Trading in NEPSE: Thinking out of box!

If you use only fundamental analysis and being bored of using it all the time or want to see the market from different perspective which is not only interesting and challenging but also profitable then this article can be of great assistance to you. In this article, I will be trying to acquaint you on the world of technical analysis and its use to study the behaviour of price in “NEPSE” stocks- thinking outside the box!

Technical analysis is totally a different ball game and likely to appeal visually oriented individuals. It is the study of price only. Some argues that it’s a way to look into the mass psychology. Unfortunately, this is not taught even in top business and finance schools. Interestingly, researchers found most of the financial market practitioners use technical analysis than fundamental analysis to analyse the market and security. 

Topic	Instructor’s mean	Practitioners’ mean
Portfolio theory	3.89	2.44
Discount Cash Flows	3.87	2.95
CAPM/Beta	3.85	2.48
Required rate of return	3.85	2.41
Dividend discount model	3.77	1.73
Efficient market hypothesis	3.54	1.85
Ratio analysis	2.70	2.56
Arbitrage pricing	2.40	2.21
Crowd psychology	1.99	3.56
Charting	1.80	3.56
Trend lines	1.70	4.39
Support/Resistance levels	1.68	4.41
Trading ranges	1.66	4.37
Relative strength index	1.65	3.54
Stochastic	1.63	3.51
Volume tracking	1.54	3.78
Moving average/Convergence	1.49	3.56
Overbought/oversold	1.46	3.93

Adapted from Flanegin and Rudd (2005), cited in Krikpatrick and Dahlquist (2010).
There are two entirely different ways to analyse security-Fundamental analysis and Technical analysis.

Those who use fundamental analysis are called fundamentalist, such as my college or university finance professors. I would like to call them fundamentalist because they never talked about technical side of the market with me.  Fundamental analysis is a method of finding intrinsic value of security by studying economic, financial and other quantitative and qualitative information related to that security. Therefore, an investor who wants to invest in bond and uses fundamental analysis would look into the overall condition of the economy such as, interest rates, credit ratings etc. Similarly, a stock investor uses company’s financial statement to analyse and project earnings, growth, profits, return on equity and other data to find intrinsic value and make projections before buying and selling stocks. If you use CAPM, DCFs model, Dividend discount model etc, you use fundamental analysis. The point is if you use fundamental analysis to select stock, you need to have information about that stock before the market to profit from investment. Ability to sense information before the market and employ them correctly while making investment can be very profitable to investors. But, nobody has outperformed the market except Warren Buffet, according to my knowledge. It has become very difficult to know information before the market at present times due to the advancement of technology. Everybody can have same information at the same time. The use of fundamental analysis, hence, is limited. 

A technical analyst is also known as chartist. The job of the technical analyst is to study past price movements, make projections and invest on the dominant market group. This does not mean that a chartist can absolutely tell what will happen next. No. He/she can only tell you what is likely to happen to price over the period of time based on what has happened in the past. Is it possible to do so? Yes. Traders and investors have been using technical analysis since early 1970s while investing in stocks, currencies, commodity and financial derivatives.

Like any other theory, technical analysis is also based on some principles. There are three basic principles. These principles are very important to comprehend and to think like a chartist.

   1.      Price discounts everything.

   2.      Price movement is not totally random.

   3.      History repeats itself

These principles are the basis of technical analysis. Technical analysts believe that all available information in the market including economic, political and other important quantitative and qualitative information is discounted in current price (first principle). Technicians also believe that price trends. Market can be uptrend, downtrend or flat. The job of the chartist is to find major trends (second principle). Technical analysis also believes that people have ‘memory’ and hence past techniques can be applied in the future (third principle).

Can we use technical analysis to analyse NEPSE stocks? To answer this question, I have used TA approach of analysis to BOK stock. The chart below tells this story.

Above chart tells interesting story about BOK stock and satisfies all the principles of technical analysis which has been discussed above. It reveals that the market was in uptrend during Jul-Aug and reaches 670 (highest price) then takes a dive. The break of the uptrend line at around 640 confirms the end of the bullish pressure and start of the bearish trend. Head & shoulder pattern is seen in around 660-620. Head & shoulder in an uptrend is a reversal pattern. It supports of our claim of bearish trend at the break of 620. The stock takes a dive after the break of that level. The bearish pressure ends momentarily at around the strong support of 540. Some bulls become bolder and buy more. New bulls also joined the party which pushes prices higher to the resistance, 620 levels. Some hogs also joined bulls in 580 but lost confidence after few days of the rally. BOK stock observes a double top after couple of days. Bearish pressure has increased after the double top pattern and the stock is sold heavily after that. The selling stops at the psychological number 500. This ends the downtrend of stock. The stock becomes cheaper at this price and bulls enjoyed buying. Some bulls exit on the resistance at previous around 540 and some joins the rally. Finally, a symmetrical triangle is observed just below the resistance 540. End of the story.

If this is the past story, what can be the future? You might want to know. Don’t you? Sorry, I can’t tell the future. I can only tell you what is likely to happen based on what has happened. In order to make valid projection about future price you need to know few things: principles of future trend direction, market structure, chart patterns, technical indicators and market psychology. Based on these I can tell the likelihood of future trend direction but, to some extent only. We have observed that the stock rallied after it hits 500 and breaks the channel support and again bounced at 50% Fibonacci level. We can also see a symmetrical triangle just under the former support, which is now resistance. So there is greater probability of breaking price above 550 and it did. It went up and up and crossed the highest price 660, as predicted. Isn’t this fantastic? What if the price breaks below? Can it happen? Yes. Anything can happen in the market but technical analysis helps you to find right risk reward ratio for investment. Risk and reward is very important to calculate before analysis and it varies from investors to investors. Technical analysis can help you to set appropriate risk and reward price levels.

As claimed above, does technical analysis works in other stocks too? It is difficult to say. However, I have tested in other stocks and sub-indices of Nepse. The outcome is really fascinating. The reason could be the behaviour of investors is more or less similar all over the world. After all, all the markets, whether be it in US, Europe or Asia; is driven by hope and expectations of greedy bulls and fearful bears. Nevertheless, like other methods, technical analysis is also not without limitations but, using it with fundamentals can make your stock selection process more interesting and objective. Happy investing!