price. The period may be extended to weekly, monthly, quarterly. A bar chart may be classified into inside, outside, down, or up bar6. Point & Figure Charts The technical analyst uses this type of chart to predict the price movement of a particular stock. They are always one dimensional and there is no indication of volume or price of stock under observation. Candlestick Charts They may be considered as an extended version of bar charts. They rely on colours to explain what happened during trading period. This chart helps to identify a shares’ open, close, low, and high. The vertical axis plots share price while the horizontal axis plots time period. Interpretation – If the open price of stock exceeds close price, the candle stick body is black. When the close price exceeds open price, the candlestick body is white. The thin vertical line is called ‘wick’ and the thick portion is called the ‘body’. Uses – They are used to summarise price data, helps identifying trends, and helps to understand certain patterns easier to recognise7. Chart Patterns Head & Shoulders In this pattern there are three rallies resembling the left shoulder, right shoulder and the head. A neckline may be drawn that connects the lows and tops. When the stock price cuts the neckline from above, it implies a bearish phase. The left shoulder is created by the upward price movements. At the top left shoulder represents buy at up trend. The dip represents selling of shares8. 9 10 11 Cup & Handle When the patterns on the bar chart resembles with a cup and handle, the pattern is popularly called the cup and handle. It may be u-shaped or inverted u-shape. The side that has low trading volumes is represented minor downward glide. When the stock under observation will incur selling pressure it will make the stock trade sideways with a falling pattern. This trend may last for about two to four weeks after which it comes back to normal12. 13 14 Topic 2: Part (i) FTSE 100 index reflects the share index of 100 listed companies on the London Stock Exchange. It is considered by many investors as a measure of business affluence. The total market capitalisation of the stock as on April 2012 was £ 1550 billion. Technical analysis can be conducted on FTSE 100 stock index by observing and analysing the chart patterns of FTSE 100 over time. These patterns help a technical analyst to predict future stock price movements and trend reversals. The following fig. 15 depicts the FTSE 100 stock price movement: 15 16 The 52 week range of FTSE 100 is 5,229.80 – 6,412.40. It implies that the stock moved within tolerable range. This also means that over medium to long term, the FTSE 100 has created wealth for the investors and could further rise in future. To perform technical analysis on FTSE 100, the bar charts can also be used as a tool. 17 Interpretation – The one month bar chart of FTSE 100 index shows that at the beginning of period the trading volume opened low but the gradually picked up. From the second week of February till 18th February, the stock was under selling pressure but then again from opening of 3rd week of February, the stock experienced increased volume of trades as the investors expected the stock prices to further rise in future. Recommendation – On the basis of Bar chart technical tool, it can be said that with increased volume of trades, the FTSE 100 stock index will rise in near future. Hence investor should buy the stock. To perform technical analysis on the FTSE 100 stocks of 100 listed companies in London Stock Exchange, the line chart analysis can also be used as tool for analysis. The following figure 18 shows the movement of FTSE 100 stock index for one month. 18 Interpretation - The line chart of FTSE 100 index represents that at the beginning of period the trading volume opened low but then it gradually picked up. The market closed with fall in stock on February 18 but again from the start of 3rd week of February, the stock started experiencing investor confidence. As the investors put their money on the stock, its prices began to rise. From the chart it can be concluded that the stock prices are further expected to rise. Recommendation – The investor should buy the stocks now as the price of stock is expected to rise in near future on the basis of line chart analysis. Monthly candlestick chart analysis done on FTSE 100 stock index is shown below in fig. 19, 19 Interpretation – During one month period starting from the last week of January, the open price of FTSE 100 index exceeded the close price only four times. It is shown with black body of candle stick. When the open price exceeds the close price, it reflects that prices may fall in near future due to selling pressure from the investors. The third week of February’s opening shows that close price exceeded the open price which indicates that the stock prices will move upwards in future. Recommendation – There is an indication of upswing in stock price movements, so the investors should buy the stocks. Part (ii) The individual stock chosen from FTSE 100 is Vanguard FTSE 100 ETF (IE). The bar chart and the candlestick chart can be used to perform the technical analysis on this stock. 20 From the technical analysis using the Bar chart on Vanguard, it can be seen that the trading volume for the stock is very low on the third week of January. There was an unusual buy pressure on the stock at the end of second week of February which may have been caused due to market speculations. The market however corrected itself by the beginning of third week of February and stock price came back to normal levels. Overall, the stock is experiencing a downside trend and so the investor is recommended to sell the stock as prices will fall further. 21 From the technical analysis using the Candlestick chart on Vanguard, it can be said that the open price of stock exceeded the close price only six times in a month. Overall, the stock is experiencing a downward moving pattern. The price of stock started falling at the beginning of third week of February and is not showing any sign of corrections. So, this downward trend may continue for some time in near future. The investor is recommended to sell the stocks now and buy cheap later in order to make profits from technical analysis. References J. Smithson, Rediscovering Gann’s Law of Vibration, The Traders Journal, Vol. 4, no. 10, pp. 11-17. C.D. Kirk Patrick, Technical Analysis: The Complete Resource for Financial Market Technicians, Pearson Education, Inc., 2011, p.3. J.D. Schwager, Technical Analysis, John Wiley & Sons, Inc., 1996, p.3. C. Brown, Technical Analysis Demystified, Tata McGraw Hill, 2008, p.5. L. Stevens, Essential Technical Analysis: Tools and Techniques to Spot Market Trends, Omega Research, Inc., 2002, p.38. J. L. Person, A Complete Guide to Technical Trading Tactics, John Wiley & Sons, Inc., New Jersey, 2004, p.35. D. Keller, Breakthrough in Technical Analysis, Bloomberg Press, 2007, p.35. R.W. Schabacker, Technical Analysis and Stock Market Profits, Harriman House Ltd., 2005, p.42. R. R. Wasendorf, SFO Personal Investor Series: Technical Analysis, Wasendorf & Associates, Inc., 2007, p.64. Yahoo Finance, Basic Tech. Analysis, 2013, Retrieved 20 February 2013, . Read More