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-- Intended for Start-up Analysts and Researchers --
While there are many
ways to learn to analyze stocks or the stock market as a whole, here is one
simple way I generally propose:
1. Instead of starting with a Stock or ETF, consider a
liquid Index/Average like Dow Jones Industrial Average (DJIA), which comprises
the 30 largest cap stocks. You may look at it as the front-end of the stock
market. This type of analysis is known as the top-down approach (analysis of
individual stocks represents the bottom-up approach). Alternatively, you may
use the S&P 500, a.k.a. the broader market.
2. Whether you decide to experiment with stocks or
indices, the most common database will consist of these variables: Date, Open,
High, Low, Close, Adj Close and Volume. In terms of frequency (time interval),
the common choices are: daily, weekly and monthly. Some sites may offer yearly
roll-up as well (yearly prices are used to study historical trends like Laureate Shiller's CAPE ratio, etc.).
3. Though the Daily Adj Closing Price is the most frequently
used data (along with other variables) in defining trend and strategy, use the
Weekly/Adj Price as part of your first attempt. As you can imagine, weekly
prices are less noisy and much smoother (than the daily prices), leading to
easier data visualization. Once you get into more advanced analysis and
modeling, you will use the other variables either as ratios or as independent
variables.
4. The best way to get a good feel for the data, trend
and outliers is to create a scatter plot. Eyeball the scatter and fit your
trendline. Since you are dealing with weekly averages here, leave out the
moving averages. As you learn to analyze the daily data, you will see the
utility of 60 to 200-day moving averages which are standard metrics in this
business. If you are unsure of the differences amongst linear, logarithmic,
exponential, polynomial, power, etc. trendlines, go back to your text books and
brush up your knowledge.
5. One of the skills you must develop is to quickly
identify the outliers (noise). If you are working on defining trends leading to
business strategy, it is absolutely imperative to work with the data as
outlier-free as possible. Look at the two scatter graphs above. The only
difference between the top and the bottom is that the latter has three fewer
data points (week of 1/7/18, 1/14/18 and 1/21/18), resulting in a much cleaner
dataset with higher r-squared. If you remove two more data points (12/31/17 and
1/28/18), the r-squared jumps to 0.923 (not shown). Again, one of the skills
(perhaps habits) you must develop is to be able to identify the outliers
quickly; otherwise you will end up fitting wrong trendlines.
6. Once you have the data and trendlines under
control, the first thing you will look for is the formation of supports. If the
stock/index bounces off a price level repeatedly, a support is being buoyed.
When the support extends out to form a double bottom (like W), any reversal
tends to be bullish.
7. The next thing you need to learn is to identify the
congestion level. If the stock/index makes an extended sideways move within a
band, it is considered "stuck" within a congestion zone. For
instance, if it remains range-bound between $40 and $45 for several weeks, it
has developed a short-term congestion. Many professional traders take advantage of the congestion by "channeling" those stocks/indices.
8. Often, a stock/index makes a rally but falls apart
quickly at a particular price point. For example, if the stock makes multiple
attempts to cut through the $45 area but fails, it has developed a short-term
resistance there. Traders who buy on strength tend to develop a watch list of such
stocks/indices. Professional traders generally write covered calls when the stock fails to break out.
9. When a stock/index eclipses past the resistance and
maintains the upward move, it is considered a breakout. Traders who buy on
strength wait for a breakout to occur. As soon as the breakout is confirmed
(closes above the breakout price), they start to initiate long positions (or buy calls, sell puts, etc.).
As you get started, these are some of the market
basics you must be very comfortable with.
Good Luck!
- Sid Som, MBA, MIM
President, Homequant, Inc.
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