Investment in Equity (Part 2)

Here is my theory: Buy when price starts rising and sell when price starts falling.

The theory is surprisingly short, I know.

Is that all, you might ask. Yes, that is all.

This one single theory is enough and more for you to make substantial profit in the stock market, over the long term. By long term, I mean a few years. If you survive in stock market that long, faithfully following this theory or principle, you will never want to leave the stock market, I will guarantee it.

Before I proceed to explain the theory, let me give you some caution. The trading hall in a stock market is a place where free advices come to you by the dozen. Some of these advices might help you earn some little amounts of profit, while the rest will take away whatever profit you have earned and, most probably, even a chunk of your very capital. The trading hall is a great leveler. It gives you profit with one hand, but takes it away with the other. Anyone who goes by rumours which keep spreading in the trading hall, will soon burn his hands.

The share-price alone should be your sole guiding light. The price considers every news and every rumour, digests it all quickly, and adjusts itself in response to it. This adjusting process is what we see in every trading terminal (computer). The share prices in a terminal keep blinking most of the time. The price changes colour many times in split seconds. When price rises, it turns blue or green. When price falls, it turns red.

Let me repeat the theory: buy when price starts rising and sell when price starts falling. Easier said than done. The price keeps rising and falling all the time. Here, for illustrative purposes, we shall select a price movement of 5% as the trigger for our actions. Buying and selling are the actions. Please listen carefully, this is very important: We will buy a scrip when price rises 5% from a recent bottom. We will sell it away when its price falls 5% from its recent top.

Share and scrip – these are two terms which you will frequently come across in this write up. Both are the same. However, in a trading hall, they could be slightly different. SBI, Reliance, ONGC, Infosys, TCS – these are all often considered as scrips. If you are discussing TCS with your friend, he might ask you, “Do you have that scrip in your portfolio?” You might answer, “Yes, I have that scrip.” “How many shares of it do you have?” he might probe. You might say you hold 10 shares each. You will say that you are having 10 shares of each of the scrips, but you will not say that you are holding 10 scrips of the shares. Hope you are now familiar with scrips and shares. No harm if you use either.

The price of every well traded scrip forms tops (highs) and bottoms (lows) all the time. What is a top or high? Let us imagine that the price of a scrip has been rising from Rs. 100 and has touched the level of Rs. 120. After hitting Rs. 120, the price falls to Rs. 105. In stock market parlance we will say that when the price rose to Rs. 120, it met with resistance. The price could not pierce the resistance. Or, it failed to overcome the resistance. Selling emerged, and the price fell from Rs. 120 to Rs. 105. In the process, the scrip formed a top or high of Rs. 120. In other words, Rs. 120 is the last formed top or high.

Let us continue to imagine that, in the above mentioned example, the price, which had fallen from Rs. 120 to Rs. 105, then rose from Rs. 105 to Rs. 135. In stock market parlance we will say that the price formed a bottom or a low, at Rs. 105 where it had received support. The support it received at that level made sure that the price did not fall further. Not only that, the support grew strong enough to see that the price rose from Rs. 105 to Rs. 135.

In the above mentioned example, the price first formed a top or a high of Rs. 120, and then formed a bottom or a low at Rs. 105. These are the levels from which the 5 percent trigger should start reckoning. Let us see how the trigger works. Let us first take the bottom formed at Rs. 105. Let me quote the theory for ready reference: buy when price starts rising. Remember, the trigger we had chosen for action was a price movement of 5%. When the 5% trigger is applied, we must buy when price rises 5% from the bottom of Rs. 105. When the price thus rose 5% from Rs. 105 to Rs. 110.25, we must have bought the scrip at that level.

A little bit of explaining is needed at this point. What is meant by the trigger? What is it for?

As mentioned earlier, price keeps fluctuating. It rises and falls. We can’t buy whenever price rises a few paise, and we can’t sell whenever price falls a few paise. Although a ten paise rise will satisfy our theory of buying when price starts rising, we do not consider a ten paise rise as sufficient to decide that the price is starting to rise. We will decide that the price is starting to rise or has started rising only after the price has risen as much as 5%.

In the case of selling, just the opposite will come into play: when price has fallen 5%, we will decide that price has started falling and trigger ourselves into action, which, in this context will be selling.

Let us imagine that we have bought the scrip at Rs. 110.25, and that we are holding it. The price now rises to Rs. 135. After touching Rs. 135, it falls 5% to Rs. 128.25. The theory asks us to sell away the scrip when its price falls 5% from a recently formed top or high. The recently formed top or high was Rs. 135, and when the price falls 5% and touches Rs. 128.25, the sell-trigger should work, and we must sell the scrip away.

What all have we done?

We did two things: (1) When the price rose 5% from the last formed bottom or low of Rs. 105, we bought the scrip. (2) When the price fell 5% from the last formed top or high of Rs. 135, we sold it away. In other words, we bought the scrip at Rs. 110.25 and sold it away at Rs. 128.25.

Luckily for us, this particular deal ended in profit. We earned a gross profit of Rs. 18 per share. The NSE dealer’s brokerage will also have to be paid; let us assume that the total brokerage (for purchase as well as sale) came to a total of Rs. 1.28. Our net profit will thus be Rs. 16.72 per share.

Not all the deals are likely to be as rosy as this. We will go into it in detail later. Before we do, I must raise the question: Why is 5% chosen as the trigger? Why not 2%, 3% or 4%? No one will ask me why not 10%? Whether one raises it or not, the question, why not 10%, also, has to be dealt with. We shall deal with all this in the next few parts.

Hope at least a few of you will stay with me.

(To continue)