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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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