WHATS THIS BLOG ABOUT? The main theme is to discuss the basics of stock investing. But, stock market is not a topic that can be studied independently. Discussing stocks requires reference to many topics on finance, economics, accounting and taxes. So, to support the main theme, these topics will also find a place in this blog. Why stock markets? Because, Stock markets is the only place where you can start creating wealth with a little money. All it requires is a bit of discipline, average intelligence and good temperament. Any other form of investment (like real estate, gold etc..)are not strictly regulated like stocks and they may also require substantial capital investment. The reality however, is just the opposite. People have made more money by investing in assets like real estate and the stock market still remains infamous for destroying common mans wealth. Worldwide, youll find more people who have invested and destroyed their wealth in stock markets. People with bad temperament and emotional attachment generally fail in stock markets. The reason for this is that, profitable investing in stock requires proper financial knowledge and a cool mental attitude. Hence, this blog is for anyone who aspires to get knowledge in stock markets and if you are one among them, were sure this site is going to help you a lot. Choosing Stocks (or any other asset for that matter) to invest from the many choices available is not an easy task to do. Depending on the type and nature of investment you choose, there are varying degrees of risk associated with it. As you will realize from our basic lessons on investing, risk is part and parcel of all type of investments and success of any investment youve made depends on how well you have managed the risk part of it.
Not just stocks
Another reason why youve navigated to this blog is because you realize that money is a precious tool. We work hard for it and we try our best to save as much as possible. However, in these uncertain times, just working hard and saving money may not be enough to maintain a comfortable living. You are supposed to protect and grow your money so that you are safe from financial crisis at any stage of life.
You also need to assess the way you handle your money and take corrective measures if required. The degree of financial discipline you have will decide how much you can save and invest. We hope our articles on financial planning will throw some light on the right path.
Where did we get the idea from?
The motivation to develop this blog came from the realization that there are many web sites which offer theoretical explanations but there arent many in the Indian context. Some web sites are great in giving fee based stock recommendations but fall short when it comes to explaining the theory. Another reason is that over the years, thousands of sure profit stock calls have been made by brokers and analysts. But unfortunately, the reality is that majority of the stock market investors are still in loss. Whether its recession or boom, the brokers primary aim to generate more brokerage so that their broking business is in profits. For that, daily trades should keep ticking. The way to achieve this is to keep on giving Buy and Sell calls.
So, through this blog, we attempt to strike the golden mean. We believe that anyone who takes pain to learn the basics would never run into trouble investing in shares. This site will help you immensely on your way to become a full fledged investor.
Besides my own experience, my writings are also influenced by myriad sources which I have used to study about the subject. Although this site discusses the subject in the Indian context, the principles discussed are universally applicable.
You may also find stock suggestions based on fair valuations. Before committing to buy or sell, investors are advised to conduct their own independent research. Apart from discussing financial basics and stocks, youll also find useful information about alternative investments such as Mutual funds, Gold, and insurance.
What you shouldnt expect.
Easy formulas to make quick bucks. There will not be any daily stock calls or sure profit tips n tricks. Such tactics dont work in stock markets.
The reality is in front of us. Do you think you should take chances with your hard earned money? Stop for a moment and know whats going on ..
Welcome to Sharemarketschool.com Learn whats the secret behind successful investing.
Financial Discipline for all. Millions of people fall prey to financial frauds;millions suffer from financial imbalance despite earning good money;even billioners have committed suicide due to financial problems- The root cause of all this is failure in handling their money in an informed manner. People from all walks of life face this problem of financial indiscipline.In the following articles,we detail the basics one must follow while handling their money in order to stay safe and have peace of mind. Some are concepts, while others are practical tips. The story of Adolf Merckle Principle 1.Finding money ! Principle 2.Time value of money Principle 3. Compounding Principle 4. Interest rates. Principle 5: Cash reserves and idle cash. Principle 6: Never stretch beyond your limits. Principle 7. Dont try Get rich quick schemes. Principle 8. Inflation Principle 9. You are not safe with fixed deposits alone. Principle 10. Have a Monthly budget Principle 11. Utilize credit cards wisely. Principle 12. Lending money to friends and relatives. Principle 13. Signing surety for friends. Principle 14: Multiple streams of income. Principle 15. Do not spend recklessly Principle 16. Avoid financial litigations Principle 17. Pay your taxes. Principle 18. Safeguard your documents. Principle 19. Insurance is a must. Principle 20. Know your net worth Principle 21. Think of retirement when youre young! Principle 22. Diversify your investments. Principle 23. Valuation is the key to right investments. Principle 24. Gold A must in your portfolio Investing Basics Get a firm grip on what investing is all about in this series of investing lessons. The articles in this section will give you solid idea about what investing is all about , where you can invest and the risk involved in investing . What is investing? Why is investing important? Where can you invest? Which investment is best for you? What care should one take while investing? What are the stages in investment process? What is the risk involved in investing? When should you start Investing? What should be the right mindset for investing? What is Financial planning? Investing or gambling? Should you Borrow Money to Invest? Thumb rules to build wealth Lessons in computing returns I Percentages Lessons in computing returns II Simple returns Lessons in computing returns III Compounded returns. Lessons in computing returns IV Returns from shares. Lessons in computing returns V The Rule of 72 Lessons in computing returns VI Rule 114 and Rule 144 Lessons in computing returns VII Break even return Investing vs Trading vs Speculation 5 steps to become a smart investor Shares & Stock Markets In this section, know more about shares, stock markets and market indexes. The term stock market appears in the news every day. What is a share? What is a stock market? Why do we need a stock market? Where does the stock come from to begin with, and why do people want to buy and sell it? What is a market index? What is Sensex? How is index constructed? If you have questions like these, then, the following articles will open your eyes to a whole new world. Some truths about stock markets Stocks-explained Basic charcteristics of shares Should you invest or trade in stocks? Benefits of owning shares Stock markets in india What is a stock index? BSE stock classifications What is Sensex? How is it calculated? What is nifty? How is it calculated? Do stock indices tell the right story? Bulls, Bears and Stags How much money should you invest in stock markets? What drives the stock market ? What are Blue-chip shares? Invest for a long term or short term? Ethical Stock Investing Indirect way to invest in stocks Mutual funds. The Only 2 ways to buy stocks Primary markets & Secondary markets. Stock Market timings. Introduction to Financial Statements Whether you watch analysts on Television or read articles in financial magazines and newspapers, youll see lot of financial jargons being used by them, which makes it difficult and confusing for you to understand what they actually tell. If you already have an understanding about what balance sheet and income statements are, then this tutorial will help you to get a better grasp on the whole subject. If you are totally new to the field, dont worry at all since these lessons are written from the angle of a stock market investor and its meant teach you the important factors that make or break an investment decision. Understanding Annual reports. How to read an Annual report. Introduction to financial statements The components of financial statements The Income statement : Basics The Income statement : Understanding the matching principle. The Income statement: Understanding the components. The Income statement: Profits The income statement : Difference between earnings and revenues The Income statement :Understanding Depreciation The income statement : Revenues an important figure. Balance sheet : what is it? Balance sheet components: Assets Balance sheet components: Liabilities and Equity. Cash flow statement. An introduction. Understanding Cash flow statements More about cash flows. Financial ratios. As mentioned in the first chapter the first step to become a smart investor is to learn the basics. Any investor interested in stock analysis should be able to calculate financial ratios. The basic source of these ratios is the companys profit & loss account and balance sheet that contain all kinds of important information about that company. The ratios really help to bring those details to light and identify the financial strengths and weaknesses of the company. When assessing ratios, it is important that the results are compared with other companies in the same industry and not to be taken in isolation. What may seem like a poor ratio at first glance may well be normal for that industry and, of course, the reverse applies, in that what may seem a good ratio on its own, could be below average for that industry. This session lists out the formulas and relevance of ratios used in stock valuation. Introduction to financial ratios Understanding Earnings Per Share (or EPS) Price to Earnings ratio or P/E ratio More about P/E Measurement of size- market capitalization More about Market-caps. Understanding price to sales ratio Understanding price to book ratio Understanding Dividend pay out & retention Understanding Dividend yield & Earnings yield. Understanding ROE & ROCE. Understanding interest coverage ratio Evaluate debt-Understanding Current and quick ratios Understanding PEG ratio Stock investing strategies There is no one way to pick stocks. Every stock investing strategy is nothing more than an application of a theory a best guess of how to invest. And sometimes two seemingly opposed theories can be successful at the same time. Perhaps just as important as considering theory, is determining how well an investment strategy fits your personal outlook, time frame, risk tolerance and the amount of time you want to devote to investing and picking stocks. To have your own stock investing strategy is very very important. This chapter takes you through the various stock investing strategies followed by investors. Technicals vs Fundamentals. Stock investing strategy-Fundemental investing Stock investing strategy: Technical investing Stock investing strategy- Value investing Stock investing strategy Growth investing Stock investing strategy- GARP Stock investing strategy- Index investing Stock investing strategy-Momentum investing Stock investing strategy-CAN SLIM Stock investing strategy: Contrarian Investing. Technical Analysis I If value analysis was all about fundementals, technical analysis takes a completely different approach. It doesnt care about the value of a company. The only concern in this approach is the price movement and volume. It is important that you learn the language of technical analysis because, many share market analysts combine fundamentals and technicals when they speak. This series of articles will help you to be familiar with technical analysis terms. Read on. Technical Analysis Types of Charts Trendlines Support and Resistance Importance of Volume in Technical Analysis A study of chart patterns Continuing patterns 1 : Flag & Pennant Continuing patterns 2 : Triangles Continuing patterns 3 : Cup with handle Reversal Patterns 1 : Double tops and double bottoms Reversal Patterns 2 : Head and Shoulders Reversal Patterns 3 : The Wedges Reversal Patterns 4 : Rounding Bottom Reversal Patterns 5 : Triple tops and Triple bottoms Summary of Chart Patterns Theory of Price Gaps Technical analysis II The second part of our technical analysis series in which we will look in detail at certain technical indicators and oscillators and about how to use them effectively. There are hundreds of indicators in use today, with new indicators being created every week. Even with the introduction of hundreds of new indicators, only a select few really offer a different perspective and are worthy of attention. Strangely enough, the indicators that usually merit the most attention are those that have been around the longest time and have stood the test of time. Introduction to technical indicators How does a technical indicator work ? Oscillators Types of indicators/Oscillators Understanding Moving average Understanding MACD Understanding Average Directional Index (ADX) Understanding RSI (Relative strength Index) Understanding Stochastic oscillators. Understanding Williams %R Understanding Average True Range. Understanding Bollinger Bands. Before Picking up stocks.. Now that you know about share markets , Earnings , Profits , Book value, market capitalization, profits and dividends, its time to accumulate some more useful tips and use it effectively in picking up a good stock. Can you measure management effectiveness? Using price and volume to find market trends. Bonus shares A positive sign. Using Beta to gauge volatility. Is a stock buyback scheme a good sign? Using Advance / Decline to spot market trends Keep an eye on the factors that cause volatility in stock markets Balancing your investments. Shareholding pattern it tells you a lot. Is it possible to predict Markets accurately? 3 silly mistakes a beginner should avoid. Choosing a Broker and opening Demat Accounts With so many stock brokers around, heres a little guide to find out the right broker for you. What are Demat accounts? What is a trading account? Who is a stock broker? How to choose a Stock broker? The Brokers role in investing. Investment advisors- An introduction. What is a portfolio? Whats portfolio management? How to select a Portfolio Manager? How much should you pay for the right portfolio manager? Investing in Indian stock markets- A guide for NRIs Going Online Understanding the online trading software Online vs. Offline Keep an eye on brokerage costs. Make your debut !! Now you know about stock and stock markets, about technicals and fundamentals, about de-mat accounts. What we have discussed above are only the basics.See for yourself if you have some grip on your trading platform- how to transfer money, how to buy and sell in live market etc.. The following lessons would give you more tips. The real process of investments starts only once you master the techniques of valuation and portfolio management. Theres a long way to go The first step Paper trading. Initial wealth building strategies- 1 Initial wealth building strategies 2. Initial wealth building strategies 3 Buying & Selling shares How to practice buying/selling shares in live market. Dont let emotions take control 4 simple Must follow rules for everyone. Stop loss orders A way to protect your capital Cost Averaging- A strategy you should use carefully. Say no to day trading ! Never attempt short selling 3 basic questions you should answer before investing. Most common stock market mistakes. When to sell your stock Investor protection Message from the Bombay Stock Exchange 10 Mistakes a beginner should avoid More from stock markets. Theres more from the investing world. This section contains articles on many topics thats part of stock markets.. The Diwali effect .. How does news affect stock prices? How is a bonus issue different from a stock split? Dividends vs Bonus Dividends and relevant dates Understanding Rights Issue How does interest rate affect stock markets? How do FI investors affect stock markets? How does IIP data affect stock markets? Pledging of shares -A must check. Important dates for Indian stock investors. Circuit breakers Insider trading What is Rajiv Gandhi equity savings scheme (RGESS)? Valuation of shares Valuation is all about knowing what a stock is actually worth. Knowing the actual worth of a stock is a pre-requisite for making smart investments. By going through these series of simple articles , a beginner should be able to learn the basic concepts and also some practical methods to pick stocks at reasonable prices. Its written in a language that anyone can understand. It helps you to decide whether a recommendation given by your broker is valid or not. Finding shares to invest. Qualities of a good investor Sources to pick stocks for valuation. History Scan An introduction. Eight point checklist for history scan Qualitative data analysis How to gather qualitative information? 5 Investment concepts Concept 1: Intrinsic Value. Concept 2: Book value Concept 3: Margin of Safety Concept 4: Risk premium Concept 5: Cost of equity. Estimating EPS-Growth rate Estimating the P/E Simple Valuation Method- I Simple valuation method- II Value investing common sense. Futures and Options The basics. The world of high finance is all about risk; infact, its all about taking calculated risks. So far all what we discussed was about buying shares with the money you intend to invest-on the spot. Since the whole deal is done with pure cash, Its also called cash segment. But thats one part of stock markets. If you have the heart to take calculated risks, then section is for you .. Introduction to Derivatives. Types of derivatives 1 Forward contract. Types of derivatives 2 Futures contract Types of derivatives 3 Options contract Who plays in this market? Why do derivatives market exist? Futures: Types of contracts Futures: Understanding the basic terms Futures: Understanding Open interest. Futures: Principles of pricing. Futures: Compounding and discounting techniques. Futures: Arbitrage & its meaning. Futures: Risk levels of participants. Futures: Hedging & its importance Futures : Understanding basis risk Futures: Contango and backwardation Futures: End note Options: Kick off Options: Understanding strike price. Options: Moneyness. Options: Premium Options: Option styles Options: Choices of action. Options: Break-even point. Options: Put-Call parity-Part I Options: Put call parity Part II Futures vs. options Option valuation: Introduction Option valuation: Upper bounds and lower bounds Part 1 Option valuation: Upper bounds and lower bounds -Part II Option valuation: Upper and lower bounds -Part III Option valuation Method 1. Option Valuation: Method II (Part 1) Option valuation: Method II (Part 2) Option valuation : Method III Option Greeks Understanding Options delta Understanding options Gamma. The story of Adolf Merckle by J Victor on July 30th, 2010
Adolf Merckle was one of Germanys richest business man. He developed his grandfathers chemical wholesale company into Germanys largest pharmaceutical wholesaler, Phoenix Pharmahandel . He was educated as a lawyer, but spent most of his time investing. He lived in Germany with his wife and four children. In 2006, he was the worlds 44th richest man. Merckles group of companies employed 100,000 workers and had an annual turnover of 30 billion euros (around 39.9 billion U.S. dollars). All this turned upside down after his business empire was plunged into difficulties due to the financial crisis. Merckle hit the headlines in 2008 when he suffered massive losses on investments he had made on movements of the share price in Volkswagen, Europes largest car company. On Jan 06,2009 German news agency DPA reported that Merckle, 74, threw himself under a train at his hometown of Blaubeuren, a small town near southern Germany city of Ulm, and a railway worker found his body by the side of the track. Before his death, he had been negotiating with banks for a bridging loan of 400 million euros (around 547 million U.S. dollars) to save his empire, which includes the pharmaceutical company ratiopharm and drugs maker Phoenix. That figure shows the depth of financial crisis he had. The picture above shows the place where his body was found. What a tragic end to the life of one of the worlds richest man. MERCKLE ISNT ALONE
Heres more - In Jan 2009 , The national suicide preventing hotline in US reports that, calls have soared by as much as 60 per cent over the past year many of the calls were from people who have lost their home, or their job, or who still have a job but cant meet the cost of living. A 45-year-old businessman in Los Angeles murdered five members of his family before turning the gun on himself, saying in a suicide note that he had done so because of his troubling financial situation. Karthik Rajaram, 45, who had made almost 900,000 on the London stock market, shot his wife, three children and mother-in-law in the head before shooting himself at the family home near Los Angeles.He did this after seeing his familys fortune wiped out by the stock market collapse. A 90-year-old Ohio widow shoots herself in the chest as authorities arrive to evict her from the modest house she called home for 38 years. In Massachusetts, a housewife who had hidden her familys mounting financial crisis from her husband sends a note to the mortgage company warning: By the time you foreclose on my house, Ill be dead. Then, Carlene Balderrama, shot herself to death, leaving an insurance policy and the suicide note on a table. WE INDIANS ARENT BEHIND.. Thousands commit suicide unable to bear the pressure and crisis, that mismanaged investments create. Internet and newspapers report about people falling prey to financial frauds like get-rich-quick schemes and money chains, eventually losing every penny they had earned. Did you know that a small state like Kerala spends more than Rs 40 crores a day on lottery tickets alone?According to Tehelka.coms reporter Shantanu Guha Ray , Illegal lottery tickets account for atleast 60 per cent Roughly Rs 7,200 crore of the Rs 13,000 crore gambled every year on lottery tickets in India. All sections of the society are involved in this. I know doctors, HR consultants, engineers, stock market investors, Government officials,housewives and students who regularly put money in lottery tickets. Anyway, lottery tickets ( if youre lucky to get an original one ) at-least gives you a chance to win. There is another section of people who gets involved in money chains where wealth gained by participants entering the scheme earlier, is the wealth actually lost by those coming later. In-spite of hearing about many schemes in which people have lost their wealth, India continues to be a happy hunting ground for such fraudulent operators. The root cause of all this can be brought under one head-Greed for money and financial illiteracy. This is exactly the reason why we will first discuss about the basic principles of money management . People spend lakhs to get a doctors degree or a MBA from the most prestigious of institutes. They spend a lot to pursue their hobbies such as music and salsa. But when it comes to managing their money , they hardly make any effort to learn at-least the basics , forget about gaining specialized knowledge ! The next chapter will take you through the basic principles of money management. These principles are important to everyone out there housewives, businessmen,musicians, students, professionals , priests , social workers.. anyone who deals with money directly or indirectly. No related posts. Principle 1.Finding money ! by J Victor on August 1st, 2010
Thats interesting! This is one topic everyone will read very carefully because it all about finding money! Imagine that you found Rs 1000 between the pages of an old book on the shelf. You kept it some months back and forgot about it. How does it feel? Even if that money was never found, you would have still lived with whats left in your wallet without even bothering where it disappeared. isnt it? This is the principle behind accumulating savings from your income. Set aside your target savings and forget about it as if it were not there and live with the rest. Its not easy as you think,but definitely not impossible. And , its never too late to apply this principle ! To most of us Savings = Income (or salary)- Expenses . However, this formula doesnt work ( as you would have already experienced ) since when money is in your pocket, you get trapped by advertising tricks like discount offers on Clothes or new gadgets which tempts you to spend more. Its difficult to control expenses. As a result, your savings never hits the target. If what we said holds true for you and you seriously want to save a fixed 10% or 20% of your take home salary each month, you need a different approach to savings. We suggest Robert Kiyosakis method from his famous book Rich Dad Poor Dad. What kiyosaki said is very simple. Instead of trying to limit your expenses every month, first deduct an amount which you intend to save and keep it in a separate account so that you live with only whats left. So our formula has to be modified like this : INCOME SAVINGS(INVESTING FUND) = EXPENSES Smart ! isnt it ? This formula forces you to pay yourself first, before the other expenses. That way you know your savings will not get lost in the daily grind of living expenses. The other side of this formula is a forced discipline. You hold your expenses to no more than 90% of your take home pay. You can even automate the process by having 10% (or any amount you want) deducted from your Salary account and transfer it into a separate account or fixed deposit, recurring deposit or other savings instrument . So thats the basic trick to find money! But, thats not all. You can also find money from many other sources. For example, Instead of going for parties and shopping, you can set aside extra payments like bonuses, commissions and so forth into your savings Fund. So try to make it a habit to set aside 10% ( or what ever percentage you would like to set aside) and live with rest. If you do that, you have a great chance to succeed. MORE TIPS TO CONTROL YOUR EXPENSES: SPEND LESS This is one simple method to save more. Sit back and analyse your spending habits and look where you spend more unnecessarily. Once you have identified certain areas of high spending, try to find ways to cut back. Take a decision that youll not spend more than a fixed budget. MAKE A BUDGET A budget is a very important tool to control expenses. Be it individuals or corporates. A budget is nothing but a chart or a statement that shows how much you earn and hence, how much you can spend. PAY OFF YOUR LOANS Loans carry high rates of interest. If you have a lot of EMIs to pay, it naturally reduces your capacity to save more. It also shows that youre living on high levels of debt which is not a right thing to do. If you have loans, first look for ways to pre-pay it as soon as possible. Another common area where you could lose a lot of money is credit cards. Credit cards companies slap huge interest for delayed payments. TRY TO AVOID LATE PAYMENTS Any bills like electricity or telephone or internet or credit card has a deadline within which you are supposed to pay the dues. Unnecessarily delaying such payments results in payment of fines. Such expenditures can be avoided if you can get organized on your bill payments. Make a list of monthly payments and the deadline within which you are supposed to pay. These days banks also allow their customers to automate or link their periodic bills to their savings account or credit card. Credit cards over dues need particular mention here. Credit card companies slap huge interest and fines for delayed payments. THINK BEFORE YOU BUY Do not buy anything on impulse. Before laying your hands on any fancy thing which is up for sale, think if its really needed. SHOP SMART Most of the big brands will be available at throw away prices once theres an off season sale or sales promotion drive. For example if you want to buy an expensive watch, wait for the company to announce some discount offers. All the big brands announce discount offers at least twice a year. KEEP DISTANCE FROM LAVISH FRIENDS High spending lavish friends are may hinder your route to save money. Its natural for you to get tempted by such friends to buy new gadgets every year. They may be nice guys and may not harm you in anyway, but to keep up with them , it may become necessary for you to spend high ( for example latest electronic items or cars , parties, expensive dresss etc ) which other wise ay not be required !
SAVING ENOUGH IS HALF THE JOB DONE If you have saved enough,good. but saving is only half the job done.You have to give your savings the right opportunity to grow. Putting all your funds in fixed deposits or fixed income bonds is not a good idea. Your investments should have the right mix of equities, bonds, gold and fixed deposits.Deciding the right mix of investments is something an investment expert can do. It depends on an individuals age and risk profile.
KNOWIT Finding money is a matter of making it a priority. Pay yourself first and learn to live off with what is left. You will always have money with you. It may be difficult at first. But gradually, you will see your fund growing and that would encourage you to stick to it until you reach your goal of finding enough money. Bonuses and extra pays you get are opportunities to buy the latest iphone or Blackberry but a prudent option would be to create a savings out of it You can save a lot of money if you control your expenses. As time goes by, your small saving will also give you additional money in the form of interest. Finally, youll find that youve done a great job,creating more money than expected. Take our word. Its fool proof !! Principle 2.Time value of money by J Victor on August 1st, 2010
The best money advice anyone can ever give you is the time value of money concept . It is a vital concept in finance. Every financial decision involves the application of this concept directly or indirectly.The calculation of time value involves simple mathematics and its easy to calculate. Since this topic is a very important to everyone, we put it down as principle number two. ENTER-TIME VALUE OF MONEY The principle is Rs 100 today is more valuable than Rs 100 a year from now. The reasons for this is quite simple to understand - First, since the cost of living goes up , your money will buy less goods and services in the future .So, today, money has more value or the purchasing power of your money is more Second, if you have that money today, you can invest and earn returns.When you receive the money at a future date instead of receiving it today, you lose the interest or profit you would have made, had this money been with you now Third, you prefer to have money today since the future is uncertain. EXAMPLE : Letss assume that you are 25 years old. You have Rs.2500 with you now. You can either put it in bank FD or buy yourself a new dress. Now, let me further assume that you opt for buying new dress.The reality is that you are spending far more than that Rs 2500. How? Lets try to calculate the real cost of not investing that money. FV = pmt (1+i)n FV = Future Value Pmt = Payment I = Rate of return you expect to earn N = Number of years
HOW TO SOLVE THE EQUATION?
N = Number of years invested - The money youve spend on a dress is lost forever. That means, that Rs 2500 could have compounded in the bank for atleast 35 years. How did i get that 35 figure? I assumed that youll retire at 60 and since you are 25 now, theres 35 years left. lets substitute 35 for n in the equation. I= Rate of return expected The I in the formula stands for the expected rate of return. Since bank fixed deposits would pay around 8% and stock markets have returned an average of 15 %- 17% , Lets assume you would earn some where in between an average of 10% rate of return. So, well assume I as 10% . PMT is the value of the single amount you want to invest (in this case Rs 2500). Now substituting the figures, our formula would be FV = 2500 (1+.10)35. Enter 1.10 into your calculator (this is the sum of 1+.10). Raise this to the 35th power. The result is 28.1024. Multiply the 28.1024 by the pmt of Rs 2500. The result (Rs 70,256 ) is the true cost of spending the Rs 2500 today (if you adjusted the Rs 70256 for inflation of 6 % , it would probably work out to about Rs 9150 That means your real purchasing power would increase approximately 4 fold). Now, after realizing the actual cost of spending Rs 2500, would you prefer to buy a dress for Rs 2500 today or Rs 9150 in the future. The answer is entirely personal. Once you understand this vital concept, you would realize that all those bits and pieces of money you spend unnecessarily are costing you thousands in future wealth. This is why time value of money is considered as the central concept in finance. MORE EXAMPLES.. Future value of money compounded annually. You deposit Rs 50,000 for 5 years at 5% interest rate compounded annually. What is the future vale? FV= PV ( 1 + i ) N
FV= Rs. 50,000 ( 1+ .05 ) 5
FV= Rs. 50,000 (1.2762815) FV= Rs. 63,815. Future Value of money Compounded Monthly You deposit Rs 50,000 for 5 years at 5% interest rate compounded monthly. What is the future value? (i equals .05 divided by 12, because there are 12 months per year. So 0.05/12=.004166, so i=.004166) FV= PV ( 1 + i ) N
FV= Rs. 50,000 ( 1+ .004166 ) 60
FV= Rs. 50,000 (1.283307) FV= Rs. 64,165. GOING BACKWARDS. Present Value of money Compounded Annually You will receive Rs 50,000 5 years from now. How much money should you get now instead of Rs 50,000 5 years later if the interest rate is 6%? (i=.06) Rs.50,000 = PV ( 1 + .06) 5
Rs.50,000 = PV (1.338) Rs.50,000 / 1.338 = PV Rs. 37,370. Present Value of money Compounded Monthly
You will receive Rs 50,000 5 years from now. How much money should you get now instead of Rs 50,000 5 years later if the interest rate is 6% calculated on monthly compounding basis? Here , (i equals .06 divided by 12, because there are 12 months per year so 0.06/12=.005 so i=.005) FV= PV ( 1 + i ) N
KNOW IT A rupee received today is greater than a rupee received tomorrow because money has time value The time value of money is the compensation for postponement of consumption of money. It is the aggregate of inflation rate, the real rate of return on risk free investment and the risk premium. Time value of money can be different for different people because each has a different desired compensation for postponing the consumption of money. Principle 3. Compounding by J Victor on November 10th, 2010
When asked to name the greatest mathematical discovery, Albert Einstein, one of the most influential and best known scientist and intellectual of all time replied compound interest.
Lets try to understand why he said so with a very simple example: Jerry starts saving when he turned 25 and invests Rs 50,000 every year. He earns a return of 10% every year.At the end of ten years; he has been able to accumulate Rs 8.77 lakh. After that, he dosent invest Rs 50,000 anymore. He leaves that investment there until hes retires at 60. At that time, he would have accumulated around Rs 95 lakhs . Tom, had fun and lived his first few years spending on all kinds of things and did not think of investing regularly. At 35, he starts to invest Rs 50,000 regularly every year until he retires at 60. I.e. for 25 years. But, he would have managed to accumulate only Rs 54.1 lakhs which is around Rs 41 lakhs less in comparison to Jerry. 5 simple points spell out from this story: Even by investing two-and-a-half times more than Jerry,Tom has managed to build a corpus which is 43% less! Why? Because,Jerrys Rs 5 lakhs was allowed to compound for a longer period of time than Toms. As the fund grows, the impact of compounding is greater.Jerry starts at 25, accumulates 50,000 for ten years, stops at 35 and then, his 8.77 lakhs (5 lakhs + Interest) is allowed to compound for 25 years till hes 60. Whereas Tom starts at 35 and invests Rs 50,000 for the next 25 years, accumulates 12.5 lakhs (50,000 x 25) only to get 54.1 lakhs at 60. Now lets assume that Jerry had allowed the fund to compound for only 20 years i.e. Till he turned 55. At 10% return every year, he would have accumulated an amount of around Rs 59 lakhs. By choosing to let his investment run for 5 more years, he accumulates Rs 45 lakh more. Essentially, compounding is the idea that you can make money on the money youve already earned. Compounding is very powerful.As Napoleon hill has said- make your money work hard for you, and you will not have to work so hard for it To take advantage of it, you have to start investing as early as possible.The earlier you start, the better it gets. Easily said ! isnt it? I know it generally doesnt work as i said. Because at 25, most of you havent drawn a plan to invest 50,000 a year. Even if youve done it , somewhere down the way , youve missed to add to your corpus regularly year after year. And , due to some emergency that crept in, you took back some amount from the corpus and dint let your money grow ! So , how can a regular person use it to his/her advantage? Always remember to reinvest interest or dividends received on your investments. Over a period of time, such small amounts will add up to a tidy sum. FREQUENCY FACTOR IN COMPOUNDING The frequency of compounding is a major factor that that influences the compounding effect. The shorter the compounding frequency, the earlier your interest is re-invested and thus you earn more interest and your money grows faster. Heres more examples: Savings of Rs 2500/- per month (Rs.30000 Per year) with 15% return will be worth Rs. 15028707/- (1.5 Crores) after 30 years. Yes, this is not typing error. It will be worth Really 1.5 Crores. Savings of Rs 2500/- per month (Rs.30000 per Year) with 15% return will be worth Rs. 30400370/- (3.04 Crore) after 35 years. COMPARATIVE CHART. Here is a comparative chart for you to understand. Lets assume that you invest Rs 10,000 annually. Your retirement age is 60. Lets also assume that the interest rate you get is 10%. At the age of 60 you will have - 49 lakhs -if you had started investing from age 20. 30 lakhs -if you had started investing from age 25. 18 lakhs if you had started investing from age 30. 11 lakhs if you had started investing from age 35. Just 6 lakhs If you start at 40!! Take note of the impact. Oh! Thats a huge difference! Now that you realized it late, what can you do? You can start now, invest more and reach the target of 49 lakh at age 60. This would mean more hard work and budgeting for you. Let us see how much more you would need. To get 49 lakhs at age 60 Invest 10,000 annually at age 20 Invest 16,500 annually at age 25 Invest 27000 annually at age 30 Invest 45,000 annually- at age 35 Invest 78,000 annually at age 40!! Generally what I find is that most of the Indians start thinking of saving and investing at the age of 30-35. The above calculation is made assuming that the interest rate you get is 10 percent. But the average interest rate of banks is less than that. I hope the picture is now clear for you. The more you delay, the more you need to invest.
Hope you have understood the concept of compounding and how it impacts your savings. Thats principle 3 for you. Principle 4. Interest rates. by J Victor on November 11th, 2010
INTEREST Interest, usually expressed in terms of a percentage, is the additional amount you pay for using borrowed money or the return you get when you invest it with an institution like a bank.Its also the compensation you can demand if someone delays a payment thats due to you. If you think clearly, the two concepts we discussed earlier viz, time value of money and compounding were based on the concept of interest rates.In this post we are discussing certain practical scenarios where interest rates can baffle you. Its discussed under two heads 1. Interest payments 2. Interest incomes. INTEREST ON LOANS Interest rates are always tricky. In most of the cases, interest rates advertised by the banks are not the actual rate of interest you pay. Its something more than that. Trap 1. When you apply for a loan, there are a lot of financial charges you need to consider before deciding whether to avail it or not. For example you are offered a loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMIs payable in advance. Effectively, you are getting only Rs 164,000 in hand. But since the interest rate is calculated as if the entire 2 lakhs is given to you, the rate of interest you pay is actually very high. Is that all? No. The bank will also deduct a processing fee of 1 % of the total amount ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000. Trap 2. You are offered the same loan for reducing balance interest. You feel light thinking of the fact that interest is charged only on the balance outstanding. But look closer reducing balance can be on monthly basis, half yearly basis or on Annual basis. If its on annual basis your interest is calculated on the amount outstanding at the beginning of the year. So, you keep paying interest on a higher amount even though your loan is decreasing every month. This pushes up the effective rate of interest you pay.So always confirm whether the reducing balance is on annual basis or half yearly basis. Trap3. Higher loan pre-closure charges. The bank would like you to pay your EMIs regularly. If you do that, the bank likes you so much that on the basis of that regular loan track, they will sanction a second loan if you want. But if you try to close off your loan liability before the stipulated loan period the bank will charge an additional amount of 3% to 4% on the outstanding principal. They dont want their customers to be Too regular. strange isnt it?. Thats the way bank deals with its customers. If you try to be too good , youll be fined This preclosure charge you pay effectively raises the cost of your loan. The solution- The best way to deal with these traps is to stop comparing the interest rates and instead, compare the EMIs and compute the total amount going out of your pocket including processing fee and pre-closure charges. This will give you the right picture of which loan is actually right for you. INTEREST INCOME The principle to be applied is quite simple The earlier you get it, the better it is. This principle will help you to compare different offers. For example A bank offers 8% P.a interest on FD , payable annually. NSC also offers 8% P.a but, payable half yearly. You get another offer on FD which pays interest at 8% p.a payable monthly. Which is better? The one you get on monthly basis, of course!. Why? Because, the banks effective rate is 8% , the NSCs effective rate is 8.16% and the third option of FD gives you an effective annual interest rate of 8.30% ! How? Lets calculate with an example Lets assume that you have 2 lakhs with you. The first bank would give you 8% annually so, you receive an interest income of Rs.16,000 at the end of one year. Suppose you depoited the same with NSCThey would give you 8% -half yearly. So, at the end of 6 months you get Rs 8,000 which can be again invested for 8% interest for 6 months whch gives you an additional interest of Rs. 340. So, the total interest you receive is now Rs 16,340. effective rate 8.16% Similarly , when you work out 8% interest received on a monthly basis the effective interest rate would workout to 8.30% Principle 5: Cash reserves and idle cash. by J Victor on November 12th, 2010
Cash reserves are money kept aside as an emergency fund. We are discussing the need to keep cash reserves as our fifth principle because, this is one important idea which most of us neglect. When you set aside some money from your earnings to meet unexpected expenses, there are four advantages that automatically comes with it: 1. Financial safety. 2. It allows you to take advantage of a surprise financial opportunity 3. It creates a compulsory saving habit. 4. Since funds are kept in liquid cash or gold, it earns interest or appreciates in value. We recommend to create an emergency fund that equals to 4 or 5 months of living expenses; however, you do not need to set aside this total amount in cash alone. It can be in short term fixed deposit or Gold etc.. HOW MUCH RESERVE? That depends from person to person. There are a number of factors that influences your decision on the quantum of emergency fund that needs to be created. Factors such as age, occupation, health condition, monthly EMIs, number of members in the family, other sources of income needs to be considered on a one to one basis. 1. AGE: Depending upon how old you are, the emergency fund required keeps changing. As you grow older, the possibility of medical emergencies is also high. Hence, if your age is on the higher side (lets say youre 45 years old) you also need an emergency fund thats higher than some one who is just turning 30. 2. OCCUPATION: The style of occupation/business you do is another factor that influences emergency fund decisions. If you are doing a seasonal business or if your job has an uncertain future, you need a higher emergency fund. People living on commission based income would also require a high emergency fund. 3. HEALTH CONDITION: More reserve funds may be required for a person whose health condition is questionable. The amount of insurance cover he has should also be considered while assessing his future requirement. Higher the insurance, lesser the need for reserve funds on these grounds. Again, if you have your parents or grand parents living with you, you might need to plan accordingly. 4. MONTHLY EMIs. The volume of debt you have needs to be analysed to get an idea about how much EMIs youll have to pay a month. Typically, while creating reserve funds, an amount equal to 6 months EMIs should be kept aside so that in case of emergency, you dont default in your loan payments. A clear track record of loan re-payments is absolutely necessary for your future financial needs. 5. NUMBER OF MEMBERS IN FAMILY. If the numbers of members you need to support are more (say 7 members) naturally you need a higher reserve than what would be required if you have only say, 3 members in your family. 6. OTHER SOURCES OF INCOME You can count on your other sources of income, if any, while creating a reserve fund. One time or casual income or credit card limits should not be considered in this group. However, you can count on the income of your spouse or other family members staying with you in case of emergency. 7. OTHER POSSIBLE EXPENSES. You may also want to consider other expenses like possible higher education fees for your child who is about to enter college or a possible repair for your house. It all depends from person to person. HOW TO KEEP RESERVE FUNDS? Hundred percent of your reserve funds need not be kept in liquid cash. A portion of it can be kept in short term fixed deposits or debt funds and a certain portion in gold or easily marketable securities. Any cash lying idle over and above your emergency fund results in a lost investment opportunity. You are not making your money work efficiently for you. THUMB RULE The thumb rule is You should have enough reserves to meet all the expenses for 4 or 5 months plus some extra to meet unforeseen expenditure like medical expenses.
HOW TO SPOT IDLE FUNDS? First estimate how much emergency fund youll require. (typically 3-6 months expenses) Now see how much you have in your bank account plus cash in hand. Deduct 3 or 6 months emergency fund. The balance is your idle fund. This fund should be invested immediately. You can take up a systematic investment plan so that an amount gets invested automatically every month; or you can open an online trading account and invest in stocks or mutual funds at your convenience ; you can opt to open FD linked savings account so that any balance above a certain limit automatically earns interest at a higher rate and so on.. Principle 6: Never stretch beyond your limits. by J Victor on November 13th, 2010
Money will come and go; after all, you just have a life to live why not live it to the fullest? Sounds perfect and positive, isnt it? Unfortunately, if you are living your life like that, not everything is positive and perfect. You will realize the perils of reckless spending when you face a financial emergency. I have done it in my initial investing life reckless spending but soon realized that you cannot discount uncertainties in life. A sudden drop in my monthly cash flows turned my life into a nightmare. So, when i write my sixth principle, I have my own experiences to back it up! The principle is not very hard to follow never take money from your savings or borrow temporarily from your friends pocket to buy a little more luxury. Be it a slightly bigger house that caught your wifes imagination or the latest electronic gadgets. WHERE IS THE PROBLEM? The lifestyle you want to maintain depends on three factors: The circumstances in which you were born and bought up The kind of friends you have The place or community where you live. Have you asked your parents about how they started their life? They dint have a big car or latest electronic gadgets. They probably didnt live in the big apartment or villa theyre living right now. They built everything brick by brick. It would have taken a lot of time, effort and disciplined life to get to where they are now. Thats exactly the way you should also start off. If you try to achieve all the lifes goodies in very short time, theres every possibility that youll borrow a lot of money assuming that youve the ability to re-pay everything in 5 or 10 years and chances are that youll get into debt trap should there be an unexpected fall in your monthly income. Another problem amoung youngsters is that spending habits are greatly influenced by their friends and colleagues. Bank balance doesnt matter, the car or home doesnt matter what matters is the answer yes to this question- Are you better off than your neighbor , friend , relative or colleague? If the answer is yes, you are confident, you feel happy. Or else you stretch beyond your limits to maintain yourself the standard of living that your friend has! You will over borrow, over spend or do something to satisfy your ego. This category of people falls into the trap of personal loan providers. Personal loans are easy to get. There is less documentation and there are no restrictions on how you use the money. Since money comes in quickly with minimum documentation, you wont mind the higher rate of interest. Another reason for reckless spending is that these days, a lot of technologically advanced gadgets and appliances are introduced into the market that drives everyone crazy. Financial schemes are introduced by institutions which would seem like a very simple deal. These schemes are advertised in such a way as to lure customers. Such facilities tempt us to spend more. When you buy into such schemes, what you are actually doing is getting into the finance trap. I am sure 99% of people reading this would have done this in some form or other. Thats principle 6 for you. Its always wise to stay within your limits. Principle 7. Dont try Get rich quick schemes. by J Victor on November 14th, 2010
Let wealth come in by comely thrift And not by any foolish shift. How about getting some money quickly? I have an offer- All you have to do is to join this site for a small fee of 1000 and then keep introducing others to it. For every person that joins by giving 1000 through your reference, I will pay 250 to you. Give me 1000 subscriptions and take home 25000!! Sounds good? The truth is that such schemes dont work. If any of you were attracted to my scheme, definitely youre lazy and have greed for money. Think about it Any scheme that offers a higher rate of return than normal returns given by bonds or debt funds should be carefully investigated. Why should someone pass you the trick to make big money? Or how can someone create a 500% or 1000% return in a year? If he really knew the trick, dont you think that he would have worked for himself, make a lot of money and try to be with the likes of Mr. Bill gates and co? Our 7 th principle is simple and straight- Get rich quick schemes dont work. There is no need to try such a scheme. Such schemes operating around the world are illegal. If youre pressured by someone close (like your relative or friend), politely reply to them that it is not possible to join and what they are trying to spread is a fraud scheme. All scams that have happened in the past are known to have spread through the link of near and dear ones. Such schemes are a loss for the country. They distract people from doing productive work. Some countries have legally banned such schemes. Unfortunately, there is no legal provision in India to curb such schemes. WHY DO WE GET ATTRACTED TO SUCH SCHEMES? Apart from personal pressures we said above, here are three simple reasons: The guy who introduced the scheme to you has already played with your emotions and has got the best out of your greed for money. He has convinced you about the genuineness of the scheme by showing some certificates or bank accounts. Youre hooked to it. It costs very little to start, hence youll take the risk. You can join the race with a subscription and then it works through word of mouth. So, you think there nothing much to lose. As more and more people join on your behalf, you get rewarded, if you dont get people to join, youll let go that small amount. These schemes are marketed aggressively and its generally hard for an amateur to crack their arguments in favor of the schemes. THIS IS HOW IT WORKS.. Typically- a well dressed guy with all the latest gadgets appears in front of you and would introduce the scheme. He will also show you proofs of money pouring into his bank account with little effort. He will pretend as if he has made a smart choice by joining the scheme early. The investment scheme typically would be to buy some products or tour packages for a small fee. Then, youre supposed to pass on this message and bring in more people. As more and more people join on your behalf, you become a team leader and starts getting a commission based on the number of people that has joined the scheme. The moment the company doesnt get new recruits or agents, the office of the company disappears. The promoters abscond with the huge amount of money they compiled through subscriptions and the money of a wide group of people who joined last is lost. EASY MONEY SCHEMES AROUND THE WORLD. How it started These types of investment schemes are called ponzi schemes. The name is derived from the name of Charles K Ponzi, who masterminded the first ever fraudulent investment scheme. He claimed that he could make 400% returns from arbitrage between Italy and US markets by investing in postal reply coupons. Needless to say, the scheme was a fraud one and people lost millions of dollars. Read the detailed list of ponzi schemes from around the world at wikipedia page here. HOW TO SPOT A GET-RICH-QUICK SCHEME. Such schemes offer to make you rich in a matter of months without any hard work! In most of the cases, all these investors have to do is to bring in more and more investors. Minimum effort , maximum results! In all probability the corporate office of the company will be in a distant place from your country. They will show you photographs of the overseas office and also the official website and phone numbers. They will pressurize you to join quickly so that you will be on top of the many others who will be joining the scheme soon. That way, you stand to benefit. If you are still not convinced, someone may actually appear in front of you who would claim that he was working with a bank or some other organization but now, after joining the scheme , has left his job- thanks to the financial security and financial independence the scheme has given. All the meetings of the company will be hosted in big venues with lavish dinner and celebrations. Most of these schemes will be advertised as a risk free investments, and some sort of personal guarantee from the promoters would be given. Sometimes the whole game starts with a simple sms to your phone declaring that you have won millions in lucky draws conducted somewhere (?!!) by somebody (?!!) and in order to claim your money, all you have to do is to put some money as processing fee to a bank account. On searching the net, we have found countless illegal get rich schemes operating in india and abroad. The Reserve bank of India has published long list of companies who are engaged in ponzi schemes in India. The point is, Its your hard earned money and you just cannot put it into some illegal business expecting big profits. The onus of putting your money in right investments is on you. If you cannot understand this simple fact, nobody can help you. Nobody can double your money in few months. Theres No easy money!! As the saying goes If there is something too good to be true, it probably is . Principle 8. Inflation by J Victor on November 15th, 2010
Inflation in laymans terms is when you pay 15$ for a 10$ haircut you used to get for 5 $ when you had hair Sam Ewing WHAT IS INFLATION? In simple terms inflation is nothing but rise in the general level of prices of goods and services.Or in other words , the value of your currency has gone down, and hence, you need more of it to buy the same quantity of goods. HOW DOES IT AFFECT YOU ? Lets try to understand with an example- THE BIRTHDAY BASH Your wife has just delivered a sweet baby girl. One year from now, you are supposed to celebrate her first birthday. To make a budget, you enquire at the event manager about the costs and they say it would cost one lakh right now but they cannot guarantee the same price 1 year down the lane, because the cost of materials can go up. So you immediately put this money in a deposit that would give you 8% return by the year end. At the end of year 1, you have 108,000 with you. (Lets ignore tax). Now, its one year and you have to celebrate your babys birthday. Lets assume that the inflation during the year was at 10%. That means the general price levels of all products have risen by 10% and hence your event manager is going to bill you 110,000 for a party instead of 100,000 earlier. So to arrange a party now, you have to incur an additional expense of 2,000 from your pocket. Why? Because, the money you have, has lost its value to the extent of 2,000. And, you could manage to make a return of only 8,000. If the general price levels moves up at this rate, it would cost you more than 250,000 to host your daughters 10 th birthday! Had you managed your money to get a return of 10%, you wouldnt have to spend that additional 2000 from your pocket. Thats inflation for you try to understand this vital principle in order to manage your money. So, if you are getting 8% on a 10 lakh Fixed Deposit and if the inflation rate is 8%, do you think you have gained a penny? - No. Inflation eats away the value of your money. The only way then, is to target a return on investments that would beat the rate of inflation. REAL RETURNS Many people while measuring the returns on their investment, forget to consider the effect of inflation. But thats not the correct way to measure returns. Returns calculated without considering the effect of inflation is called nominal return. The return calculated after considering the effect of inflation is known as real return. In addition, if you account for tax implications the real return would be even lower. So next time you have money to invest, keep in mind this Real return concept. Real return is what you actually earn from investments -and not the advertised rate of return. FORMULA FOR REAL RETURNS To calculate real returns at any point of time use the following formula:
Taking figures from the above example the rate of return (8%) and i is the inflation rate (10%) 1.08 / 1.10 is 0.9818 0.9818 1 is -0.01818 -0.01818 * 100 is -1.8181 The effective or real return earned on this investment is -1.8181% ! So even though your investment has made a return of 8% (nominal return). After considering the inflation rate (10%), the real return is a negative 1.81. Which means actually on maturity you did not make any money, infact your money has lost value due to inflation. The Money Illusion Its very important that you learn the effects of inflation. For example Lets assume that youve got an increment of 8% in your salary. Your feel happy since, in real terms , your salary has increased by 8%. But thats not the real picture. You have to find out whats the inflation rate and deduct that from the 8% increment you got. Now, lets assume that inflation is at 8%. That means, although youve got 108 in place of 100 earlier, the cost of goods that costs 100 earlier has also gone up to 108! Effectively, youve earned nothing! Thats money illusion. If you dont account for inflation, youll be under the illusion that youre earning a lot. The effect of money illusion will be more when inflation is unanticipated. HOW DOES INFLATION AFFECT INVESTMENTS? FIXED INCOME INVESTMENTS Since fixed income investments are locked into a particular interest rate, your earnings may not keep up should the inflation rate accelerate. The principal you have invested also deteriorates in value if inflation rises steadily over a period of time. For example -Lets assume that your tax rate is 20%. If you invest 2,50,000 that gives you 10% return, you will get 25,000 as return from which you will have to pay 20% tax . Amount Invested = 2,50,000 Maturity Amount = 2,75,000 Interest Earned = 25,000 Tax on Interest @ 20% = 5,000 Net Amount in Hand = 2,70,000 Interest Earned = (20,000/2,50,000) * 100 = 8% If the inflation prevailing is 7%, then Real rate of return/Inflation adjusted return = 8% 7%= 1% This implies value of money at your hand has increased only by 1% and not by 10% or 8% although you were under the impression that you were earning 10% on your investments. STOCK MARKET INVESTMENTS. Inflation and stock markets are negatively co-related. When inflation is high, it hinders economic growth of the country and such a scenario would definitely affect stock prices negatively.So as inflation increases, stocks tend to perform poorly. GOLD AND SILVER INVESTMENTS. The reverse would happen to gold and silver. Since stocks are not attractive, investors would naturally resort to gold and silver which are safe havens. Gold and silver go up during inflation. The reason is that, as inflation begins to creep up, the purchasing power of paper currency loses it value. Once paper currency has been invested into this precious metal, it will not lose its value as a result of inflation. Investments in gold protects you from inflation. We will show you how with an example- Lets assume that you have Rs 1000 in currency. Inflation is at 8 % and hence at the end of the year, your 1000 is worth only 920. Instead, lets assume that you bought gold. That move will protect your currency from losing value. How? When inflation goes up, the demand for safer havens such as gold will also increase (at least at the rate of inflation). Hence if inflation rate is 8%, the gold prices will also move up by 8% approximately. In such a scenario, your 1000 invested in gold is now worth 1080 whereas if the money were held in cash, it would have lost its value to 920. So when you invest in gold , you maintain the purchasing power at the same level . Heavy investments in gold can be considered as a warning sign that inflation is coming. Thats principle number 8! Inflation is a concept you cannot miss. The rate of inflation and the taxes you pay on returns have to be accounted for while measuring returns. Principle 9. You are not safe with fixed deposits alone. by J Victor on November 15th, 2010
Principle 9 is in fact, a continuation of our earlier post on inflation. The reason why we are posting it separately is because there is a certain section of people who think that they are financially safe if they have a regular income from bank deposits or debt instruments. This way of Generating income is so popular. World over, people think that if they have a considerable amount in fixed deposits or debt instruments, they are safe. Thats not the real picture. You earn money only if your investment can generate a post tax income which is greater than the average combined rate of inflation and tax prevailing in the country you are living. We will explain that: Lets take the example of Mr. A who lives in India: He invests 200,000 in Fixed deposits for 8% interest and gets 16,000 as interest at the end of year 1. But effectively, he would get an amount lesser than 16,000. Thats because of two factors: 1) Income Tax. 2) Inflation. Assuming that the bank deducts 10% as tax , Mr. A will get only 14,400.00 as interest. Now, the second factor that reduces your income is Inflation.The average inflation rate in India is around 8%. That means, your 214,400 is further reduced by 8% in value at the end of year 1. So your 214,400 gets effectively reduced to 198,518 By depositing your money for 8% interest, you dint actually earn anything. in fact you lost 1482 from your capital Hence if you have all your money in debt instruments like fixed deposits, youre not safe. You principal amount would keep reducing in value over time. So, the point here is that, you have to look for investment opportunities where you can generate an income that is higher than the combined rate of tax and inflation. How to check: Step 1. Multiply the money invest with the rate of interest offered.
Step 2. From the interest amount received in step 1, deduct the applicable tax.
Step 3. Find out the average rate of inflation prevailing in your country ( search in Google, its just a click away)
Step 4. Apply the rate to the amount received after step 2 and find the present value. ( how to find present value has been already explained in our earlier posts) Yes ! Its time to think smart. You should look at instruments that can at least cover you against inflation and tax. Principle 10. Have a Monthly budget by J Victor on November 15th, 2010
You plan to fail, when you fail to plan . WHAT IS A BUDGET? Budget is a careful allocation of your monthly income. Based on a study of your income, present expenses and future plans, a set of spending rules are identified. You spend your money only according to the pre-decided rules. The idea is to control expenses and make a surplus so that you financial goals are achieved. HOW TO MAKE A BUDGET? Budget is vital in keeping your finance in order. Before you begin to create your budget, it is important to list out all your sources of income and expenses separately. Heres a step by step general guideline to make a good budget. Step 1. Write down your sources of income The first step is to write down all your sources of income. Apart from salary or business income do have any other sources like rent or agricultural income? Have fixed deposits? Remember to include all such sources of income. Step 2. Set aside a sum for income tax. You cannot start dividing your money straight away. The first and foremost thing to understand is that whatever income you earn, you are liable to pay tax to the government. Thats mandatory everywhere. Some of you may get income only after deduction tax. Depending upon your expected tax liability, you are supposed to set aside an amount to meet the tax commitments. Tip: if you can consult a tax practitioner, he will tell you the exact amount of tax! Step 3. Make a list of fixed commitments. Once you have computed your total income after tax, the next step is to find out your monthly fixed commitments. Fixed commitments include your monthly rent, school fees for children, EMIs, SIPs etc.. These are expenses that stay the same every month and you cannot bring it down by adopting any cost cutting measures. First deduct the total of fixed commitments from the amount you computed in step 2. Now, whats the balance left? For example, you have a monthly income of 50,000 from which you have to pay a tax of 10% which is 5,000. you find that your monthly fixed commitments works out to 28,000. So, 17,000 (45,000 28,000) is the balance left with you. This is the amount which is absolutely in your control. You can save it or spend it! Step 4. Variable commitments Step 2 minus step 3 gives you a clear idea about how much you can spend on variable expenses. Variable expenses are those on which you have absolute control. Expenses on Items such as entertainment, eating out, gifts etc are variable. It depends on how effectively you control it. It is in this category of expenses that you make all the adjustments. For example, if you have decided to subscribe for one more Systematic investment plan, you need to cut down and find money from your variable expenses part. HOW TO TRACK YOUR BUDGET. Total your monthly income and monthly fixed expense and monthly variable expenses and see if your income is more than your expenses. If yes, youre doing well. The surplus can be used to pre-pay your loan commitments as soon as possible. However, If your expenses are higher than income, thats an alert sign. In this case, youll have to control your expenses. If you have some surplus cash left, try to pre-close your loans to the maximum extent possible so that your fixed expenses part can be reduced to that extent. That step may be a bit difficult to do since it involves cash outflow. But, you can definitely control your variable expenses part. A budget once drawn will not remain fixed for ever. It may have to be re-drawn when your income or fixed expenses part has a change in it. Good financial budget planning should include provision for emergency funds. Its better to include the emergency fund in your fixed expenses. Because it is very important to have some money in the bank in case you need it for something unexpected such as a medical treatment. Just in case you had to spend a little more than your budget this month, make sure you cut back your expenses in the following month and compensate for the overspending. Instead of writing budgets on paper, it will be more convenient to use a spreadsheet like excel where you can easily add or subtract or mike any corrections. Corrections are possible without much fuss and you can also easily plot a variety of different graphs to clearly see things visually. CONCLUSION. Whats said above are very simple steps. We all do budgeting to a certain extend every month through metal calculations, although unsystematically. If you are not budgeting you will never know how your income vaporized. Thats principle number 10 for you !! Principle 11. Utilize credit cards wisely. by J Victor on November 16th, 2010
CREDIT CARDS Technically speaking, a credit card is an unsecured loan a very dangerous instrument if used recklessly. It is issued based on your income. The concept behind it is very simple you can purchase goods or dine in a restaurant without making immediate payment. The bank would make the payment for you and will allow a credit period of 30 or 40 days to clear it back to the bank. As long as you utilize this credit facility very cleverly, theres no problem. In fact, its like getting a temporary loan without any interest. If you can pay the amount due on it within the credit period mentioned, its free money. But thats where the benefit ends. THEN, WHATS THE TRAP? The first trap is that it will tempt you to shop more. Most of the credit card bills will also contain a list of offers thats too tempting. For example my latest credit card statement has a shopping broacher attached to it in which I am offered an interest fee facility to buy a smart phone at a particular rate mentioned in the broacher. I can pay back in six equal installments. Its natural for youngsters to get tempted on such offers. The second trap is that the statement will exhibit an amount called minimum due which if paid at the right time, will keep you out from the list of credit card defaulters. Hence, after overspending, just in case you could not pay back the amount, you can still survive by paying just the minimum due which would be lesser than 10% of the amount outstanding! For example if your dues are 35,000 your minimum due would be around 1,750 only! You may get an impression that this amount consists of interest and some portion of principal but, actually, this amount is fully charges as interest. Thats effectively 60% interest per annum. Thats why its such a killer. Trap three- it gives you the facility to withdraw cash from any ATM counter. The moment you do that, youre billed 1.5% or 2% of the amount withdrawn as processing fee and the interest is charged on the amount withdrawn plus the processing fee. For example if you withdraw 10,000 you will have to pay back 10,150 with interest on it till repayment. There is no interest free credit period for cash withdrawals. Its only for purchases. Trap four- You will be tempted to do a lot of online shopping. There are hundreds and thousands of online shopping websites now. Online purchases require your credit card number to be disclosed. If such datas are not transmitted through a secured system, it may reach fraudsters who will mis-utilize your credit facilities. Finally youll end up responsible for the dues they make. Online purchases an be made only through trusted websites which has visa approval. Trap five If you have overdues on credit cards, that is, if you fail to make at least the minimum due on the card, that going to cost you even higher. Once a credit default is made, you will be slapped a fine of 250 or 500 plus a higher rate of interest. From there on your liability will skyrocket if not cleared immediately. Credit cards are like boomerangs. If you know to handle it, it will give you results. If used recklessly, it might just come back and hit your face. The thumb rule is simple First know when the credit cycle starts. ( say 1 st of every month) Then know your credit period (say 30 days). Utilize those thirty days interest free. That is, do all the shopping in the first week itself. If you purchase something on 25 th , all you have is 5 more days left Always keep track of your credit limit and make sure you never cross that limit. Once you cross the limit, you free credit period ends there and the money becomes payable immediately. Principle 12. Lending money to friends and relatives. by J Victor on November 18th, 2010
Be careful about lending friend money. It may damage his memory. ~ unknown. Its difficult to watch your friends or relatives struggling financially. If youre well off and good at heart, you might want to reach out to them as well. Theres nothing wrong to lend a helping hand. Infact, we are supposed to help them in whatever way you can. Thats helping quite different from lending. When you help them with an amount, you dont expect it back. It could be a small amount. Its ok if you dont get it back. But lending is different. You lend money when your friend or relative officially asks for some money, stating a purpose and with a repayment term loosely said I will return it as soon as possible. What happens in such situations is that you will be held up in a dilemma- It would be difficult to say no given the depth of relationship between you guys It would be difficult to ask for a written agreement. If you are good in finance, you may also have a calculation of the interest that might be lost at the back of your mind Since the repayment terms says as soon as possible and not a definite date, practically it could prolong for an indefinite time and you may feel very awkward to remind him about your money. If you dont help him, you might just lose that relation also. Its actually a trap. If you have lend money like that, you have only two solutions left Politely ask back the money indirectly. Write it off ! HERES SOME TIPS Remember, it is your money. Whether you decide to lend the money is up to you. Here are some tips that will help you take a decision to lend or not. Ask your friend why he needs so much of money? If he cannot give a genuine answer immediately, hes hiding something fro you. Watch what he is answering! if he needs fund for a medical emergency, consider helping him. But if he needs funds to pay off another person from whom he has borrowed money or to settle some financial deals which you find is not proper, you need to think twice. Think about how he has dealt with money in the past. Is he a reckless spender? Is he constantly in a debt trap? What has he done with his salary so far? Does he party all night and lives a lavish life ? If you are not comfortable with his life style and attitude, stay off. Politely say that you cant lend him money. If he asks for a huge sum which you cannot afford, say no immediately. Also if hes asking funds because he knows that youve got a loan from elese where, do not lend. Remind him about the money, just before the due date. Politely say that youll need the funds very soon. I case he couldnt make the payment on that day, ask him when you can expect the payment. Let him say a date. Also let him explain the reasons why he couldnt give you the payment as promised. Based on what he has explained, set another date and time and tell him that he cannot miss the date this time. Always keep your cool and never let show any frustration. Keep a broad smile on your face while asking back your money. There should not be any mistake from your part. Visit his home. Indirectly tell his parents / siblings / spouse that theres some money deal between you and him. That would automatically create pressure on him. If you really want your money back, keep pressuring indirectly but at the same time never utter a rough word or show a frustrated expression. Once he gives your money back, its possible that you guys may not be friends any more. Carefully think if this situation is going to have any negative impact at work place or between other friends. CONCLUSION. Experts warn that loans given to friends or relatives ca lead to strained relationships. With the following words, we sum up our advice about lending money to your friends / relatives: If you can afford to lose a friend, go after your money ; if you can afford to lose your money , lend as much as you can ; if you cannot lose both, try to strike the golden mean ! Principle 13. Signing surety for friends. by J Victor on November 19th, 2010
This is even more dangerous than what we discussed in principle 11 Lending money to friends. On the face of it, you might think its ok to stand as a personal guarantor. WHO IS A SURETY? When you stand surety for someone, you are promising the lender that in case of a default from the borrower, you will take up the responsibility to pay off his debts. Sureties are also known by other names such as co-applicants co-signer co-borrower guarantor etc. What ever be the name, the effect is the same. Whether to sign a surety or not is not a simple decision to take. Because once you sign it You completely become responsible for your friends debt. Your credit records are immediately updated with this information. In case your friend defaults, you will also be liable for other expenses like legal expenses, recovery expenses, court fees etc.. Your name will be added to the list of liability holders for credit score purposes. Hence you credit score will be low and when you need a loan for your purpose, it might be difficult to get one since the bank will count the first loan as your liability. WHY DO WE END UP SIGNING CO-GUARANTOR AGREEMENT? The act of signing a surety is taken very casually by youngsters without thinking about the consequences. They think that its just a signature help for a friend. It could be your dearest friend whod be asking for this help and it would be difficult for you to say no. You might have previously made him guarantor for your loan. Hence, now its time to reciprocate. May be your friends are taking advantage of your friendly character. The only two questions that needs to be answered before signing a surety are - Do you know the borrower very well? Can he /she be trusted? do you know their financial background if the answer is yes and if they are from financially sound background, go to the second question or else stop here. Can you pay off the loan In case the borrower defaults in his payments? If the answer is yes go ahead. Or else stay away. CONCLUSION Thats our 12th principle Try your best to avoid signing sureties. If its your family members (your brother or sister) consider taking the risk. If its for your friends and cousins think twice. If its for business partners consult a financial expert like a chartered accountant. And , If its for your boyfriend or girlfriend or girlfriends best friend well, you are inviting trouble!! Principle 14: Multiple streams of income. by J Victor on November 30th, 2010
WHY IS IT NECESSARY? No job is hundred percent secured these days. A lay off or cut down in employee strength can be expect anytime. Hence, if you rely on one income source alone, what would you do if there is a temporary stoppage of work? When you have different sources to earn money at the same time, you have multiple sources if income. By doing that you are making your financial future more secure. We need multiple sources of income because, if you look around youll see that the cost of living keeps increasing every year. Prices the grocery stores, fuel costs, cost of medical treatments, everything is becoming costly and hence, you have to think of adding new ways to earn money. Should one source dry, the other one will save you. But not all of us need to think on these lines. People who belong to high income class need not think seriously about having a second source of income. So, basically, whether you need to try a different source of income depends on your financial position. WHAT COULD BE THAT SECOND SOURCE OF INCOME? Anything! You can start a small business or open a shop. It depends on what type of skills you have. For example If you have excellent command over language, why not try content writing? That something you can do from the comfort of your home. How about starting a blog and share some ideas? Know to play a musical instrument? Why not start a music class at home? HOW TO GET STARTED First, look at where the opportunities are. The opportunities are going to be different for everyone, depending on your skills, network of friends, business connections and most importantly, what you find interesting to do. For example, if you can cook well, you have the following options- Write a book Open a coffee shop Take classes Do television shows Write about recipes in magazines Compete in shows like master chef Open up a large catering unit Arrange small birthday parties Open a web site and sell recipes Write a blog on food and nutrition.. Specialize on one item like cakes or oil less cooking. Make a collection of traditional recipes country wise or culture wise. Sell home made sweets. Bid for contracts to run eating joints in big malls Be a food and nutrition consultant.. .. So, basically you have to sit and think ways to build a source of income. The options are many. Its for each one of you to decide. Principle 15. Do not spend recklessly by J Victor on November 30th, 2010
MIKE TYSON. Tyson, the legendary boxer, is believed to have amassed a wealth that exceeds 400 million dollars in his 20 year career. I have watched him on televisions. His fights were furious and fast. Yet at the age of 39, he had 38 million in debt and was declared bankrupt. If you see the list of how he spend his money, you will realise what overspending is all bout. He spend $4.5 million to buy cars and motorcycles $3.4 million to buy clothes and accessories $ 1,40,000 was spend to buy two white Bengal tigers $ 1,25,000 for its trainer $ 2 million for a bath tub for his wife , Robin givens $ 4,10,000 on a birthday party $ 2,30,000 on cell phones and electronic gadgets $7m8 million on unidentified personal expenses. Employed more than 200 people including bodyguards, chefs, gardeners etc. Tyson, I admit, knew how to knock down his opponents. When the basics are right, you perform. He knew the basics of boxing. Unfortunately, he has never learned the basics of finance. When someone who doesnt know the basics of finance trys to manage money, such profligate spending stories are written. Money came in fast in and it went out even faster. With a negative net worth that large, Mike Tyson is easily one of the poorest man alive in this world. The purpose of this is story is not to degrade Mike Tyson in anyway, but to alert you about the dangers of spending more. WHY SPENDING FEELS SO GOOD? Why do some people feel good when they spend more or why do some people spend so much when they get money? We have asked few people regarding this and the five common reasons we found are Instant gratification: They spend because, that gives them an instant pleasure that they were able to buy something expensive. It satisfies their desire to buy. So, even if they are aware that its quite expensive and beyond their budget, still they go out and buy it to get that instant empowerment. Nobody is wiling to wait because they feel that they deserve it, now. Status quo: They want to keep up with their friends and neighbors who live flamboyantly. When you spend to impress others, it naturally goes out of your control. Past life: some spend to compensate the entire struggle they suffered in their past. They might have had a time when they were surrounded by things that they wished to buy, but couldnt afford. So when they start earning, they try to compensate all that. Easy availability of credit: When credit is available on the spot (like credit card offers) it tempts them to spend. Lack of basics: Lack of understanding about the basics of finance-specially basic concepts such as time value of money, compounding, present value and inflation. Psychologists say that depression and low self esteem also results in spending more. They say that some people shop more to compensate their feeling of low self esteem and to boost their confidence. Stress relief and trying to overcome the feeling of inadequacy are also cited as reasons for overspending. Thats our 15 th principle in managing money. Spend only half of what you have! If you are spending in order to get that instant pleasure or to compensate for a tough past or to boost your confidence, you certainly need to correct yourself. You might require a personality trainer. If its due to lack of basics, these basics lessons are just meant for you! Principle 16. Avoid financial litigations by J Victor on September 20th, 2011
FINANCIAL LITIGATIONS Be it against banks and financial institutions or against individuals litigation is a painful experience. The problem with these litigations is that in 99% of the cases, litigations between individuals may drag on for years and years. So its always wise to give a careful thought before embarking on any type of financial litigation. But the same cannot be said when a lending institution moves against you. Lending institutions secure their funds through solid agreement that runs into pages. The borrower, at the time of availing the loan, would have signed each page without even bothering to read whats written.And, there is an ACT in India called the SARFAESI Act which helps lending institutions to act fast against you. SARFAESI ACT- Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, popularly called The SARFAESI Act, grants special powers to lenders to take the assets pledged without first going to court. Once the provisions of the Act is applied , it gives juts 60 days for the borrower to repay his debts. If he doesnt pay within that time, the bank will proceed to seize the asset pledged. Alternatively, the borrower can file an appeal in the court for extension of time. The court normally allows a time of 6 months in addition to 60 days. So, whats important is to find out whos actually on the wrong side. Mere reasons are not enough; you should also have the documentary evidence to prove your point. IF YOU ARE ON THE WRONG SIDE.. If you are on the wrong side, clear your debts the earliest. There is no point in starting a litigation since anyway, youll be finally asked to pay back the amount with all incidental expenses like legal fee, penalties, interest and fines. Finally it may add up to an unmanageable amount. The best option in such cases is to reach an out of court settlement. Such settlements may be advantageous to both the parties. For example you availed a loan, say a car loan, from a bank but unfortunately your business is in troubled waters and you have made some defaults in paying monthly installments. Now, in such cases, the bank has a separate recovery team who would liaise with you for pending payments including penalties. The best way to come out of such troubles is to ask for a full and final settlement. Ie, the agent handling the recoverywould give you a flat discount on the capital outstanding (and not on the total dues including bank charges and penalties). You can either sell off your car and pay it off, or find some alternative sources and finish off the debt. The advantage is You get a one time settlement offer which includes a welcome discount. Your asset is free of debt. Your name is removed from the credit defaulters list. The bank will not take any legal action against you. Saves a lot of time. Save a lot of other expenses like attorneys fee. Preserves your reputation and goodwill. Finally Peace of mind not only for you , but for your entire family. ON THE OTHER SIDE Now lets think about the opposite situation. You have to get money from somebody. In most cases that would be an individual or firm to whom youve given credit. You may have some form of written agreement with you to prove your point. The best option is to try for an out of court settlement since, if you go for a litigation against the party, its going to take years and years to get a decree. The court generally doesnt consider the economic effect of delay in justice. Hence, they do not consider the effect of inflation or interest rates. For example, if you sue a person to get back 2 lakhs, it may take 4 or 5 years for the court procedures to settle and get back those 2 lakhs. Isnt it better to try for a settlement of 1.75 lakhs immediately? The effect would almost be the same. You can also try to bring in a mediator like a politician or a bureaucrat and find a solution to the matter. Thats our 16 th principle. Financial litigations may take a lot of time to settle. If you are on the wrong side, today or tomorrow, you will have to pay back the amount or your assets will be lost. If youre right, still its better to reach an out of court settlement or else your funds will be stuck for a long time. The Hence always try to avoid such situations. Principle 17. Pay your taxes. by J Victor on September 20th, 2011
Income tax is never an easy subject to understand, especially in India. Its important to pay your tax bill after properly planning it and pay whats due to the government. Thats our responsibility. Its not only about being responsible. Having a tax clearance has lot of advantages. Heres a list of points that came into my mind in no particular order: Standard income proof: The income tax return is considered as a valid income proof not only in India but also globally. If you are looking for higher education or employment overseas, your present tax status may add more credibility to your application. Fast loans These days, if you are not paying income tax, it would be difficult to get a loan sanctioned in your name. But if you have all the tax papers, it immediately creates an impression that you are a responsible citizen and that youll not make default in repayments. PAN Power The PAN or permanent account number card is a valid proof for your signature and date of birth. This card is required for all monetary transactions above a certain limit. Its also required to buy a car, to open bank accounts, to subscribe to mutual funds and to invest in stocks. Excess refunds. Bank and financial institutions are required to collect tax at source. By promptly planning and filing your return, you may get tax credits. Avoid enquiries /penalties and fines. Income tax law imposes severe penalties and fines for those who are not proper in disclosing and filing tax. BEFORE FILING RETURNS: The income tax Act contains various provisions that may help you to reduce you tax bill. It may not be possible for everyone to understand the language of law and hence, its prudent to consult a tax practitioner who will guide you on the matter. By properly planning your tax, you can reduce your tax liability to the minimum. By planning we mean an early planning of tax not at the fag end of the deadline. Tax planning is done by legitimately using tax exemptions, rebates, reliefs and deductions to your advantage. To utilize the provisions of deductions, you may be required to invest money in certain instruments like tax saver bonds or life insurance premiums or may be required to donate to eligible schemes of the government. All this cannot be done just before the deadline. There is a time limit for making such investments and payments. Following steps should give a brief idea about how to plan your tax: First list down all your sources of income. Possible sources can be employment, business, profession, gains from selling assets like land or shares, winnings from speculation, interest, dividends, rent, commissions and brokerage. Estimate the total income for the year from each source. Add up everything and you get your expected total income. If you have incurred loss from any source, make sure that youve deducted it from the total. You need to pay tax only for the net amount. Calculate the probable tax liability. See if you can make any investments or donations that are allowed as deductions. Such investments would reduce your tax liability. Keep minimizing your projected tax by utilizing all those provisions. You may require the services of a tax consultant for this. Keep your tax bill at the minimum. If youve done that, youve planned your tax bill very well. CONCLUSION Thats principle number seventeen! Be regular on tax payments. Plan and pay your tax. You need to pay your taxes so that you can be proud that you did your bit for the development and prosperity of your country. Principle 18. Safeguard your documents. by J Victor on October 2nd, 2011
How many of us are systematic in document filing and protection? Everyone should identify and protect key documents in such a way that its easy to retrieve it when needed without any confusion. For that, first you need to classify your documents and keep it in separate files at one place. You need to have a space in your shelf to keep all these at the same time make sure it not within easy reach of children. Now, lets have a check at what are those important documents. 1. Financial documents like bank records, loan records, investments. 2. Documents of assets you bought like warranty cards. 3. Documents related to your health & education 4. Personal documents. 5. A summary of all these in written form- in a diary. FINANCIAL DOCUMENTS. BANK RECORDS: Its important to take a print out of your quarterly bank statement and go through it. Banks are no fool proof systems errors are possible at anytime from the banks side. Keep an eye on the charges debited. Some bank accounts carry a lot of charges compared to others. Its also important to check whether the automated debits and credits are being regularly done by your banker. Always keep a file that contains at least 1 year bank records. Know the type of account you are maintaining and the features of that account- some accounts come with zero balance facility while others require a minimum monthly or quarterly balance to be maintained. Keep your cheque books safe. Never keep signed blank cheques in anticipation of an emergency. Make two complicated passwords one numeric and one alpha numeric, and use it for all. For example ATM cards, bank lockers, phones, locks etc generally require numeric passwords. All others like personal laptop, internet banking, visa secure, email ids, income tax, share trading accounts and other official sites where your have registered generally require alpha numeric passwords. A single but complicated password memorized is better than having different passwords. LOANS: Most important advice Always demand a copy of the filled loan application form submitted to the bank. This helps you a lot when it comes to follow up of your loan application. 99% of us dont have this vital record. If you couldnt do this because of circumstances take a picture of the application form on your mobile phone. Keep a list of documents submitted to the bank. When your loan gets sanctioned, your sanction letter will contain the list of documents submitted by you as per bank records. Make sure both are tallied. This check list becomes extremely useful not now- but Years later, when you pay off all the liabilities and ask the documents back. Keep a certified photo copy of property documents thats pledged with the bank. Generally the title deed, prior deed, land tax receipt, building tax receipt, location and possession certificate would be with the bank. Loan sanction letter and EMI chart. Ask for periodic loan repayment statement- this will help you to check whether the bank is charging your loan account with any extra charges. If you have insured your loan- documents related to insurance, In case you pre pay the loan If you have given post dated cheques, keep a record of the same and demand the balance cheques. If you have given an auto debit instruction through ECS, make sure that the auto debit instruction is cancelled with your bank. After finishing off your obligations with the bank, there are two more important documents to be obtained and filed- Loan closure letter and a full repayment track. Years later, when you apply for your next loan this letter may become handy. INVESTMENTS: Land and building is usually the most valuable assets people own. They can be sold and mortgaged to raise money and hence these are very valuable. It can also be target of fraudsters, especially where the owner is abroad or absent. Keep the originals of all the properties you have in a separate file. If you are an NRI who has inherited / bought property in India, make sure that proper arrangements are made to keep custody of the property. Make all the payments like municipal taxes and electricity bills through cheques so that a permanent record of the payment made is automatically created. Do Not give unlimited powers to relatives or friends through power of attorneys. Power of attorney should give only restricted powers . In any case, caretakers of the property should not be given powers to transfer the property. For any property have a compound wall and a nameplate engraved on it. Keep a video record of the entire property. Keep clear record of mutual funds, shares, insurance etc you hold. You may also have money invested in your spouses or childrens name. Keep a clear record of gold and diamonds especially if it is kept in the bank locker. If you have changed your phone number/residence promptly update with all the concerned parties like banker, insurer, credit card issuer, mutual fund house, government records, stock broker etc.. OTHER ASSETS: From phones to cars everything comes with a warranty when you buy. When you buy such assets, it comes in a big glossy pack with lots of stuff- protective wrappers, instructional manual, contact numbers, broachers etc- but the most important documents in the pack are the warranty card with the dealers stamp on it and the bill. Mobile phones, calculators, fans & air conditioners, televisions, music systems, computers, furniture, oven, refrigerator, washing machines & dish washers, grinders, watches even bags and shoes come with warranty. These bills and warranty cards are easy to get misplaced if you dont put it in a separate file. Assuming that you have the above mentioned assets with you you must have at least 15-20 warranty cards and bills with you now if you have filed it in one place. The importance of these documents arises when the equipment you bought doesnt deliver the performance that was expected within the warranty period. OTHER DOCUMENTS Although we were talking about protecting financial documents, there are other categories of documents which are equally important - This would include identity cards, licenses, PAN card, passport, voters ID, employment card etc.. The above records of the entire family can be preserved in one file. This collection can also include few passport size photographs. Hospital registration cards of your family Phone numbers of your doctor and the hospital where you do regular check up. Other documents like your babys stem cell protection certificates, x-rays etc..Every document thats got to do with your familys health should be in one file. Your education certificates right from 12 th to your professional degree to additional certifications and diplomas including a copy of the syllabus covered needs to be preserved. SUMMARY IN WRITTEN FORM. Although everything is in place, you still need to write down the details in a dairy and keep it for ready reference. For example - 1. All your bank accounts numbers bank and branch address, details about the nominee, 2. Credit card numbers. 3. Details about all the insurance policies you hold- this should also include certain type of polices that comes free with certain financial products. 4. Keeping track of all your investment commitments in a diary or planner helps you to be systematic in yearly payments. Helps you to plan ahead for it and be in control. 5. Summary of the property, jewellery or other assets you hold. 6. A clear written summary of your loans and other liabilities, with regular updation. Principle 19. Insurance is a must. by J Victor on January 20th, 2012
INSURANCE. One interesting fact about insurance in India is that its never bought for the right reasons. In fact its wrong to say that its bought; its actually sold by advisors with much strain and effort. Some consider it as an investment; others buy insurance to reduce their tax burden (because of certain tax benefits thats offered by the Indian income tax Act) some people buy a piece of insurance just to get rid of that advisor who keeps appearing politely every morning at their door step n some buy it because its difficult to say no to that known guy who could be you relative/banker/friend/ acquaintance. Indians are a bit reluctant to buy insurance. We havent searched for the reasons. The reality is that insurance is a must for everyone simply because it provides security and safety. It doesnt come free; you have to pay for being safe. The amount you pay is called premium. Insurance can only compensate for the financial loss that occurs due to death of an earning member or serious health issues that requires huge money out flow or loss /theft/damage of expensive assets. Some insurance companies sell policies like child policy, marriage endowment policy etc. These are nothing but life insurance polices in different name and form.
TYPES OF INSURNACE Insurance falls into three categories and we are listing it out in the same order of importance- life, health and then, your assets. Life insurance Medical or health insurance and General insurance. Life insurance keeps a family safe from the sudden fall in finances just in case something inevitable happens to the earning member of that family. The second one is to protect your wealth. The cost of hospitalization and medical treatments are going high every day with advancement in medical sciences. A health policy gives the financial support required for availing medical treatments. The last one, is to protect all your assets and belongings against damage, repairs etc. Insurance companies have also come up with innovative products like stock market linked policies. Such policies combine the risk and benefits of stock investments along with insurance protection. But these instruments should be opted after very careful analysis. It is always better to stick to traditional or simple insurance schemes which you can understand. SELECTING THE POLICY MIX THATS RIGHT FOR YOU Selecting a policy is not a simple task. A financial planner would be the right person to advice you on this.We advice so because, before taking insurance, a lot of factors have to be taken into consideration. For example while opting for life cover, one should carefully estimate his present liabilities, the standard of living that he would like to maintain for his family in his absence etc.. So, its no simple task to work out the right mix of life, medical and general insurance for a person. SOME PRACTICAL TIPS. If you have already opted for insurance, thats a very positive step youve taken Apart from opting for insurance, there are three more important steps to do from the practical point of view. First, All the policy documents must be kept in a file, with a summary written on top of it. Secondly, it should also contain the agents number, local office contact number and the 24 hr helpline number of the insurance company. The summary can also contain a description of the steps to be taken in case of an emergency. Finally, you have to teach your nominees about how to make a claim from an insurance company. These steps are very important because, when something happens to you, your family would already be in very tensed and vulnerable situation and that may not be the right time for your loved ones to go clueless on where the documents are kept and how to go about with the claims. Its no easy process to make a claim. There are several documents to be produced, especially in the case of death claims. Its more complicated if its an early death claim (claim within 3 months). So knowing all this would avoid a lot of stress at that time. Principle 20. Know your net worth by J Victor on June 5th, 2012
NET WORTH Net worth is simply, your assets (less) liabilities. Assets you own them. You can sell them anytime and take cash. Liabilities you owe them. Money flows out until these are settled. ASSETS. Look around. You have lot of assets with you. Some of them are very large assets like land and others are personal ones like a gold coin or a ring. The assets you have can be classified into moveable assets and immovable assets. Immovable assets are those which cannot be moved from where it is exists for example the villa or the apartment you own.
Moveable assets are those assets which your can move- those assets which you can take along with you where ever you go. All the assets apart from the villa or flat you own would fall in this category. For example gold, shares, mutual funds, insurance, fixed deposits, refundable deposits like rent deposit, cash, vehicles, furniture, electronics, art works, antiques, musical instruments, coin & stamp collections, jewellery, books etc..amounts youve lend to your friends /relatives .. All these are your assets. Some of you (for example poets or authors) might also posses certain assets which exist only in value for example copy rights and patents. These are also assets. These assets are called intangible assets- ie, assets which cannot be seen or touched, at the same time it has a value which can be realised if sold. LIABILITIES The liabilities you owe include home loans, vehicle loans, business loans, personal loans, credit card dues, unpaid taxes, any other amount borrowed from your friends / relatives, plus, students who have just got a job may have student loans pending. MEASURING ASSETS & LIABILITIES. Having known what your assets and liabilities are, the next question is how to express these assets and liabilities in monetary terms. Here are some pointers: Assets like land and building can be valued at the fair market value. Fair market value is the price that a willing, rational, and knowledgeable buyer would pay. Fair market value is recommended for immovable assets because, people tend to attach a lot of sentimental value to such assets and hence put a price tag which might be on the higher side. Fair value concept keeps this mistake in check.fair value of immovable assets can be measured by availing the services of a registered property valuer. For shares, silver, gold etc..you can use the current market value. For mutual funds, use the current NAV. For other items such as furnishings and electronics, an itemized price tag need not be made. Its enough if you can put a consolidated value for all. For fixed deposits and bonds, use the current value and not the value at maturity. Similarly, add up only the surrender value of insurance (and not the maturity value). Add amounts receivable from friends and relatives only on actual receipt. The value of Items like artworks, coin collections, musical instruments and antiques can be highly subjective. To include the value of such assets, you will have to value them by professionals or have a good idea about how much someone would pay for them in todays market.- add up everything and you will get the value of what you own. The value of intangible assets like patents and copyrights are also highly subjective . The value of intangibles should be decided by professionals. As far as liabilities are concerned, its fairly simple to calculate the amount. Most of the amount you owe would be in the form of credit card dues or loans and hence, the right idea is to take out the loan statements and then check the actual outstanding liabilities. Remember to add a margin of two or three percent to it because, most of the loans when closed pre-maturely would attract pre-closure fee. For other liabilities like amount borrowed from friends and relatives, consider the actual amount outstanding. (Unlike banks, your friends are not going to punish you for being prompt) Thats the liabilities part. HOW TO CALCULATE Make a list of assets first. On the left side, list the names or categories of assets and on the right side, write down the value of each asset determined by you. After listing all the assets, add up the figures thats the total of assets for you. Mark the total as A. Deal with liabilities in the same manner. Mark the total of liabilities as B. A (minus) B is your net worth. NET WORTH REVIEW EVERY YEAR. Your net worth will keep changing even if you dont do anything to change it. Thats because, the value of assets and liabilities keep changing. For example- one year from now, the value of land, building, gold etc in all probability, would have increased. The value of shares and mutual funds can go either way, the realizable value of assets like vehicles, furniture, electronics etcwill come down due to usage , wear & tear and technological changes. If you have paid your EMIs regularly, your liabilities will also reduce in a year. So, Its important to check your net worth and track the changes periodically. IDEAL NET WORTH There is no ideal net worth figure that fits all. There is no need to investigate into such a topic because the message is quite simple- If you are having a negative net worth, you financial condition is not healthy. You need to think of ways to better your position. Having a positive net worth is always preferable than a negative net worth. Its a healthy sign. Higher the net worth, the better it is. FORMULA FROM THE MILLIONAIRE NEXT DOOR. If you are still interested in some benchmarks, Thomas Stanley and William Danko, in their book the millionaire next door, suggests a general formula: Net worth = Age x Pre-tax Income /10 So according to this formula, if you are 30 years old and if your annual income is Rs 2,50,000, your ideal net worth will be: 30 x 2,50,000/10= Rs 7,50,000 As you grow older, your required net worth will also go up. Its Simple and very effective. It keeps giving you higher targets as you grow older. In other words, its ok to have some loans or liabilities when youre young, since, you have the advantage of age on your side. SUGGESTIONS Dont panic if you discover that your net worth is negative. If your net worth negative, It means that right now, if you sell all your assets, it will not be enough to settle all your liabilities. Thats not a case to worry because, as long as you keep paying your EMIs on time, you are making your liabilities smaller. If your assets list has cash / gold/ land/flat etc.. the value of those will keep increasing. The net effect would be a faster growth towards positive net worth. You can improve your net worth by closing your loans as soon as possible, reducing your cost of living ad by investing the surplus. Calculating net worth is a very useful task since you get an instant list of what you own and what you owe. Periodic check would motivate you to work hard and reduce your debts. Improvement in your net worth would give you more confidence in life. So thats net worth for you. It gives a snapshot of your financial health. This is the first figure you require to plan your financial goals. Principle 21. Think of retirement when youre young! by J Victor on June 19th, 2012
RETIREMENT. Retirement is a stage in your life where you stop doing a regular job. From that day onwards, your money flow is limited. For businessmen and self employed professionals, retirement is by choice. For employees, there is an age fixed by the organization, for sports men when their body doesnt listen to their minds and for actors, when they are no longer accepted. However, its not necessary that all of us would work till retirement age as said above. For some of us, a compulsory retirement may be required due to health issues or any other unforeseen circumstances. Irrespective of whatever job/profession youre in , retirement reduces (or stops) your monthly income. However, since expenses will only keep increasing, your post retirement life is not secure unless youve financially planned ahead for it. Hence, the most prudent retirement is when you have made enough money to retire. This thought brings us to two basic realities about retirement -
Retirement is not when you cross a particular age or health condition. You can think of retiring when your wealth crosses a certain limit. Retirement can happen unexpectedly. All your plans may turn upside down in a day. Hence, its very important not to postpone your plans to make a retirement corpus. Retirement doesnt mean that your monthly income has come to a dead end. For example, my cousin who retired as an RTO, now takes road safety classes and keeps his monthly income alive. May be he can do this until he turns 65 or 70. So, post retirement, some of you may have some income coming from sources like the one mentioned above. It depends from person to person. It is after this stage that you rely solely on funds that would generate a solid monthly income- like fixed deposits and RBI bonds. 4 EASY STEPS TO A GOOD RETIREMENT PLAN. Step 1. The first step in retirement planning is to know how many years are left to retire. Step 2. This step is very personal. You have to estimate how long youre going to live ! God knows, isnt it? Well, nobody can estimate that correctly but, for the purpose of calculation, some sort of an estimated remaining life has to be arrived at. From these figures, you should calculate the length of post retirement life you expect. Nobody can help you on this. This is an entirely personal calculation. Step 3. The third step is to project your retirement needs. How will you estimate your post retirement expenses at a young age? The first task is to assess your present life style. Your post retirement life style you would like to maintain will not be much different from your present one. The key to estimating expenses is to know the concept of inflation and then know how to compute inflation adjusted expenses. We will explain this with an example. We assume that you are 45 years old and hence 15 years away from retirement. Right now your monthly living expenses are Rs 10,000 and the inflation rate is 8%. To know the equalent monthly expenses after 15 years, this is what youll do- Present expenses x (1+inflation %) N (number of years left)
How to apply the formula ? First, calculate 8/100 = 0.08 1+ 0.08 = 1.08 Type 1.08 on your calculator , press the multiply sign and hit = button 14 times. Youll get 3.17 as the answer. (If you are calculating for 20 years hit the = button 19 times!) Multiply Rs 10,000 with 3.17 = Rs 31,721. This is the answer. What does that mean? This means that, today if your living cost is Rs 10,000 per month, then 15 years later youll have to spend Rs 31,721 to maintain the same standard, assuming that the cost of living rises 8% every year.
Youll have to estimate your future expenses using the same logic. Generally in India, 8% can be assumed to be the average inflation rate. The only difference you have to make in your estimation is that certain expenses like traveling expenses tend to come down when you retire (because you may not travel as frequently as you do today) and certain expenses like medical expenses will go up (because as you grow older, your health deteriorates). Applying this logic, youll have to estimate your reasonable future living costs. Step 4. From the estimate, you will be in a position to find out how much fund you need in fixed income generating instruments so that you can maintain your present standard of living in future. If you require Rs 30,000 per month in future, then you need roughly 35 lakhs in FD at 10.50% interest rate, 15 years hence. Now that you know your goal, start investing in various assets !!
TIME IS ON YOUR SIDE. The biggest mistake most of our parents did was that they failed or they kept postponing about their retirement plans until it was very late. Right now- for all the working youngsters out there the advantage for you is that there is plenty of time to plan and accumulate wealth for your retirement life. Earlier the start, lesser the effort. An early start will also give you a lot of freedom to make risky choices like equities and mutual funds. Principle 22. Diversify your investments. by J Victor on July 10th, 2012
DIVERSIFICATION. Diversification is one of the central concepts in investments. The theory says that your money should not be locked in any one asset. It should be split to buy different types of assets like land, shares/mutual funds, gold, FDs etc. The reason is quite simple no asset class can keep delivering profits year after year consistently. Thats because, every asset moves in a cyclical trend. There will be exceptional growth in some years and then it will be followed by sluggishness. This phenomenon is true in almost every assets class. So, if your investment is in a single asset, you make money only if that asset increases in value and at the same time, you also miss the chance to participate in any other asset boom. Hence, the risk you take is high. For example what would happen if youve put all your money into stocks and the stock market tumbles?
The way to reduce such risks is to diversify your money into various assets. In fact, diversification is one of the cardinal rules of investments. TWO LEVELS OF DIVERSIFICATION Diversification should be considered at two levels- Level one Diversifying between major asset classes. Level two- Diversifying within the same asset class. Level 1. At the first level, your money should be diverted into various assets which are not correlated. For example if you have 60% of investments in stocks, then its not a good idea to park your balance 40% in mutual funds or stock market related instruments since, when stock markets crashes, such assets drop in value. It happens because these assets are indirectly connected to the stock market. Instead, bonds or fixed deposits may be a good option since these assets tend to perform well when theres a market crash. Level 2. One more level of diversification is required-this time its within the asset class. For example if you have decided to diversify some amount into real estate, it is better to buy 2 plots at two different places rather than locking up your funds in one huge property. Or if you are planning to invest in stocks, its better buy a mix of large caps, mid caps and small caps in different sectors. DO NOT GET INTO TROUBLE. You have to diversify and make sure that your funds are in different baskets. Fine. But that does not mean that you should put your money into as many baskets as possible!! That results in over diversification. An over diversified portfolio would be very hard to monitor. Periodic monitoring of your investments and re-balancing of investments between various asset classes is necessary to keep your portfolio growing. Hence, while diversifying your portfolio, it is important to keep the number of asset classes at a manageable level. HOW TO ALLOCATE YOUR MONEY? The basic idea of diversification is to have different kinds of investments. That means you should have some or all of the following assets in your kitty- Stocks. Bonds and Fixed deposits. Real estate. Cash. Gold. Heres an illustration: Step 1: The first step is to set aside some amount in cash so that you can meet any emergency. Its basically an emergency fund. How much would be required depends from person to person. Lets assume that you need 20% of your money as emergency fund. Out of this money 65% can be kept in short term deposits ( for example 2 or 3 month fixed deposits) and the balance 35% in liquid cash. Step 2: As a next step, subtract your age from 90 and invest the resulting percentage in stocks. For example if your age is 35, invest 55% (90-35) of the remaining fund in stocks. Step 3: The balance 45% can be invested in bonds, real estate or gold. Step 4: Now, within that 55% invested in stocks, you need to diversify further. You cannot invest all your money into one stock or sector. You have to choose 4 or 5 independent sectors to invest. For example, you can consider investing 10% in an industrial giant like Tata, 10% in Pharma sector, 10% in banking, 10% information technology and 15% in mutual funds. Step 5: Since you are going to invest 10% in a particular sector, you need to make one last diversification. Every sector consists of large caps, mid caps and small caps. Depending upon the risk youre willing to take, you need to split that 10% across various market caps. 70% in large caps, 20% in mid caps and 10% in small caps would be a decent split. Now, assuming that you are 35 years old, lets have a look at your portfolio, if you had 30 lakhs to invest: You would have kept 6 lakhs as emergency fund, out of which 4 lakhs earn short term interest and the balance earn interest at savings bank rate. Out of the balance 24 lakhs, 13 lakhs will be invested in equities. The remaining 11 lakhs in a mix of gold, fixed deposits or bonds (in all probability, this should give an average annual return of 9 or 10 %.) Out of the 13 lakhs set aside for equities, 2 lakh moves to mutual funds and the balance 11 lakhs across 4 different sectors at 2.75 lakhs each. Out of that 2.75 lakhs in one sector, 1.90 lakhs will be invested in large caps 0 .60 in midcaps and the balance 0.25 in small caps. If we draw a graph, it would look like this:
That was a general example. The ratio of diversification depends on a persons risk bearing capacity, age, financial goals, amount of funds invested and many other personal factors. There are also many other asset classes like arts and antiques which can be considered for diversification provided you have good knowledge in its valuation. Its important for everyone to sit with an investment consultant and draw up a plan like this. Principle 23. Valuation is the key to right investments. by J Victor on July 17th, 2012
VALUATION Every asset has a true value which would be different from its market price. Thats common knowledge. The market price of any asset purely depends on the changes in demand and supply equation and hence, it could be more or less than the true value of the asset. So, when should you enter the market and buy the asset (let it be any asset)? Thats what we will explain in our 23 rd
principle. The simple rule is that an asset should be bought when it is available at a bargain so that in future, when the asset gains in value, the profits you make is high. The question is whats the basic process to know an assets true value? The answer lies in a process called valuation.
To put it straight valuation is an attempt to know what an asset is really worth. All assets like gold, land, villas and apartments, arts, antique pieces, shares, bonds, mutual funds or even cars and electronic items have to be valued so that you have a reasonable estimate of what youre going to get for the money you pay. IS IT POSSIBLE TO VALUE ANY ASSET? Yes. Its possible. Its practical too. However, the level of knowledge required to value an asset depends on the asset type and also your knowledge about the particular asset.All assets types are not easy to value. Some may require an experts help or opinion. Different methods are used to value different assets for example the method used to value a property is entirely different from the method used to value mutual funds. Whatever be the valuated figure, remember that it is still based on certain estimates and assumptions. Hence, valuation itself is not fool proof. There will be an element of uncertainty in value estimates. Valuation is not a new concept. We do a lot of valuation in our daily lives. Lets take the example of a couple who wants to buy a new villa. How would they know if the offer price of the villa is not overstated? The solution is to approach a registered property valuator who will visit the site put the right price tag for it. Then, find out how much others have paid for similar properties in that area. Buy it only if the price quoted approximately matches with the valuators opinion. Lower the price, better the bargain. WHY VALUATION IS THE CORE? Any asset is prone to overvaluation as the demand for it increases. These overvaluations can continue for many years and one day, it will eventually burst and cause the price to fall lower than its fair value. We have already witnessed this scenario in 2007-08. High demand is only one of the reasons for over valuation. Asset prices will be inflated if there is excess money in the financial system, high speculative activity, reckless lending by banks, low interest rates etc Herd behavior or the tendency to follow what the crowd is doing is also another reason why over valued assets are traded in the market. In a bull market (for any asset in general) investors ignore valuation and concentrate on the trend of price movement. They chase prices and focus on the possibility of resale of the asset. When they see the trend of rising prices, they buy those assets in hope of profiting from the increase in value. Its just like gambling at casinos. The game goes on and on and someone, at the end, will lose all his money So, high price paid for an asset cannot be justified by merely using the argument that There are other investors waiting to buy this asset and hence, even if we pay a higher price, it can be sold to the next highest bidder. Technically, the demand is high and the supply is short and hence, the prices will keep moving up. This is the new hot asset on the block, everyone is buying it. Hence, arguments in support of high asset prices are absurd. Be it shares or mutual funds or property or currency- irrespective of the asset you choose to invest, buying decisions should be based on valuation or else, you will end up buying the assets at an inflated price. A general indication that an asset market has started getting overvalued is when- The general public are investing their money on the asset There are many first-time investors entering the market. Everywhere you observe people talking about the same asset. Theres a lot of hype and stories circulating around like the story of a taxi driver who made a killing from the market or the story of an employee who resigned to take up investing as a full time profession and made millions. Theres a lot of warning bells ringing around, but no one cares to listen and the asset price keeps going north. END NOTE. Even valuation is not fool proof ! At the end of the most careful and detailed valuation, there will still be uncertainty about the final numbers since these are based on certain assumptions, projections and past data. Hence, investing after finding the right value has a lot of risk attached to it ! Imagine the risk of investing without valuing the asset ! Principle 24. Gold A must in your portfolio by J Victor on August 22nd, 2012
Gold is the base of monetary systems around the world. Its an asset thats highly liquid, accepted everywhere and considered equivalent to cash. Its also one of the lesser volatile commodities traded internationally. Gold is very effective in bringing solidity into your portfolio and reduces investment risk. In terms of returns, its not a very effective tool to bring short term profits. Gold gains in value over a period of time and hence, you will have to wait for some time (say 5-10 years or sometimes more than that) to see the real effect of gains.
How to invest in gold? Gold can be bought in different ways. You have 7 options You can buy- Gold jewellery Bullion bars from jewelers that are part of the world gold council Gold coins issued by various banks Gold exchange traded funds Equity based gold funds E-Gold Take positions in Gold futures and profit from the price movement. The first three options are about buying gold physically. If you have bought Gold jewellery, we are sorry to say that its not a right move from the investment point of view because, you would have paid an additional of 5%-30% of its value as making charges depending upon the design and some money on precious stones used in them. These stones are valueless and do not appreciate unless its a piece of diamond. Making charges paid is also a waste of money. Banks charge around 5% premium for coins sold through them. Bullion bars /coins bought through WGC networked jewellers may be the better option here since; they generally sell gold for a 2% or 3% premium. So if you want to hold gold physically, it would be better to buy it from WGC networked jewellers since they are the cheapest option. Now, physical holding of gold risky since it is prone to loss by theft / fire or such other accidents. To protect from such losses, you will have to insure it and that will be an additional annual cost to be incurred until you sell it off. The purity of gold sold by jewellers is an issue thats hard to crack. Again, it may be impractical to store it physically beyond a certain limit and in the case of an emergency if you go to a jewellery to sell your gold, they might not accept it straight away. After reading the above paragraph, if you think that storing gold physically is not practical, you have the last four options Gold ETF, equity based gold funds, e-gold and futures positions in gold. Gold ETF is nothing but mutual fund schemes that invest only in gold. One unit would roughly equal one gram of gold. These funds are managed by asset management houses. If you dont want investment houses to get involved, you can directly purchase e-gold launched by the national spot exchange. In both the cases, you will be holding gold in electronic format just like investment in stocks.All you need is a demat account. One more category of electronic gold is equity based gold funds. Equity based gold fund are basically mutual fund schemes launched by asset management companies. They do not invest directly in gold (when fund houses launch direct investment in gold, they are called gold ETFs) instead, they invest in stocks of companies that are engaged in mining, extraction and trading of gold. The last option taking positions in gold futures is a risky game. All the negatives and positives of derivative instruments are relevant here also. Its would work if you can reasonably predict the price movement of gold in the short term. Its basically speculation (or trading, if you want to call like that) and cannot be brought under the investment category. How much to invest? As a general rule, around 10 % of your investment fund can be in gold. Which is the best option? The best option would be to hold gold in electronic form through ETFs or through e-gold route. In the first option, the additional amount you have to pay is the brokerage charges plus annual fund management charges. In the second case, your annual holding cost is zero. In both the cases, you dont have to worry about the security of gold since it is held in electronic form in your demat account and the rates quoted in the exchange is 99% at par with the international gold prices. By definition of the income tax department, gold a capital asset. Any gains from investment in gold are treated as capital gains. In the case of ETFs, it is considered as a long term capital asset after one year and in the case of e-gold and physical gold, it is treated as a long term capital asset only after 3 years. The relevance of this is that, long term capital gains are taxed at special slab rates declared by the income tax department whereas, short term gains from gold ( in the case of gold ETFs, gains made by buying and selling ETF between 1-12 months and in the case of physical gold /e-gold, gains made by buying and selling it between 1-36 months) is taxed at normal tax rates. So we think that the e-gold route would be the best. Gold ETF comes second. Whats the risk of investing in gold? Generally, gold is a safe investment. It beats inflation. The risk is that sometimes, especially in boom periods, youll find the performance of gold to be slower than other asset classes like equities and real estate. So, the real risk lies in the opportunity loss. With this we sum up our 24 th principle. Know that Gold is an insurance against inflation. Its a good investment, but not the best one since its a slow performer. It brings stability to your portfolio Jewellery is not a right form of investment as its cost involves making charges and the purity of gold sold by local merchants are always questionable. Physical gold are prone to theft or other losses. Gold kept in bank lockers are not safe since, the lockers of most banks are not insured and the bank is not responsible for your assets kept in lockers. Its a capital asset and hence any gain on gold would be taxable. Paper gold or gold held in electronic form is the best way to invest in gold.
Investing Basics What is investing? by J Victor on July 27th, 2010
INVESTING Investing is not just about depositing your savings in the bank every few months. Its about growing your money. Its about making your money work for you. INVESTING IS A LONG TERM ACTIVITY When you invest, you buy an asset like shares, mutual funds, gold or real estate when its available at a bargain and wait till its price go up. You may have to wait for a long time, say 5 or 10 years to get a real appreciation for your invested funds. So, investing is a long term activity, you have to wait for your rewards. ITS ALSO ABOUT GROWING YOUR MONEY PRUDENTLY. Money is a weapon thats to be used very very carefully or else, it can backfire within no time resulting in a total ruin of your life. By being prudent we mean, determining an action or a line of investing thats practically wise, judicious and careful. When you look around for opportunities to invest, its natural to stumble upon ideas like multi level marketing of certain financial schemes or money chains etc that may seem to be too good an opportunity to make a quick buck. Its important not get tempted by such investment offers. Any investing decision you take must be practical, legal, safe and capable of creating wealth for you in the long run. REWARD FROM INVESTMENTS Investments range from risky types like stocks to very safe ones like fixed deposits. Depending on the type of investment youve made you get return in the form of rent, interest, dividends, premiums, pension benefits or appreciation in value. The more risk you take, the more you earn as rewards. OBJECTIVES OF INVESTING Objectives or purpose of investing would be different for different people. By choosing to budget your expenses, accumulate money, invest that accumulated fund and limiting the amount of debt you can achieve most of your lifes goals. Normally, a person would invest with one or many of the following objectives in mind: A Regular Income Creation of wealth Preserving his capital Planning for retirement life Education /marriage of his children. To start a business THE PROCESS OF INVESTING The process of investing is quite simple- Depending upon the money you got, you will have to short list the type of asset suitable for investment. Next, youll have to assess yourself and find out how much knowledge you have in that particular asset category. This assessment will tell you where you stand right now, and the amount of preparatory work you need to do before investing you money in it. Once you gain enough knowledge, try to draw a plan to invest systematically get access to the right information, plan properly and make the right choice. REASONS TO INVEST Why does investing acquire so much of importance? Thats because of three core benefits of investing- First, the probability that youll beat inflation. Second, the probability of achieving your financial goals quickly. Third, the probability of building something for your next generation. An investors main focus should be to beat inflation. Inflation and its after effects were discussed in our previous articles. Youve to invest in such a way that the rate of return beats the inflation rate. If you dont do that, it eats away your returns. Unless your rate of return beats the inflation rate, youre not growing your investments.We said probability because, investments carry the risk of not hitting the desired targets. When you set higher targets ( higher returns) the risk of not achieving it is also high. Apart from achieving financial goals and securing your childrens future, another important reason would be to plan for your retirement. When do you plan to retire? At 60 or at 50? You can opt to retire when you have a sufficient amount of wealth so that, you can maintain the standard of living that you are maintaining today. The earlier, the better! In the coming lessons, we take to you through different aspects of investing. Each lesson has a concept to share. At the end, youll know what investing is all about, why its essential to invest early, different avenues to invest etc..In our next article , lets see why investing is the most important activity one should have. Why is investing important? by J Victor on July 28th, 2010
50 YEARS BACK. Recall the scenario when your parents were workingIn those times, it was common for people to stay in the same job all their working lives. Most of them had government jobs where job security was ensured. Opportunities were limited. So they were content with what they had. With whatever financial assistance and savings they got, they managed to raise children, educate them and buy a home. Medical field wasnt so technology driven and expensive. When they retired, they got the benefit of pension that has dearness allowance built in so that, their pension pay grows with inflation. And, they expect their children to look after them in their old age. NOW.. But now, times have changed. Most people work in the private sector where there is no guaranteed job security. But, every sector has an ocean of lucrative job opportunities to offer. This generation lives in a very competitive world than ever before. Its a situation where they need to work really hard to make a mark.At the same time, they need to look after their aged parents, take care of their childrens needs, and fulfill their own dreams. Medical expenses and retirement are real big issues.With advanced technology being used every where, the cost of hospitalisation and treatments are so high that , its almost beyond the reach of common man. You need not expect your children to look after you just because, they are going to live in an even more competitive , stressful and faster world. So it becomes quite essential for todays generation to invest for their future needs. Mere savings from job may not be enough. You have to create wealth by investing. Simply put- while your work hard for more money, you money too should work for you! Investing is not something which only wealthy people can do. Investing is possible for all classes of people. For this, irrespective of your income levels , you need a proper financial plan. You need not have big funds to start investing. even if you invest small amounts regularly, you will be able to achieve all your goals. The starting point is you should decide where you will invest and how long. To choose wisely, you need to know the investment options thoroughly and their relative risk exposures. Thats the importance of investing. Investing is the best way to secure your future. PLAN AND INVEST The key to wealth is to plan and invest. Your job is only half done when you save money. That money has to be invested in wealth creating assets in prudent ways. As a first step, you have to clearly define your short term and long term financial targets. Once you have a clear idea about your financial goals, the next step would be to draw a clear road map to reach your target. However, readers should not think that financial planning is all about creating wealth. Financial planning, in fact, is a very broad term and Investing is only a part of your financial plan. A proper financial planning can be done only if you can clearly chart out your strengths , your goals and your capacity to take risk. Later on, we will discuss what financial planning is all about and the advantages of having a definite plan.Right now ,our next chapters would explain more helpful topics like when should you start investing and The right mind set for investing. Where can you invest? by J Victor on July 31st, 2010
Wealth creating assets in which you can invest can be broadly classified into the following classes: Equity or stock market investments including mutual funds Debt or fixed deposits and government bonds Gold & diamonds and other precious metals Real estate Art and Antiques So, its either financial assets including securities market related instruments or physical assets. EQUITY When compared to any other class, investing in equities is definitely riskier, more rewarding than you can imagine and every exciting too. World over, and in India stock have outperformed every other asset class in the long run. An investment of just Rs.10,000 in companies like Infosys , Ranbaxy , Cipla and Wipro in 1980s would have grown into Crores and Crores of rupees by now . As an equity investor of a company, you become part owner of that company and hence participate in the overall growth opportunities of the same. However, as said earlier , equities are risky investments. Hence, you cannot put all your money into equities. DEBT Debt investments includes fixed deposits with banks, debt mutual funds and government schemes where you will be rewarded a fixed rate of interest year on. Debt schemes are popular because it carries less risk, you get definite income by the year end and your income is always predictable. This is not to say that debt instruments are risk free. They too, carry risk. Even governments can default in repayment. Secondly, inflation is another serious risk.. We have already talked about inflation earlier.So, putting all your money in debt is not a good idea. Yet, it is essential to have some amount of money invested in debt to bring stability to your investments. GOLD Investors must have this item in his portfolio in order to diversify and also reduce the risk and volatility in his portfolio and to bring consistency. Especially in India, gold is the most liquid investment. Bank fixed deposits, national savings certificates etc would take at least 3 to 6 days to concert to cash. But gold can be converted to cash almost instantly over the counter. REAL-ESTATE If you have lakhs or millions in your bank account, real estate investments are for you. This class of investments gives high returns at lowest risk. The benefits of investing include higher risk adjusted returns, assured regular income and definite capital appreciation. However, you need to be careful in this filed too. In most Indian cities, real estate prices are at its peak and consequently, getting target returns out of it has become quite confusing. Nature and volume of income from it depends whether your property is in a residential area or commercial area or is it a vacant space fit for godowns/storage houses or is it an open space fit for wind mills and industries. Real estate investments are one of the most illiquid investments. Normally it takes at least 5 to 6 months to convert it to cash. One more disadvantage is that you need at least 15-20 lakhs to start investing. ARTS AND ANTIQUES If you have the money and the guts to try something new and exciting-consider arts and antiques. Especially art. It is supposed to be the next big asset class. Earlier, it was not considered as investments but now, works of great artist are sold for millions. The key is to find out artists who have the potential to become high profiles in he future. But, for that you need to know about the subject thoroughly. Experts say that the Indian Art market is growing at rate of 40% yearly. However, art , as an investment vehicle, has many negatives. You cannot go out and suddenly sell off the masterpiece you own. The art market is risky because - The valuation is always subjective and there are no hard and fast rules for valuation. There is no regulation what so ever to ensure any sort of transparency. The liquidity part is always doubtful. Its one asset class which cannot be pledged. Its difficult to store fine art pieces. WHATS NOT CONSIDERED AS PURE INVESTMENTS INSURANCE Insurance is nothing but an agreement between the insurer (The Insurance Company) and the insured (You) to pay an amount as compensation if any unexpected event occurs.The goals of Investment and Insurance are totally different. A lot of us take Insurance policies as investments. Its a wrong approach and needs to be corrected. DERIVATIVES Derivatives( futures and options) are very destructive. These are not investments. Derivative financial instruments can be used for protection from losses (technically called hedging).If derivative investments used in amateur hands, they can be very dangerous by bringing excitement: fast results, quick loss or thousand fold profits may pull in the vortex of emotions and dont let out until everything will be lost.Derivatives as investment instrument should be considered only in carefull professional hands. CONCLUSION Equities , debt and gold and within the reach of any one. You can always invest small amounts of your savings into those three categories. These three category of investments are well regulated by the government. Real estates are solid investments, but requires lot of money. Art and antiques are risky investments. They are not regulated. A proper investment plan would be to create a balanced portfolio that consist of equities, debt and Gold. Real estate is also preferred Provided you have the money to invest. Which investment is best for you? by J Victor on July 31st, 2010
This is one common question that wannabe investors ask. They want to know which type of investment is better for them in terms of returns. Before deciding what assets suites you best, you need to the following questions. How much money do you have ? How long are you willing to stay invested? How much risk youre wiling to take? At what age do you plan to start investing? Whats the degree of liquidity (convertibility into cash) you require? The first factor is your financial capacity. You can enter the field of real estate investing only f you have a lot of money, say at least 15 to 20 lakhs. Thats minimum investment at this point of time. Arts and antique investments will cost you even more. So these types of investments are not for a person with very limited funds. Such investors can think of investing in gold or stocks or mutual funds since the initial amount required is very less.
As a general rule, all assets grow in value as time goes. So it doesnt really matter where youre invested in. For example If you had invested in the shares of Wipro 25 years back, very few real estate investments can surpass the wealth you would have made. On the other hand, assume that you had invested in a beach front property in Mumbai in the 70s. 40 years later, the wealth that has been created would be huge. What would be your wealth had you invested Rs 100000 in gold in 1970? It was just Rs 184 for 10 grams in 1970; today its approximately 26,000 for the same. Imagine the money you would have made. So, in the long term, all assets would create wealth. How long are you willing to stay invested? The age at which you start investing is another important factor to be discussed here. For example consider any of the examples above. If you were at the age of 50 when you invested , any of these investments would have grown in the same way, but by the time you achieve these results, youd at 90 or even more. So thats another point consider. If youre investing for your next generation, age is no problem at all. All investments carry risk. When you invest in an asset, its possible that its value may gyrate illogically. You should know how to handle risk and for that, you should asses you risk bearing capacity. For example, if you are not wiling to take any risk your only option is to invest in fixed deposits of banks, government bonds and gold. We are listing down the pros and cons of different types of investments. You should be able to choose which works best for you after reading this. REAL ESTATE-Comfortable Investment. Real estate investments involve huge amounts of money. Unlike stock, here you buy something which you can see and feel. You buy it after physically inspecting it. Its a traditional investing option which everyone is comfortable with. Its comparatively difficult to be defrauded in real estate investments. The property has to be safely guarded. As time moves on the land keep appreciating in value whereas the building it it keeps depreciating in value. You should be willing to wait at least 6 -10 years to get a solid return. Liquidity is low when compared to stocks. To sell a property, it may take 3 or 4 months. GOLD Solid & safe investment: Gold is considered as a safe investment, an insurance against inflation. Its a consistent performer. Its difficult to store gold. Security is a major issue. Even if you keep gold in bank lockers, most of the lockers provided by the banks do not have insurance cover. You can start investing with little money. Gold investments can be done through ETF route. ETFs are instruments that invest in 99.5 per cent purity gold. . Every unit of gold ETF you invest is euivqlent to 1 gram of physical gold. All you need for investing in gold ETFs is a demat account and a trading account with a broker. STOCKS The greatest wealth creator. In-spite all of the stock-market crashes, stocks are one of the greatest wealth creators for investors. Stocks give business ownership. For example, when you buy shares in Infosys, you are the owner of Infosys to that extent. You benefit from the companys profits. The shares of highly profitable companies rise in value over a period of time. They also pay their shareholders a portion of their profits in the form of dividends and bonuses. Hence you benefit both ways- increase in value of the share and dividends. Diversification is easy when you invest in stocks. All it takes is a little investment. With as little as Rs 10,000 you can start investing in companies. Liquidity is very high. You can sell you shares in the secondary market within seconds and take your money. Its easy to be defrauded in stock markets. The worlds best auditors may be in control, there may be strict laws that govern companies but still- Its easy to be defrauded in share markets. ART AND ANTIQUES: Its complicated. Art and Antiques are interesting and profitable alternatives, but it is also extremely risky. Art can never be considered as financial asset. There are no proper yardsticks for measuring arts. Its highly illiquid and there is no organized market to buy and sell arts. The investment required is very high. It would be very difficult to store and protect art pieces. FIXED DEPOSITS: Sure shots These are the most liquid form of investment. The return is already known and hence, you invest in it only if the percentage of return offered by the institution is agreeable for you. So, there no question of being dissatisfied with the returns. You can plan your finances according to the money flow expected. YOU CAN ALSO BALANCE YOUR INVESTMENTS TO GET THE BEST OF BOTH WORLDS- For example If you are someone who knows the real estate field well, you can invest in the shares of real estate companies- By doing that, you take part in the overall real estate boom in the country (and not in a particular areas price hike). If you need money urgently, those Stocks can be sold in a matter of seconds. It offers liquidity that no real estate investment can match. Lets assume you have shares worth 40 lakhs in DLF and you urgently need 2 lakhs to meet your parents medical bill. You can immediately sell 5% of your shareholding and raise 2 lakhs or you can pledge your shares and immediately raise 2 lakhs. Instead, assume that your money was invested in one of DLFs apartment. Can you sell 5% of your Flat? No. The only option is to either pledge youre flat or borrow money. Both takes time. CONCLUSION. Having explained so far, now its your call.Go ahead according to your budget, knowledge and risk taking ability! And dont forget our 22 nd principle! What care should one take while investing? by J Victor on July 31st, 2010
Before deciding about any investment, there are a lot of things one should be careful about. This includes: COPIES OF DOCUMENTS Any investment scheme will have a written document which explains the offer. Its important that you ask for those documents and keep it in a file with you. Investment advisors and sales person work on a target basis and they work under lot of pressure from the management. Obviously, these people would explain details in a way that the scheme is attractive to you. Its part of their duty to present it well and attract customers. They are trained to do that. Many of those offers may be subject to lot of terms and conditions. Finally, when you find a mismatch with what was said by the sales person and whats happening the investment scheme, the company will ask for written proofs!! So always insist on obtaining a copy of any document you sign. READ, UNDERSTAND AND THEN SIGN IT. Some people do collect all the information in written form, but they fail to read the lines carefully. In any investment broacher or document, the negative factors or unfavorable terms and conditions will be written in the smallest of letters possible!! VERIFY THE LEGITIMACY Investment scams have become very common these days. People invest in schemes that are received through email or phone calls or representatives who lure them to invest in a product or property or forex. Before investing consult a financial advisor or an advocate and verify if the legitimacy of the company thats promoting the scheme and also if such schemes are allowed to be operated. Also note - The licenses or permit granted and the Act or Law under which the scheme is allowed to operate. The truthfulness of testimonials and references they present. Details of head office, branch offices etc. If possible try to visit the office. Most fraud schemes are very confident about the results but fall short when it comes to details. Remember that existence of Websites and phone numbers are not proofs for the legitimate existence of a company or scheme. In India, any investment scheme should have governments approval. Approval would be in the form of licenses or registration numbers. The constitution of the business as a company under the companies Act, ISO certifications, testimonials from high officials etc does not guarantee that the scheme operated by the company is legal. Never pay cash. Always pay by cheque and get a receipt for the same. Cheques paid should be a crossed account payee cheque in favour of the the company or scheme name. DO A COST BENEFIT ANALYSIS The costs should justify the benefits. Some investments carry a lot of hidden charges. Its hidden in the sense that, those charges will be disclosed in the offer document in such a way that you get confused about the way in which those charges would be applied. ASSESS THE RISK OF INVESTMENT The thumb rule is- higher the return, higher the risk. There is no such thing called low risk-high return investment. All investment carry risk and the degree of risk increases as the expected rate of return increases. KNOW THE LIQUIDITY AND SAFETY ASPECTS Your investment should be liquid, ie, it should be convertible into cash quickly. Also evaluate the after tax return on investments. Most of the investment schemes talk about returns before tax. COMPARE At any point of time, youll have many investment opportunities in front of you. List out your objectives and financial goals first. Then, analyze whether those investments would help to meet your financial goals. Also compare it with similar investment schemes offered by other companies. DEAL THROUGH AUTHORIZED INTERMEDIARIES Most of the investment companies use the help of intermediaries to generate business. For example- mutual funds are sold through AMFI certified agents. Make sure that the agent that represents that company is qualified to do so. Ask all the clarifications you need to the intermediary. SEARCH THE WEB The internet is full of information about any topic you need. Search the net before you talk to the representative. The net will contain reviews by experts on investment schemes. Read at least 3 or 4 reviews. Since these are written by people who are already experienced, it would benefit you a lot. WHAT IF SOMETHING GOES WRONG? Explore the options available to you if something were to go wrong; Is there a regulatory body who would address your grievances? Do they have a local office in your state? After all this, if you are satisfied, make the investment. Whats said above is the minimum level of understanding you should have before embarking on an investment. Take care ! What are the stages in investment process? by J Victor on July 31st, 2010
There are 4 stages 1. Investment style / policy 2. Investment analysis 3. Valuation process 4. Right mix of investments INVESTMENT STYLE / POLICY This stage involves taking decisions. It involves finding answers to the following questions. Whats the risk youre willing to take? Risk and returns are closely related. The more risk youre willing to take, the more returns youd expect. Where do you stand are you a moderate risk taker or a heavy gambler? Or are you a really risk averse person? How much money can you set aside to invest? With the money you have, what are the assets in which you can invest? How much time can you wait for your investments to grow? What are your financial objectives? Do you think that you will be able to achieve your objectives with the money you have decided to invest? If yes, have you arrived at that decision by calculating the returns at a reasonable rate? If your answer to the above question is no, how would you strike a balance? Will you bring down your financial goals by cutting off certain goals or would you try to increase your investable fund? If you decide to invest in different assets like shares, real estate, gold etc.. How much are you willing to allocate to each type of assets and why? Would you like your investments to be actively managed? That is, would you like to utilize the services of investments experts who would do their best to extract maximum gains for you using their expertise and experience? Are you willing to pay for their services? If youve decided to take the stock market route, would you adopt a growth investment strategy or a value investing strategy? Or would you try to strike a balance in between ? Whatever may be the style you adopt , would you prefer to invest in a mix large caps , mid caps and small caps or would you like to stick with one category? Finding answers to the above questions would reveal your preferred investment style. INVESTMENT ANALYSIS A Comparative analysis of your chosen mix of investments. This would help you to decide whether the mix is optimal to achieve your goals. At the base level it includes the analysis of your chosen investment asset equity, debentures, bonds, commodities, real estate etc.. Broader level analysis would include analysis of the economy and industry, qualitative and historical analysis. INVESTMENT VALUATION This is the most important part of investment. Valuation is the process of estimating what the assets is actually worth. Valuation can be done for all assets. It is an attempt to determine the reasonable price at which an asset can be bought so that it increases in value over a period of time. It is quite different from the market price which is what a willing and able buyer is prepared to pay. For example if a builder offers an apartment for 65 lakhs, would you blindly buy it without analysing the builders track record and the facilities offered? Wont you try to find out why he charges 65 lakhs for that apartment? Finally you would buy that apartment only if you find it attractive at that price. It is an individual decision after considering all the factors. The same process needs to be done in any form of investment whether its shares or mutual funds or commodities. You have to make sure that the asset you get is worth the money you spend. RIGHT MIX OF INVESTMENTS Putting all the eggs in one basket is not a good idea. There are some people who think that putting it all in one is better since they can concentrate on it and escape from the trouble of carrying multiple baskets at the same time. Thats a very wrong approach in investments and it needs to be corrected. For example if you put your money in real estate alone, should the real estate prices crash- as we saw 3 years back, youre locked up with no other options. Instead, if you had your money diversified in stocks, gold, real estate etc youd be better off since when your money goes down in some, you gain in another and thereby reduce the risk of losing all your money. Deciding the right mix is technically called portfolio and managing it to achieve maximum results- in terms of risk reduction, capital preservation and returns is called portfolio management. What is the risk involved in investing? by J Victor on July 31st, 2010
RISK. In simple terms, risk is the probability of loss. Your knowledge in investing is never complete until you learn about risk and its relation with returns. When we talk from the angle of an investor, risk is the combined effect of Probable Loss of money invested. The estimated loss of interest, should the money be invested in secured deposits. Inflation that reduces your moneys worth. When you invest, deviations can happen from the expected outcome. That deviation can be positive or negative. If deviation happens to the positive side, that would be considered as windfall gains. The negative part is called risk. Risk is part and parcel of every investment. Every type of investment involves risk of varying degrees, which can be very low in the case of government bonds to high as in the case of stocks. We talk from the angle of an investment, different invest assets have different degree of risk. For example government bonds are considered to be the least risky asset and logically, have the lowest potential return. Equities are considered to be highly risky and have the potential to gie you very high returns. RELATION BETWEEN RISK AND RETURN. The above example also brings to light the relation between risk and return. If you target for a high return, there is an equal possibility of a high loss. So, Higher the risk; higher the returns. What we mean to say is that risk and returns are directly related. RISK TOLERANCE CAPACITY Tolerance means easiness or acceptance. I simple words, its your capacity to sleep peacefully when the market is falling!! Risk tolerance capacity is our ability to accept or to live with a potential risk. Risk tolerance capacity would be different for different investors. It could also vary according to ones knowledge about investing, his emotional balance, his age and life stage , his sources of finance, marital status, number of dependents etc.. Your views about risk will keep changing with variations in these factors. So one point we would like to say here is that, before you invest in any asset, you should have a clear idea about The risk such an investment carries and Your risk bearing capacity ( which should match with the risk of the investment) For example You are interested to invest in stocks. After a self evaluation, you realise that you can afford to loose only 5% of your invested fund. Naturally, a proposal from your investment advisor to invest in a stock that may move 10% in either direction will not suit your preferences. Thats because, if risk works out, your loss would be 10% of the amount invested. Alternatively how about an investment call that has the possibility to give you 5% either way? You may accept. Because, if you gain, you get 5% but if you lose, you lose only 5% which is ok with you. CATEGORIES OF INVESTORS BASED ON RISK Now, depending upon how well youll adapt to risk, youll either be a conservative investor or a moderate investor or an aggressive investor. Conservative investors should not invest more than 20% of their money in high risk investments like stocks. Bonds and fixed deposits will be more comfortable for them. Aggressive investors can invest 90 or even 100% of their money in high risk investments like stocks. Moderate investors should try to strike a balance in between. Asset allocation and diversification becomes more relevant for moderate risk takers. Thats because, the risk averse would concentrate more on debt funds and hence they need not think about risk tolerance anyway. The aggressive would put major chunk of their money in stocks and have high capacity to tolerate risk. Hence, its the moderate risk takers who will be caught in the middle. For them , its necessary to create a balanced combination of high risk, moderate risk and low risk investments. THE REAL RISK. Sometimes, in order to achieve your financial goals, you may have to take a risk which may be higher or lower than your tolerance capacity. That risk which you should actually bear is called the real risk. For example you have just 4 years to invest but you are targeting a return of 200%. To achieve this you may have to take a risk that may be higher than your risk tolerance capacity. MATCHING YOUR RISK. Your risk tolerance capacity and the real risk should match in order to take effective investment decisions. This may be a confusing process. If you are not sure about how to do this, a financial advisor should be able to help you out. CONCLUSION. Investors jump head on to buy investment with great potential for returns without assessing their risk tolerance capacity and the real risk. Its easy for such investors to get burnt in the process. The rule is simple, and you have heard it many times before- The higher the returns, the greater the risk. The lower the risk, the lower the returns. We will take up the topic of optimum risk and allocating assets accordingly in a different chapter. Right now, at this beginning stage, its enough for you to understand that there are two types of risk one from the investors angle and the other from the investments angle. When should you start Investing? by J Victor on August 1st, 2010
No need for any calculations or discussion here. The simple answer to this question is As early as possible ! WHY? One- Delaying to plan for the future would mean investing more later to keep up with what youve missed Two- when you start early, it allows you to take more risks and aim high returns. Three- If you fail to plan NOW, you plan to fail LATER. Its always better to maximize savings in your early years. As you grow older, it would be difficult for you to commit more money due to responsibilities. Not having enough money may not be an issue when you start investing early. Even small sums put aside regularly can build a handsome corpus over a period thanks to the power of compounding. Heres a simple calculation- Suppose you want to have Rs 50 lakhs when you are 55. If at 25, you set apart Rs 3,500 every month (assuming a return of 8 percent), you would be on your way to achieving this goal. But if you were to put off this investing decision by 10 years, you would have to invest as much as Rs 8,500! Setting aside a higher sum when you have other commitments would be a tough task (in most cases effectively impossible). Maximizing saving in the initial years doesnt mean that you should live the life of a miser. You must spend money for pleasures- but in a self disciplined way. Investing from early on could give you regular, handsome sums at various stages of your life. It merely postpones your spending. Begin investing now, and you might have more money in your hand in your thirties, when you may want to spend on something substantial- For example, a new flat/villa for your family. The biggest advantage of investing early is that it allows you to take risks. What you thought would be a jackpot may turn out to be a crackpot. But, you can write it off to experience without too much agonizing. Later in your life such a loss could be expensive, and you would also have less time to rebuild your wealth and recoup your losses. Dont know how to find money to invest? Click here for a perfect tip. It works ! The world of investing is very interesting. Investments, if properly done, would help you earn more money than you thought. Would like to learn more? Youre at the right place. Our beginners lessons are for you. What should be the right mindset for investing? by J Victor on August 1st, 2010
WIN ALL THE WAY ? You cannot have a Heads I win , tails you lose- attitude when you start investing. Unfortunately, thats the attitude of many investors when they invest. They want to win all the time. Thats not a positive attitude to have. (Of course, nobody wants be on the losing side) Think about it. Is it possible to be on the winning side every time? in that case, who will lose ? to win all the time is an illogical thought. Realize that every time you invest, you will be investing in a group of assets. Some may prove to be good picks whereas some others may not perform at all. You may have a mix of rising and falling investments and hence, all probability, youll have an overall portfolio that may perform somewhere between the best and the worst. As you start investing, its important to have a positive outlook. Its natural for investors to look back and see missed opportunities that were knocking at them. A simple investing indecision may leave an investor wondering how his life would have been different if he had made the right choice. Thats how every investors life is its always understood backwards. However, its important not to curse yourself or think negatively. Golden misses are part of every investors life. Realise that Self-inflicted psychological damage is difficult to overcome. So, keep these simple thoughts in mind while you invest Make sure that you have done your home work well. When you invest your money, you should be clear about the objective- how much profit do you expect? How much time will you hold on to it? Why are you buying it do you have enough reasons to justify your actions? Most importantly, how much loss are you willing to tolerate? Always try to avoid pointless conversations about what could have been done. Dont look at the past and count the profits you lost because of a wrong decision you made. Realize that however badly you have done, it could have been worse. Instead of analyzing individual investments, evaluate your entire portfolio. You might have lost in one, but won the other. If you are invested for the long term there is no point in getting worried over the current value of your investments. Current value may be down due to various reasons. If you have been experiencing a streak of good luck, its better to slow down. Do not rely on your instincts or gut feeling or excellent luck every time. Cook your own recipe for achievement. Sure, a sound knowledge in every aspects of investing is required to produce a good result. You have to learn from others, use books and web based material a lot. But, make sure you are using the right resources. Investing is a tough and serious business. On the contrary never be too hard on yourself. Relax. Have fun. Keep your mind clear and concentrated. Having a positive mindset can give you immense results and at the same time, have fun while you earn your bucks. Always focus on the positive aspects of what you have done. Take investing like a sport where you win in some games and you lose in some other. But be sure to learn from both experiences-and never forget what you learned. What is Financial planning? by J Victor on August 1st, 2010
FINANCIAL PLANNING Financial planning is a broad term and investing is just a chapter in it. Financial planning is all about listing down all you sources of finance, assessing your financial needs for the future, assessing your appetite for risk and then charting a plan to achieve your dreams. It also involves planning for your childs future , your new home, planning for tax and retirement. So, its a very broad term and you might need an expert to draw it for you. FINANCIAL GOALS-LONG TERM VS SHORT TERM When you chart your financial goals for the future, it important to classify them into short term goals and long term goals. A short term goal is anything that needs to be done in , say , 5 years. For example buying a 3 BHK flat. Any financial goal like your sons higher studies or your daughters wedding which has ample time left to think and plan, can be said to be a long term goal WHATS THIS FUSS ABOUT? WE ARE AWARE OF ALL THIS. ..But still, the importance of financial planning needs to be emphasized in todays world. Today, the work pressure is so high that people want to opt for early retirement from their full time jobs, preferably in their mid 40s or early 50s. They have realized the importance of living their life to the fullest. Thanks to advancement in medial sciences, the average life expectancy has increased to 70 or 80 which means that a person who has retired at 50 has another 30 years to live, without depending anyone (Preferably!). Financially, this means that during you working life, you should create wealth enough to help you maintain the same standard of living after you retire and also take care of your medical expense which keeps going high as you get older. Planning for all this is definitely a difficult and disciplined task. Such a target is not easy to achieve and it requires meticulous planning and disciplined carry through. Thats why financial planning is so important. DO I NEED A FINANCIAL PLANNER? May be or may be not. That depends on who you are. A financial planner is a person who is an expert in his field. Its better if you can consult a financial planner because even though its possible that you are well versed in finance; youre still not a financial planner. A planner will be able to analyse of your current financial situation quickly and suggest recommendations that are right for you. There are also personal finance magazines and self-help books to help you do your own financial planning. At the end of the day the right amount of money should be at your disposal at the right time. Seek the services of a financial planner if: You find it difficult to analyse your risk profile. Most of us are not fully aware of where we stand in terms of risk. You dont have time to do your own financial planning. You want to take a professional opinion about the financial plan you have done. You think that you should improve your current financial situation but still dont know where to begin and how to implement those changes. FINANCIAL PLANNING ISNT JUST FOR THE RICH All right, anyway I dont have much money to invest. Whats there to plan? If youre thinking on these lines, youre wrong. People with limited income should definitely plan you finances at some point of time you need to get married, buy a home, raise children and look after your ageing parents. The rich will always manage all this even if they havent planned their finances properly. But if youre from a middle class background, you just cannot ignore financial panning. Basic financial planning is not so complicated. If you have loans first pay them off at the earliest. Loans will anyway carry a higher rate of interest. Be debt free. That definitely is the first step. Then , think about how much you can save. Start a recurring deposit. Accumulate small amounts fro your monthly income even if you have to live on a shoe string budget. Two years down the lane, youll find that youve done a good job accumulating some money. Once you have some cash, start a systematic investment plan. Take insurance policies. Buy gold when ever you can, even if it is a tiny piece. Youll be on your way Investing or gambling? by J Victor on August 1st, 2010
An investment is simply a gamble in which youve managed to tilt the odds in your favor. Peter lynch. INVESTING OR GAMBLING ? The first question before investing in any asset is Have you learnt the basics? Do you know the rules of valuation and decision making? Do you know the potential of that asset and the risk youre taking? If you have committed money to something which you dont know, realise that you are gambling. When you do a lot of research and put your money in assets that would make you rich after a long time, youre investing. Investing is a good thing to do. Thats a positive step. The odds to win are in your favor. On the other hand, when you gamble, youre putting your money in something which is considered to be a hot asset. It may give you gains. But, the risk you take is very high. In most cases, such assets would be in an overvalued state and you might end up buying at higher rates. In short, odds-to-win are not in your favor. Some other positive aspects of investing are that Its done with specific goals in mind for e.g.-buying a home. Its a continuous effort. You put in your money not once but several times after a lot of study and effort and wait for thing to be favorable to you. Its a long process and results are achieved after a lot of hard work and analysis. Its not by luck. Investors achieve their targets by taking risks, positively. They take risks in a very calculated way. As opposed to all this, gambling or speculation is not done with specific long term objectives. Money is put into any asset recklessly without analysis. They rely on luck and if they win they get what they desire-an instant gratification. This negative aspect of gambling can sometimes become addictive too. This is not to say that investing is not addictive. Surely it is. Warren buffet and our own Rakesh jhunjhunwala are definitely investment addicts. Getting addicted to something positive is a good thing. It has no side effects! But, gambling is definitely a problem to be rectified. It has many side effects. People lose millions, wealth of families has been wiped out, and many have ended their lives due to loss from gambling. I know many stock market players who jump into F& Os even without knowing what they really are or the dangers it can bring. A lot of so-called investors do not research meticulously and buy on tips or rumors, or based on some analysts price target. These guys can also be included in gamblers list. Similarly, investors who make investment decisions purely on the basis of emotions rather than being professional and sticking with their strategy, are to some extent gambling. ENTERTAINMENT OR SERIOUS BUSINESS? Internet has revolutionized the way we buy and sell stocks in the market. With internet, trading is done at the comfort of your home. However, such advancement has also made some section of people addicted to online trading as a form of entertainment. They just have fun playing in the market. While making friends from investing circle, make sure that your friends are serious investors! Or else, its not god for your investing future. Hope youre clear! Should you Borrow Money to Invest? by J Victor on August 1st, 2010
BORROWING TO BUY SHARES. You know that stocks have returned an average of 17 to 18%. So you borrow some money at 9% interest and invest that amount in stocks. Until you realize the profit, youll pay interest or EMI from your pocket.Anyway you look at it, its going to be profitable. How about that? If you are planning to do something like that youre at the right time reading this article. Calculations on paper may show that it is practical. But in real life, such strategies are extremely risky. We advice not to leverage (thats the financial term for using borrowed funds) your investments in any form. It not a good idea at all. There are three perils waiting for you when you leverage It multiplies your risk. Even when the value of your holdings go down, you have to pay your loan installments. The effective cost you pay is very high. There will not be any peace of mind. Guaranteed! HOW DO INVESTORS LEVERAGE? There are different ways:- Take a personal loan or pledge you home or property or gold. Borrowed funds from others like friends. The attraction here is that, it normally comes interest free. Using borrowing facilities at the brokerage firm. Short sell the stock. It is same as selling what you dont have. Hence effectively, you are borrowing shares from someone and selling it. Take the derivatives route ( futures and options) The first two options need not be explained .Its straight, simple and needless to say, totally dangerous. In the first case, If you could not pay back the money, your lose your home. In the second case, youll lose your friends and may also have a difficult time facing them. It might also put your friends in trouble. So stay away from such tactics. The other three points need some explanation. Brokerage firms allow you to borrow money from their account based on the current total holding you have in your demat account maintained with them. What they do is very simple. They will take pledge of all your share holdings and give you a loan which would be a percentage calculated on the market value of the holdings. In case you couldnt pay back the money to the broker, they will immediately sell off those shares in the market and realise the amount. At the time of signing the agreement itself, such clauses are already built into the agreement. The interest charged for this kind of temporary funds is also very high and its calculated on a day to day basis. You can adopt this way of leverage when you do it for a very temporary purpose. For example you were eyeing a particular stock and that stock is now at the price where you want to enter. You have money in your bank, but youre travelling and not in a position to transfer it now. You can use money from your broker and pay it back in two days. Another way to leverage is short selling. When you short sell a stock, you are selling stocks which you do not own. What you are effectively doing is, you borrow shares (instead of money) from the brokerage firm and when the price falls, will buy it gain and give it back to the broker. Short selling is a dangerous method to make money. What will you do if your calculations go wrong? You will have to pay more money and buy back the shares from the market and return it to your broker. Through derivatives, you leverage in a different way. For a small sum (called margin money / premium) you can take big positions in the markets. Its like playing a Rs 100,000 game with just Rs 10,000 in hand. The risk in such cases is very high. It has the potential to wipe off all your money. Derivatives are the favorites of speculators, although these instruments are basically meant for managing risk. In short, if you ask us whether you should borrow funds, our suggestion is: No, if youre just a beginner or amateur. No, if you dont have any other sources of income to suddenly raise funds if calculations go out of control. No, if you do not have an alternate plan to pay off these debts. Yes, if you can get some funds totally interest free for a long period of time Yes, if you are a very seasoned investor and you know with some certainty how the markets will move. Yes, if you want to utilize a sudden surprise opportunity. Yes, if you have fully understood the risk and the financial destruction it can bring, but still, youre the daredevil type ready to face anything. BORROWING TO BUY OTHER ASSETS. if you can get loan funds at a lower rate of interest (NRIs can get it , say at 4%) you can bring that funds to India and invest here in debt funds or NCDs that give as high as 13% per annum in return or they buy gold or just put it in fixed deposit with banks. Anyway , thats not going to be a loss. One factor that needs to be considered while buying assets with borrowed funds is that the loan to asset value should be preferably be kept at around 60%. That is, to buy an asset worth 10 lakhs, it good to borrow up to 6 lakhs and pay the balance in cash. And remember, cars and electronic gadgets are not assets hence, relying on loans to buy such things Involves great loss.Such loans carry high rate of interest and these items depreciate heavily with time. CONCLUSION. Investing with borrowed funds is not recommended, except in very special circumstances. It is a very risky and aggressive strategy and should be used with a lot of caution. Thumb rules to build wealth by J Victor on August 1st, 2010
Building wealth is a topic thats searched by millions of people. Thumb rules to build wealth tries to summarize all the concepts that were discussed earlier, in a different format. TWO STEPS Basically, The entire process of building wealth boils down to just two steps: The first step is to control your expenses according to your income and make a surplus out of it. It demands a lot of financial discipline to achieve this step. Many financial principles that would help you to save money were discussed in our first sessions. The second step would be to find assets that have the potential to grown in value and invest your money in it.Thats it. The first step is completely under your control and no one can help you out. You have to work hard, get a job , make a steady income and save some money for yourself. The earlier you start saving, the better it is. Once you start earning, its natural for anyone to think about availing loans to realise their dreams for example a big car. The bad news is that, more debts prevent you from saving more at the initial years. All successful investors have accumulated more money in their initial years. Early investing has many advantages as we have already explained in one of our previous posts. Hence, the second step is to gain some basic financial knowledge. You are supposed to know some basic rules and concepts like inflation, compounding, opportunity cost, a bit of taxation and accounting. Learning the basic money magic will dramatically alter your view about finances and investing The third step investing, is the one where you will have to consider a lot of things. Youll have to draw up a plan, list out your financial goals, assess your risk profile, seek the help of experts for valuation of different assets, assess the pros and cons of each type of asset and finally choose the best investment style and vehicle. In this, drawing a plan and listing out your financial goals with some accuracy is the initial step. Clear cut and realistic financial goals have to be drawn. The most important factor that would help you to bring in realism into your plans would be your level of savings. You cant draw up big plans if you expect to save only little. Once you have drawn you plans, you can look for avenues to invest. Here, the best lesson you can get is from Warren Buffet, one of the richest stock investor. He never invested in businesses which he couldnt understand. His advice is simple If you dont know the business model, what the company does on a day to day basis, or how it generates revenue now, and in the future, then its better to stay away from it. This principle can be applied to all types of investing. You have to make sure that you understand the basics. This advice assumes significance because; investors have a tendency to follow what the crowd is doing. If a particular stock is doing well at the bourses, investors jump in and put money without bothering to analyse what business the company is into. In short, you have to be through with the basics. Diversification is the next area to be addressed. Diversification of money into different asset classes is required since you cannot predict the movement of asset prices and you cannot say which asset would perform best in a year. So, must have some money in all possible asset types. Thats what diversification is all about. When you have a mix of assets in your kitty, what you have is a portfolio. Your portfolio will have to be periodically checked, reviewed and rebalanced since the value of assets with you will keep changing from time to time. For example- you have a portfolio in which 60% of the funds are in large caps and balance in mid caps. That year, if the equities go up by 30% and the mid caps fall by 2%, it will imbalance your portfolio and to make it back to that 60:40 levels, you will have to sell large caps that went up and buy mid caps that came down. All the principles put together, you should be able to make a good return from your money. The thumb rules are: Rule 1. Make money Rule 2. Learn the basics of investments Rule 3. Identify the assets to invest. Rule 4. Diversify Rule 5. Review your portfolio. Lessons in computing returns I Percentages by J Victor on August 1st, 2010
Hi there, Most of the financial calculations are expressed in percentages. Not only profits, there are many other places where this knowledge can be very useful. Lets catch up with it: PERCENTAGE POINTS A percentage point = 1% Example You go to a bank to open a fixed deposit account. The bank says, interest rates have gone up from 8% to 10%. How much is the increase? Is it a 2% rise? The answer is No. An 8% to 10% rise is 25% rise in interest rates. This is how we calculate it: 10 / 8 = 1.25 1.25 * 100 = 125% or 25 % increase in interest rates. Another way to ay it correctly is you can say that the interest rates have increased by 2 percentage points. In financial markets, Instead of percentage points, the term used is basis points. 1 basis point is equal to 1 / 100 th of a percentage point. 1 basis point = 1/ 100 th of a percentage point So, 100 basis points = 1 percentage points. Next time , when the Reserve bank revises the interest rate by 25 basis points , understand that what the bank means Is that it has revised the interest rates by 0.25% Here are some questions for you to try out- 1. A bank is offering a 30% increase in the interest rates on fixed deposit. The old rate is 6%. What is the new rate? 2. You see an advertisement in paper saying that loan rates have slashed from 12% to 10%. What is the actual drop in loan rates? 3. The RBI increases rates by 25 basis points. If the old interest rate was 6%, what is the new rate? 4. A bank cuts interest rates by 125 basis points for the 2 rd consecutive month. If the interest is 8 % now, what was the interest 2 months back? 5. The fixed deposit interest rate has gone up from 8% to 10%. What is the rate of increase in percentage and in percentage points? Answers: 1. The old rate is 6%. The increase is 30%. So, the increase in rate is 6* 30% = 1.8%. The new rate would be 7.8% 2. The loan rates have been slashed fro 12 % to 10%. The decrease in rate is 2 percentage points or 200 basis points or 16.66% 3. The new interest rate would be 6.25% 4. The present interest rate is 8%. So, last month the interest rate was 9.25% therefore, 2 months back, the interest rate was 10.50%. 5. Increase in terms of percentage points = 2 and increase in terms of percentage is 25% Lessons in computing returns II Simple returns by J Victor on August 1st, 2010
SIMPLE RETURNS: Simple returns are used for evaluating short term returns. BASICS FIRST: The formula for computing simple returns is Simple Return = FV / P - 1 Where, FV is the amount received on maturity date and P is the amount invested Example 1 You deposit Rs 10,000 in a bank for a year and gets Rs 11000 in return. The simple return would be 11,000 / 10,000 1 = 0.1 or 10% Example 2 You purchased 200 shares of ABC Company at 50 per share. You paid Rs 300 as commission to your broker. On a later date, you sell the stock for Rs 75 and pay a commission of Rs 450 to the broker. What is the simple return on investment? Total cost of the share = number of shares x rate + commission paid = Rs 10,300 Sale proceeds = number of shares x rate commission paid =Rs 14550 So, the simple return will be as follows: 14550 / 10300 -1 1.41 1 = .41 or 41% Example 3 You purchased 200 shares of DEF Company at 50 per share. You paid Rs 300 as commission to your broker. On a later date the company declares dividend of Rs 2 per share. You sell the stock for Rs 75 and pay a commission of Rs 450 to the broker. What is the simple return on investment? The simple return will be as follows: Total cost = 10,300 Total returns = 14,550 + 400 = 14, 950 Simple returns would be 14950 / 10,300 1 1.45 1 = 0.45 or 45% Thats about simple returns. Remember, simple returns are useful only for short term investments. Till my next post .. Have a nice day !! Lessons in computing returns III Compounded returns. by J Victor on August 1st, 2010
Hi there, Lets catch up with compound interest in this article.. BASICS FIRST. The formula for compound return is as follows:
FV = P ( 1+ r) n
Where FV is the future value P is the money invested r is the rate of return n is the number of years for which the amount is deposited. Situation1. You invest Rs 50,000 today and it grows to Rs 100,000 in five years. The five-year return is 100 per cent; but what is its annual return? To calculate this, you need the formula on compound interest. Using Rs 50,000 as principal, Rs 100,000 as future value and five as the number of years, lets find out the annual rate. FV = P (1+r) n
Therefore, r = (FV/P) 1/n 1 Here, the first step is to calculate 1/n = 1/5 = 0.20 Now, r = (50000/ 100000 ) .2
0 -1 r = 2 .20 -1 2 .20 = 1.1487 1.1487- 1 = 0.1487 Therefore r as a percentage would be (0.1487 * 100 ) = 14.87 % This 14.87 per cent is the compound return, and is the only relevant return when you analyze an investment. If you divide the 100 percent by the number of years, you get the answer as 20%.This is the simple return. The 100 per cent is referred to as holding period return. The holding period return keep on changing with the period of holding. That brings us to the first moral of computing long term return. compounded returns is the best measure for long term return. You can also use the rule 72 discussed elsewhere and arrive at the approximate rate of return since in this question, the investment has doubled in 5 years. Situation 2. Suppose you want to make an estimate of future rate of return of a stock. One way of doing so, is to look at the past rate of return as an indicator of the future. Heres how the return is computed in this case. Consider a stock, A Ltd, whose return during each of the last five years has been 10 per cent, 20 per cent, 15 per cent, minus 30 per cent and 20 per cent per annum. Hence its simple average is 7 per cent per annum. Consider another stock, B Ltd, whose return during the last five years has been 10 per cent, 15 per cent, 20 per cent, 10 per cent and minus 20 per cent. Its simple average return too is 7 per cent per annum. So should we say that they are identical performers? Surprisingly, the answer is No. Heres why. If the stock price of A Ltd began at Rs 100, it would have grown to Rs 110 ( 100 * 110%) in the first year Rs 132 (110 * 120% ) in the second year Rs 151.80 ( 132 * 115% ) in the third year Rs 106.26 (151.80 * 70%) in the forth year (the company grew at -30%) Rs 127.51 (106.26 * 120%) in the final year. Rs 100 growing to Rs 127.51 is a compounded rate (CARG) of 4.98 per cent using the compound interest rate formula. Similarly Y Ltd, which began at Rs 100 at the beginning of the first year, would have sequentially grown to Rs 110, Rs 126.5, Rs 151.8, Rs 166.98 and Rs 133.54 at the end of each of the five years. Rs 100 growing to Rs 133.58 is a compounded rate of 5.96 per cent. See the difference in the compounded rate. Yet the simple average of the growth rate was same. Clearly, Rs 100 growing to Rs 127.51 is not the same as Rs 100 growing to Rs 133.58. So, compounded annual growth is considered the right measure of return; The simple average is used for purposes of year on year measurement or short term measurement of returns. Till my next post . have a nice day !! Lessons in computing returns IV Returns from shares. by J Victor on August 1st, 2010
Hi there, In the case of shares, there are two types of returns you expect Dividends Capital appreciation How would you compute returns in such cases? lets discuss with two examples. Example 1 You invest in 1000 shares of AB Ltd for Rs 100,000 a year back. At the year end, the shares are quoted at Rs 150 and the company also pays you a dividend of Rs 2 per share. That is, you get Rs 2000 as dividend, and at the same time, you investment is now Rs 150,000. You sell the share. How would you compute your overall return from this investment? The gain you made is as follows Appreciation in market price Rs 50 Dividend received Rs 2 Total gain Rs 52 Return = Rs 52 / Rs 100 = 52% Example 2 You invest in 1000 shares of AB Ltd for Rs 100,000. You hold on to it for 3 years. The dividends paid during these 3 years are follows- Rs 2, Rs 2.50 and Rs 3. The market prices at the end of each year are Rs 90, Rs 95 and Rs 110. How would you compute your yearly return from this investment? The cost per share at the point of investment was Rs 100 Fist year return would be fall in market price Rs 10, dividend paid Rs 2 Therefore, net loss = Rs 8 Return = -8 / 100 * 100 = loss of 8% Second year The cost of share at the end of first year = Rs 90 Year end price = Rs 95 , dividend paid = Rs 2.50 Therefore , net gain = Rs 7.50 ( 95-90 + 2.50) Return = 7.50 / 90 * 100 = 8.33% Third year The cost of share at the end of second year = Rs 95 Year end price = Rs 110 , dividend paid = Rs 3 Therefore , net gain = Rs 18 ( Rs 110-95 + 3) Return = Rs 18/ 95 * 100 = 18.94% Overall return from investment would be = (-8%) + 8.33% + 18.94% = 19.27% So, while computing yearly returns from investment, you should consider capital appreciation or depreciation (although its notional) and also the dividends received. Bye for now, Have a nice day !! Lessons in computing returns V The Rule of 72 by J Victor on August 1st, 2010
Hi , So we were playing some games with percentages in the last few posts. In this article, let me introduce a short cut an approximately 500 year old formulae to help you in your calculations- Rule 72. For those who love math and accountancy, the rule 72 may not be new. Luca Pacioli (1445 1514) , in his book summa de arithematica discusses the rule when he talks about the estimation of the doubling time of an investment. However, its not Pacioli who invented this rule. RULE 72 The rule is very simple Divide 72 by the Interest Rate. What do you get? You get the number of years it would take for your investment to Double. Practical, very simple. The Rule of 72 is not absolutely precise, but it gives you a practical estimate that you can work out in your head. Example 1. You go into a bank that offers 9.50% annual interest on your FD. How many years will it take for your capital to double? Its Simple- Divide 72 by 9.50. Roughly 7 and half years. Example 2. At what rate should you invest to double your money in 5 years? Divide 72 / 5 . The answer is 14.40%. so if you can manage to get 14.40% return on your investment, your money doubles in 5 years. Example 3. The rate of interest you pay for your credit cards is 24%. Your credit card liability is Rs 25,000. What happens if you keep paying your minimum due for 3 years? In 3 years (72/24), you end up paying Rs 25,000 as interest alone. Youll still have the Rs 25,000 liability remaining. Example 4 You read from papers that the countrys GDP grows at 7% a year. How long would it take the economy to double its growth? The answer is (72/7) 10 and 3 months approximately. Example 5. The inflation rates are at 9%. What the effect of it on your money? Your money will lose half its value in 8 years ( 72/9) Example 6 At 8% interest your money would double in (72/8) 9 years. If you decide to remain invested for 27 years, a small deposit of Rs 50,000 would become Rs 400,000! Not only in years, can you apply this rule in any time frame. So thats Rule 72. Nice little mathematical formula that helps you to take financial decisions. The rule is not perfect and it does not account for taxes. Till my next post .. ..Have a nice day!
Lessons in computing returns VI Rule 114 and Rule 144 by J Victor on August 1st, 2010
Rule 72 was amazing. Isnt it? Just as I finished writing that article, my wife (Being a micro- biologist, she doesnt have much questions to ask about finance but she reads through my articles before I publish) came up and asked a question. You wrote about calculating the time it would take an investment to double. I would like to know how long it would take for my money to triple. Do you have an easy method for calculating that? Of course, yes. Not only that, you can also find out the time it would take to quadruple your investment Enter rule 114 and Rule 144.
RULE 114-HOW LONG TO TRIPLE YOUR INVESTMENT
To find out how long it will take to triple your investment at x% interest rate, take 114/x. So, it will take 114/12 (or 9.5 years) to triple your money at 12% interest rate. Want to triple your money in 6 years? You will have to generate an annual return of 114/6 (or 19 %!)
RULE 144 HOW LONG TO QUADRUPLE YOUR INVESTMENT
To find out how long it will take to quadruple your investment at x% interest rate, take 144/x. So, it will take 144/12 (or 12 years) to quadruple your money at 12% interest rate. Again, If you want your investment to quadruple in 6 years, you will have to generate an annual return of 144/6 (or 24 %!). I would like to repeat what I said in my previous article. The above rules are not 100% accurate. However, it gives you a reasonable estimate of time required to triple or quadruple your investment at a particular rate of return. I hope this article was interesting! It will greatly help you with your financial decisions. For example, if calculations show that 20% is necessary to accomplish your goal and the risk- free interest rate is 8%, you have some choices to make. First, if you insist on the risk-free rate then you must extend the time period you are willing to wait for that money. On the other hand, if you cannot extend the time, youll have to accept a little more risk. Till my next post . ..Have a nice day! Lessons in computing returns VII Break even return by J Victor on August 1st, 2010
Hi there, In economics and finance, theres a concept called break even point. Break even point is that point at which you make no profit or no loss. This concept is also applicable while targeting returns on investments. We will call it the break even rate of return. That is, the minimum rate of return that your investment should generate in order to maintain a no profit-no loss situation. How to find out the break even target? The only two factors that eats into your returns are Inflation and Taxes. Inflation, as explained in previous articles, reduces your purchasing power and taxes reduce your disposable income. In other words, your investment should generate a minimum return that will cover the inflation and income tax. So, the key is in finding out the rate of both these factors and generating a return thats equal to it so that you are position is safe No profit No loss. To do this The first step is to find the inflation rate in your country. Inflation rates are published in almost all financial newspapers and web sites. The second step is to find the income tax rate of the particular investment. In India, only incomes like long term capital gains are taxed at special rates. The rest falls into the general slab system. So find out the slab rate or the special rate youd be taxed. Apply the following formula I / 100 R Where I = The rate of inflation ( you can also take the average rate of inflation) R= the effective personal income tax rate on investments For example If the current rate of inflation is 7% per annum and your effective tax rate is 30% , your required return from investments to break even would be 7 / 100-30 = 7/70 = 0.10 0r 10% This means that your investments should earn a minimum of 10% return just to break even and maintain the purchasing power of your money. If you earn less than 10% you are losing money. Thats about break even point. See you soon. bye for now !! Investing vs Trading vs Speculation by J Victor on August 1st, 2010
Hi there, In this article, i would like to talk about the difference between three terms investing, Trading and Speculation. INVESTING Investing is the proactive use of money to make more money or, to say it another way, you make your money work for you. When you invest, you are buying an asset like shares, real estate or gold. The basic idea is to sell it at a future date when the value of these assets appreciates. An asset can include anything from a small business to fine art, rare wines to gold coins, stocks, mutual funds, bonds, real estate, antiques, song rights, patents, trademarks, or other intellectual property. Good investments are the soundest way of growing wealthy but can take time, perhaps even years, to work out because we live in an uncertain world. Depending on the asset class in which you invest, the potential for profits and risk will also differ. Investors adopt a Buy and Hold approach. TRADING Trading is a more short term activity than investing. Its buying something at low prices and selling it for a gain. Trading can be done in many fields. So the crucial factor that distinguishes a trade from an investment is the length of time you hold on to the assets. A trader is always concerned about short-term fluctuations in prices, because hell even out them in the long run. Traders adopt a Buy & sell approach. Short term price fluctuations are caused by the variations in the demand and supply of a particular asset. So, traders generally rely on Technical Analysis, a form of marketing analysis that attempts to predict short-term price fluctuations using graphs, charts and oscillators. SPECULATION A speculator is nothing but a man who makes his living out of hope. I dont think I should explain it in more detail. Benjamin Graham the author of classic books Security Analysis and The Intelligent Investor is regarded as the father of financial analysis. Grahams key insight is the premise that investment is most successful when it is most businesslike. An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative-(Benjamin Graham, security analysis,1951) Now, at this point of time, It is unnecessary to start a complex discussion about investing, trading and saving. What is important is to understand that investing; trading and speculation are three different things. Since we are discussing about shares and stocks for trading or investment, our next chapter discusses about shares and stock markets in detail.. Till my next article . ..have a nice day !! 5 steps to become a smart investor by J Victor on August 2nd, 2010
INVESTING in can probably be more rewarding than you can imagine and certainly very exciting! World over the wealthiest people are those who have invested wisely. If you are scared to take the plunge, these are the 5 steps you should be following.
STEP 1. UNDERSTAND HOW THE WHOLE PROCESS WORKS
How did you learn to read ? you started off with A-B-C. First you learned capital letters, then came the smaller ones and finally those running letters. At the end ,you have your own distinguished style of writing and reading . Follow the same logic here. For investing in anything, the first step is to Learn the basics.
STEP 2. LEARN HOW TO CHOOSE
It is important to know how to go about selecting an investment at the right price-be it shares or gold or real estate. A little bit of research, some theoretical and practical knowledge will ensure that things seldom go wrong.
STEP3. DECIDE HOW MUCH TO INVEST
You should not throw all your savings at one particular investment because, any investment would carry certain amount of risk. So the answer to the question how much to invest would depend on your risk profile. ( i.e. your risk tolerance capacity )
STEP4.MONITOR AND REVIEW
Monitoring your investments regularly is recommended. This is more important during volatile times when there can be great opportunities for buying and averaging your cost of investment..
STEP5. LEARN FROM YOUR MISTAKES
Investing is a long, learning experience. You will make mistakes, but also learn from them .When reviewing, do identify and learn from your mistakes. Nothing beats first-hand experience. These experiences will help you emerge as a smart investor. Stick to these basics and sail smoothly into your financial bright future.
Shares & Stock Markets Some truths about stock markets by J Victor on August 2nd, 2010
Hi there, From this post onwards, I am going to kick off the discussion on shares as an option to create wealth. Let me start by saying 7 straight truths about stock markets. First, nobody gets rich quickly in stock markets. Some of your friends might have blindly invested in some stocks which, to their luck, gave them exceptional profits. Yet, they never became rich. Did they? So thats the first truth about stock markets its not a place where you get rich quickly.It takes time to grow your money. Second, it isnt easy for beginners to make money on the stock exchange. If it was such a simple exercise, Mr. Warren buffet wouldnt have become so famous. It takes genuine effort to spot profitable investments. Third, your broker, friends, neighbor, colleagues et al would come up with sure shots everyday; there are too many stock analysts out there giving out fee based stock recommendations. Its easy to get tempted by all these people around you. After many years in the market, my thoughts keep wavering when somebody comes up with such sure shots. Should I explain the fate of a beginner? Its important to stay off from these temptations. It implies that you ought to have independent thought. Independent thought is something very hard to carry through. Fourth, most of the investors are a bit too casual with stock markets. They play in stock markets. Stock exchange is a wrong place to have fun, speculate and try luck. The Stock market is actually a place dominated by big investment houses and financial experts. This is a place where the worlds brightest finance professionals put their best efforts to make right investment decisions. Nobody is playing around. So, to be successful, you too, need to be serious. You have to view it as a business. When you buy shares, you are buying a company to that extent. Buying a company is no Fun! Fifth, realise the fact that brokers income is the commissions you give. The more you trade, the more they get. When I was serving as the manager of a broker, I used to get monthly targets for the volume of brokerage that should be generated. If I dont do that, my salary payment gets delayed. Each branch was viewed as a profit center. Myself and my colleagues used to hit our targets but our investors rarely did! Most of the brokerage houses encourage their clients to do as many trades as possible whether its good for them or not, and keep doing it until you have used up all their money. If you get too many frequent Sure shot market tips thru sms, mails and phone calls think twice. Your broker may be interested only in generating commissions. Make sure you dont get into such traps. Do have faith in your broker, but dont blindly follow them. They can give you advice but they cant guarantee that you will make a return on any investment in the stock market. Sixth, as you begin to study the principles, youll hear about derivative instruments like futures and options. Instruments like options and futures are NOT for beginners with limited resources. They are highly technical, involve the potential to lose all of your investment quickly and need constant monitoring. Playing Futures and options without adequate working knowledge is like gambling at Las Vegas. Finally, you have to keep on working on your stock picking skills. Keep following the market developments. Youll also need to study some basics on economics, accountancy, income tax and mathematics. So, #No quick riches in stock markets #its not the place to have fun with money #you shouldnt be blindly believing your brokers recommendations #never try your luck # and, learning is the only way -to make right choices in stock markets. So, lets begin from the roots. My next post would explain what shares are. Before you take the plunge, think about whats said above. To succeed in stocks, youll have to put maximum efforts to learn the game and be serious with investments. May God help you to achieve your goals. Stocks-explained by J Victor on August 2nd, 2010
INTRODUCTION The first step for anyone who aspires to invest in stocks , is to understand stocks ! The words stocks and shares mean the same thing. Share means a portion of anything. In our context, share means a portion of ownership of a company.Now,it would be better to discuss this concept with the help of an example. This will help you to get a clear idea of what a share is. Lets try to explain that with the story of a company called Say-it-with-flowers. SCENE 1- The beginning A group of girls decides to start a business. Since they knew floral decorations, they decide to start a flower shop. They name their business as Say-it-with-flowers. For initial expenses, they borrowed some money from the local bank and opens their shop in a small space. The business was successful. However, they made little profit because; all the earnings were invested back into business since the customers were increasing and they had to meet the growing demand for their floral decorations. SCENE 2- A decade after. Ten years later, the bank loan has been paid off. Profits are over Rs 10 lakhs per year. It also has a book value of Rs 50 lakhs. (Book value is the net value of what the company owns- machinery, furniture, building less any loans). Having made their business a success, the girls now wants to expand their business. Their idea is to open two more branches at neighboring towns. After a detailed study, they find out that its going to cost over Rs 52 Lakhs to open two outlets. To find this 52 lakhs, they had two options- one, take out a loan from the bank. Two, sell part of their company. Since interest rates are high, they decide to take the second route. But how? What would be the cost of a share in say-it-with-flowers? Who will do the valuation? There were several questions to be answered. SCENE 3-The big leap To sell part of their company, the company has to be valued. The person who values a company is called an underwriter. So they approach an underwriter who checks their past records, future prospects, background of the promoters etc, The underwriter decides that the company is worth 10 times its current profits. The current profits is 10 lakhs. So 10 times 10 lakhs is 1 crore. This one crore is actually an estimate based on various qualitative factors. Add book value to it, and you arrive at Rs 1crore and 50 Lakhs. This means, Say-it-with-flowers is worth Rs 150 lakhs. 40% of 150 is 60 lakhs. So, the girls decide to sell 40% of their company.A group of investors who were willing to buy the 40% shares in that company gives a check for Rs 60 lakhs. The girls still have control over the operations of the company since they still have 60% share. SCENE 4- The benefit Now, For the girls, 40% stake is lost but they get 60 lakhs in cash. They have the money to expand their business.As planned, they opened two new outlets for Rs 52 lakhs.The balance 8 lakhs is used for day to day operations of the three shops. Both the new stores hit a profit of 10 lakhs a year. That means the total profit of the company Say-it-with-flowers is now Rs 30 lakhs. ( 10 lakhs x 3 shops ). The value of the business is now Rs. 450 lakhs (3 shops x 10 lakhs x 10 times + 50 lakhs x 3) and the couples 60% stake is worth Rs 270 lakhs.(450 x 60%) SCENE 5 At the stock market. Since the investors who bought 40% of the share for 60 lakhs, is now worth 180 lakhs, the shares of say-it-with-flowers is in great demand. Since the company increased the wealth of shareholders 3 times, there are investors who are willing to purchase the shares even for an amount higher than 180 lakhs. Each day, shares of say-it-with-flowers are sold to the highest bidder. The place at which the bidding and buying process takes place is called the stock market. SCENE 6 You as an investor.. Lets assume that the total shares of the company are 50,000 shares. So, 40% available to the public is 20,000 shares. The issue price was Rs 300 (60 lakhs/20000) but, now the share is worth Rs 900(180 lakhs / 20000). Since a section of the public feels that this winning streak of the company would continue, there is heavy demand for the share and due to this, the price keeps moving up. Suppose the price is Rs 1250 now. Should you buy? The answer is no. Why? Because, the shares are trading above the real value of Rs 900. This real value is also called intrinsic value. Price drops to Rs 750. Should you buy? Now, one day, due to some rumors, the stock market crashes, and consequent to that, the price of the share plummets to Rs 750 per share. Should you buy? May be, yes! Why? Because, now the share price is below the real value and some time later , you can expect the rumors to settle and that will result in the prices moving back to its original level of Rs 1250 or more. Where should you sell? Although the price may move back to Rs 1250, your selling point theoretically should be at Rs 900 . Why? Because thats the actual value point. The price rise above Rs 900 may be due to several reasons like investor sentiment which should be ignored. CONCLUSION. The good investors job is to identify companies like say-it-with-flowers that are selling below their true worth due to some illogical reason and invest in such stocks. Hope Weve made it clear. Basic charcteristics of shares by J Victor on August 2nd, 2010
SHARES OR STOCKS? Thats right. The first step is to clarify that point. Shares and stocks mean the same thing. Shares are collectively called stocks. So if your friend says that he owns stocks, what he means to say is that he has bought shares in many companies. But if he says he owns shares, hes being specific there. What he means to say is that he has bought shares of a particular company. CHARACTERISTICS OF SHARES Shares have these following distinctive characteristics: Ownership rights. When you buy a share, you are buying a piece of that company you become its part owner. That ownership gives you certain rights, including voting on important matters of the company and participating in the profits. High profit potential. When you buy stocks, you become the owner to that extent and when the company makes more and more profits and expands, the demand for its shares will also rise. As a result, the share prices also move up. As an owner, you already have rights in its profits. Now, as the demand for the shares goes up, a second benefit in the form from of appreciation in capital invested opens up. For example: Many of the early employees of Infosys are millionaires because their stock has gone up dramatically. Risk However what if the company dint make profits as expected? There wont be much demand for its shares nor it will carry a high rate of profit share. Hence, along with the potential for extraordinary gain comes the potential for high loss. These two go hand in hand. If you are not careful in choosing a company, you can lose money by investing in stocks. Not only in stocks, in fact, have even the safest savings deposits carried unseen risks. When you account for inflation and taxes, youll find that most of the so called risk free investments are not so safe. Source of Income We have already explained that. Since share holders are part owners of the company, they are entitled to get a part of the annual profits of the company. Shareholders get income by way of dividends and bonus shares. KNOW IT Shares and stocks mean the same thing. Shares are collectively called stocks. Shares give you right to ownership, voting, decision making and profits in a company. Investment in shares can be risky if recklessly done. Share investments have the potential to make you millionaires. It gives you income in the form of dividends and bonuses. Should you invest or trade in stocks? by J Victor on August 2nd, 2010
THATS AN ENTIRELY PERSONAL QUESTION ! Should you invest or trade in stocks? The answer to this question is entirely personal and it would depend on lot of factors. However, we will not recommend trading to anyone. In our opinion, shares should be considered as a long term investment. The reason why we dont recommend trading is that, in our experience, most of the traders ( especially beginners) feel that its quite easy to buy at lows and sell at highs. But, its not so. Trading is a highly technical activity. Newbies tend to underestimate the difficulties of day trading and overestimate their ability as a beginner. 90% of them lose money and get out of the markets in the first 2 years.It would be better to study the fundamentals and try to invest ( at least for a short term) rather than doing day trading. However, Its your money and the decision is yours. What we can do is, well list out some suggestions based on which you can take a decision whether to trade or invest or do both. 1. People who cannot monitor the market regularly should not get into share trading. Share trading requires constant monitoring of price, volume, trend etc.. Most of us may not have the tools to analyze all these factors on a real time basis. 2. Young guns out there who cannot actively take part in share markets should start investing small amounts in shares. The idea is to accumulate small amounts of shares that will eventually grow into millions. Young investors can also consider trading in shares for short term profits to build up their capital initially. 3. Those who are planning to be active in share markets should allocate their available funds into two categories- one part for investing and the other part for trading. 4. If you are nearing retirement and havent started saving, heavily investing in the stock market is probably not a good idea. However, if you have enough funds to meet your financial requirements for next five years, you may enter into stock markets. 5. Markets are always risky in the short term. Hence trading involves more risk than investing. Markets will keep moving up and down and its easy to get emotionally disturbed when you keep watching those price fluctuations. 6. Investing, if done right, would result in huge results in the way of capital appreciation, dividends, bonus shares, rights issue etc. trading does not have such advantages. Trading results depends on the price movements and how well you time the market. 7. Short term profits or trading profits are taxable income in India. Where as profits from long term investments are tax free. 8. Trading tends to become more speculative as you try to make profits from every price movement. Some of these price movements may be due to rumors or manipulations and its easy to get trapped in such situations. When you invest, you take a lot of time to study the fundamentals and about whats happening around. Hence its highly ulikely that you get into such traps. CONCLUSION To trade or to invest in stock markets would depend on ones age, nature of income and attitude. In any case, you should go by the fundamentals supported by the technical factors. Technical analysis and fundamental analysis are seen by many as polar opposites but many market participants have experienced great success by combining the two. Having both the fundamentals and technicals on your side would only have advantages. We will be discussing in detail about fundamental analysis and technical analysis later on. Benefits of owning shares by J Victor on August 2nd, 2010
What are the benefits if you own shares? There are many other benefits as we have explained in the following paragraphs: EARN DIVIDENDS. Dividends are nothing but a part of companys profits distributed to its share holders. The companys management may declare dividends either in between a financial year (called interim dividends) or at the end of the financial year (called final dividends).However, it is not mandatory for the companies to pay dividends. It can use the profits for alternative uses like expansion. The decision to pay or not to pay dividends is taken at the annual meeting by the majority voting of the shareholders. Blue-chip companies (large companies) generally are consistent dividend payers. CAPITAL APPRECIATION. As the company expands and grows, it acquires more assets and makes more profit. As a result, the value of its business increases. This, in turn, drives up the value of the stock. So when you sell, you will receive a premium over what you paid. This is known as capital gain and this is the main reason why people invest in stocks. They aim capital appreciation. RECEIVE BONUS SHARES For the time being, let us understand that bonus shares are Free shares are given to you .Later on we will discuss about bonus shares in detail. RIGHTS ISSUE A company may require more funds to expand its business and for that, it may need more funds. I such cases, the company can issue further shares to the public. However, before approaching the public, the existing shareholders will be given a chance to subscribe to more shares if they want. Thats called a rights issue. This is done in order to ensure that the existing shareholders maintain the same degree of control in the company. Thus you can maintain the participation in the company profits. SHARES CAN BE PLEDGED Shares are considered as assets and hence, banks accept shares as security for raising loans. Should there be an an emergency, shares can quickly pledged to raise funds. Apart from that, Brokerage firms allow you to borrow money from their account based on the current share holding you have in your demat account maintained with them. If you want to utilize a sudden surprise opportunity in markets, but if you dont have the cash right now, you can adopt this route. HIGH LIQUIDITY Shares are highly liquid. It can be converted into cash in no time. With online trading, all it takes is the click of button to sell you holdings. You can receive your cash in two days. CAPITAL APPRECIATION OR DIVIDENDS? The above mentioned income sources may not be present in every company you buy. For example- if youre buying company that has a huge potential to grow, it may not pay its surplus as dividends. Instead, it will be used for further growth. In such cases, huge capital appreciation may happen. So depending upon your investment strategy, youll have to choose what you want. Its always wise to go for capital appreciation rather than dividends. Stock markets in india by J Victor on August 2nd, 2010
THE HISTORY OF BOMBAY STOCK EXCHANGE The Bombay stock exchange traces its history back to the 1850s, when 4 Gujarati and 1 Parsi stock broker would gather under a banyan tree in front of mumbais Town hall.The location of these meetings changed many times, as the number of brokers constantly increased.The group eventually moved to Dalal Street in 1874 and in 1875 became an official organization known as The Native Share stock Brokers association. THE PRESENT SCENARIO There are 19 recognized stock exchanges in India. The Bombay stock exchange (popularly known as The BSE ) and The National stock exchange (popularly known as The NSE ) are the most prominent in terms of volume and popularity. The Bombay Stock Exchange Popularly called The BSE is the oldest stock exchange in Asia and has the third largest number of listed companies in the world, with 4900 listed as of Feb 2010. It is located at Dalal Street , Mumbai , India . National Stock Exchange comes second to BSE in terms of popularity. Over the decades, the stock market in the country has passed through good and bad periods. Till the decade of eighties, there was no measure or scale that could precisely measure the various ups and downs in the Indian stock market. BSE, in 1986, came out with a Stock Index-SENSEX- (SENSitive indEX) that subsequently became the barometer of the Indian stock market. WHAT IS A STOCK MARKET INDEX? Stock market indexes provide a consolidated view of how the market is performing. Stock indexes are updated constantly throughout the trading day to provide instant information. TheSENSEXandotherindexes The BSE SENSEX (SENSitive indEX)is a basket of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely followed by investors who are interested in Indian stock markets. During market hours, prices of the index scrip, at which trades are executed, are automatically used by the trading computer to calculate the SENSEX every 15 seconds and continuously updated on all trading workstations connected to the BSE trading computer in real time 30 stocks that represent SENSEX.(Updated on 7/7/2010) ACC Ltd. Bharat Heavy Electricals Ltd. Bharti Airtel Ltd. Cipla Ltd. DLF Ltd. Jindal Steel & Power Ltd. HDFC HDFC Bank Ltd. Hero Honda Motors Ltd. Hindalco Industries Ltd. Hindustan Unilever Ltd. ICICI Bank Ltd. Infosys Technologies Ltd. ITC Ltd. Jaiprakash Associates Ltd. Larsen & Toubro Limited Mahindra & Mahindra Ltd. Maruti Suzuki India Ltd. NTPC Ltd. ONGC Ltd. Reliance Communications Limited Reliance Industries Ltd. Reliance Infrastructure Ltd. State Bank of India Sterlite Industries (India) Ltd. Tata Consultancy Services Limited Tata Motors Ltd. Tata Power Company Ltd. Tata Steel Ltd. Wipro Ltd. The BSE Sensex is not the only stock market index in India. The NSE has The NSE S&P CNX Nifty 50 index a well diversified 50 stock index accounting for 24 sectors of the economy. While both SENSEX and NIFTY would give you an overall direction of the stock market there are other indices which track a particular sector. For example The NSE CNX IT Sector Index tracks companies that have more than 50% of their turnover (or revenues) from IT related activities like software development, hardware manufacture, vending, support and maintenance. So for those who are tracking the performance of IT Sector this index would become a benchmark for investing. Yet another example is the BSE BANKEX index which tracks the banking sector shares. WHATS GOOD ABOUT INDEXES Indexes provide useful information including: Trends and changes in investing patterns. Snapshots, even if they are out of focus. Yardstick for comparison. KNOW IT A stock market index is a statistical indicator which gives an idea about how the stock market is performing. In India the main indexes to be tracked are The BSE SENSEX and The NSE NIFTY. The SENSEX comprises of 30 companies representing different sectors and the broader NIFTY comprises of 50 companies from 24 sectors. There are many other indexes that track particular sectors of the economy. These indexes would give you an idea about how that particular sector is performing. World over, there are a number of indexes as there are stock markets. DOW JONES INDUSTRIAL AVERAGE and NASDAQ COMPOSITE INDEX both track US stock markets. NIKKEI 225 is the stock market index of Japan, HANG SENG index for Hong Kong, FTSE 100 For UK, KOSPI for Korea, SHANGHAI for China etc. All these indexes serve the same purpose. It gives an idea about where the financial growth of a country is headed to. Next time you watch CNBC or NDTV Profit, watch these indexes flashing on the corner of your screen. What is a stock index? by J Victor on August 2nd, 2010
STOCK INDEX. The stock index function as an indicator of the general economic scenario of a country / region / sector. If the stock market indices are growing, it indicates that the overall general economy of the country is stable and that the investors have faith in the growth story of the economy. If, however, there is a plunge in the stock market index over a period of time , it indicates that the economy of the country is in troubled waters. Ita also an indication of what the corporates in that country are facing. A stock index is created by selecting a group of high performing stocks . For example The FTSE 100 ( the stock index of London stock exchange) is constructed from the top 100 companies trading in the London stock exchange. If the FTSE 100 records a jump over a period of time, it indicates that most of the top 100 companies in England are doing well at that point of time and that the investors are positive about putting their money in England. TYPES OF INDICES There are different types of indices and FTSE 100 was just an example. Stock indices can be constructed - For the entire world ( global indices) For an entire continent ( regional indices for example S&P Latin america 40) For an entire country ( national indices for example Sensex & Nifty for India ) For a particular sector in a country ( sectoral indices for example BSE BANKEX which tracks top banking companies in India) For any other theme / group of economy / companies you want to track. ( example Dow Jones Islamic world market index) The MSCI global and the S & P Global 100 are examples of world stock indices which tracks the largest companies in the world irrespective of their country of origin . The MSCI global id an index with over 6000 stocks included from different parts of the developed world. It specifically excludes companies from emerging economies. When stock indices are constructed to track the performance of the economy of a country ( like Sensex in India), it called a national index. Irrespective of the type of index, the purpose of any index is the same. It provides to the public, a quick view of how the economy ( based on which the index is constructed) is functioning. A sudden slide in indices denotes that the investors have lost faith . There could be several reasons for that like poor economic reforms , high inflation, high borrowing costs, amendments in laws that not well received by the business community, downgrades by world credit rating agencies, scams , corruption .. the list is end less. These indices also serve as benchmarks for measuring performance of fund managers or for measuring the performance of an individuals stock portfolio. CONSTRUCTION OF STOCK INDEX A stock index can be calculated in two ways - By considering the price of the component stocks alone. This method is called the price- weighted method. By considering the market value or size of the company called the capitalization weighted method. To conclude, stock indices are barometers to measure general economic performance of an particular country / sector. Its updated every second throughout on every trading so as to reflect the exact picture of the economy. Its also a permanent record of the history of markets its highs and lows, booms and crashes. BSE stock classifications by J Victor on August 2nd, 2010
SIX HEADERS- A, B, T, S, TS and Z Hi there , Do you know that he BSE classifies stocks under six headers? The Bombay Stock Exchange classifies stocks under six grades A, B, T, S, TS and Z that scores stocks on the basis of their size, liquidity and exchange compliance and, in some cases, also the speculative interest in them. You can look up any stocks grade in the Stock Reach page in the BSE Web site, under the head Group. Alternately, you can also follow the link below: http://www.bseindia.com/about/list_comp.asp A GROUP HIGHLY LIQUID These are the most liquid counters among the whole lot of stocks listed in the BSE. These are companies which are rated excellent in all aspects. Volumes are high and trades are settled under the normal rolling settlement (i.e. to say intraday buy-sell deals are netted out). These are best fit for a novice investors portfolio considering that information about them is extensively available. For instance, all the 30 stocks in Sensex are A grade stocks. T GROUP TRADE TO TRADE The stocks that fall under the trade-to-trade settlement system of the exchange come under this category. Each trade here is seen as a separate transaction and theres no netting-out of trades as in the normal rolling system. The trader needs to pay to take delivery for his/her buys and deliver shares for his/her sells, both on the second day following the trade day (T+2). For example, assume you bought 100 shares ofT grade scrip and sold another 100 of it on the same day. Then, for the shares you have bought, you would have to pay the exchange in two days. As for the other bunch that you sold, you should deliver the shares by T+2 days, for the exchange to deliver it to the one who bought it. Failure to produce delivery shares against the sale made would be considered as short sales. The exchange will, in that case, on the T+3rd day, debit an amount that is 20 per cent higher than the scrips closing price that day. This means unless the scrips price falls more than 20 per cent from the price of your sale transaction, you would have to pay a penalty for the short sale so made. Even so, there will be no credit made to you in the case of substantial fall in the share price. The exchange will, instead, credit the gain to its investor fund. Stocks are regularly moved in and out of trade-to-trade settlement depending on the speculative interest that governs them. S GROUP SMALL AND MEDIUM These are shares that fall under the BSEs Indonext segment. The BSE Indonext comprises small and medium companies that are listed in the regional stock exchanges (RSE). S grade companies are small and typically ones with turnover of Rs 5 Crore and tangible assets of Rs 3 Crore. Some also have low free-float capital with the promoter holding as high as 75 per cent. Besides their smaller size, the other risk that comes with investing in them is low liquidity. Owing to lower volumes, these stocks may also see frenzied price movements. TS GROUP A MIX OF T AND S GROUPS Stocks under this category are but the S grade stocks that are settled on a trade-to-trade basis owing to surveillance requirements. This essentially means that these counters may not come with an easy exit option, as liquidity will be low and intraday netting of buy-sell trades isnt allowed either. Z GROUP CAUTION Z grade stocks are companies that have not complied with the exchanges listing requirements or ones that have failed to redress investor complaints. This grade also includes stocks of companies that have dematerialisation arrangement with only one of the two depositories, CDSL and NSDL. These stocks may perhaps be the riskiest in terms of various grades accorded. For one, not much information would be available in the public domain on these companies, making it tough to track them. Second, the low media coverage that keeps them relatively hidden from public scrutiny also makes them more vulnerable to insider trading. Third, these companies already have a poor score in redressing investor complaints. B GROUP LEFT BEHIND This category comprises stocks that dont fall in any of the other groups. These counters see normal volumes and are settled under the rolling system. In all respects these stocks resemble their counterparts in A but for their size. Typically, stocks of mid- and small market capitalisation come under this grade. SLB GROUP Securities Exchange Board of India, in 2007, has announced the introduction of Securities Lending & Borrowing Scheme (SLBS). Securities Lending & Borrowing provides a platform for borrowing of securities to enable settlement of securities sold short. There are 207 companies in the SLB list. Investors can sell a stock which he/she does not own at the time of trade. All classes of investors, viz., retail and institutional investors, are permitted to short sell. OTHER CLASSIFICATIONS The F Group represents the Fixed Income Securities. Trading in Government Securities by the retail investors is done under the G group. Thats about stock classifications in BSE. When you invest, be aware of the category in which the stock falls. have a nice day !! What is Sensex? How is it calculated? by J Victor on August 2nd, 2010
SENSEX The SENSEX-(or SENSitve indEX) was introduced by the Bombay stock exchange on January 1 1986. It is one of the prominent stock market indexes in India. The Sensex is designed to reflect the overall market sentiments. It comprises of 30 stocks. These are large, well-established and financially sound companies from main sectors. METHOD ADOPTED FOR SENSEX CACULATION The method adopted for calculating Sensex is the market capitalisation weighted method in which weights are assigned according to the size of the company. Larger the size, higher the weightage. The base year of Sensex is 1978-79 and the base index value is set to 100 for that period. WHY IS THE BASE VALUE SET TO 100 POINTS? The total value of shares in the market at the time of index construction is assumed to be 100 in terms of points. This is for the purpose of ease of calculation and to logically represent the change in terms of percentage. So, next day, if the market capitalization moves up 10%, the index also moves 10% to 110. HOW ARE THE STOCKS SELECTED? The stocks are selected based on a lot of qualitative and quantitative criterias. You can view the listing criteria here. HOW IS THE INDEX CONSTRUCTED? The construction technique of index is quite easy to understand if we assume that there is only one stock in the market. In that case, the base value is set to 100 and lets assume that the stock is currently trading at 200. Tomorrow the price hits 260 (30% increase in price) so, the index will move from 100 to 130 to indicate that 30% growth. Now lets assume that on day 3, the stock finishes at 208. Thats a 20% fall from 260. So, to indicate that fall, the Sensex will be corrected from 130 to 104(20%fall). As our second step to understand the index calculation, let us try to extend the same logic to two stocks A and B. A is trading at 200 and lets assume that the second stock B is trading at 150. Since the Sensex follows the market capitalization weighted method, we have to find the market capitalization (or size of the company- in terms of price) of the two companies and proportionate weightage will have to be given in the calculation. How do we compute size of the company- in terms of price? Thats simple. Just multiply the total number of shares of the company by the market price. This figure is technically called market capitalization. Back to our example- We assume that company A has 100,000 shares outstanding and B has 200,000 shares outstanding. Hence, the total market capitalization is (200 x 100000 + 150 x 200000) Rs 500 lakhs. This will be equivalent to 100 points. Lets assume that tomorrow, the price of A hits 260 (30% increase in price) and the price of B hits 135. (10% drop in price). The market capitalization will have to be reworked. It would be 260 x 100,000 + 135 x 200,000 = 530 lakhs. That means, due to the changes in price, the market capitalization has moved from 500 lakhs to 530 indicating a 6% increase. Hence, the index would move from 100 to 106 to indicate the net effect. This logic is extended to many selected stocks and this calculation process is done every minute and thats how the index moves! CALCULATION OF SENSEX. What we said was the general method to construct indices. Since, the Sensex consists of 30 large companies and since its shares may be held by the government or promoters etc, for the purpose of calculating market capitalization only the free float market value is considered, instead of the total number of shares. What is free float? Thats the total number of shares available for the public to trade in the market. It excludes shares held by promoters, governments or trusts, FDIs etc.. To find the free float market value, the total value of the company (total shares x market price) is further multiplied by a free float market value factor, which is nothing but the percentage of free float shares of a particular company. So logically, the company which has more public holding will have the highest free float factor in the Sensex. This equalizes everything. Example- lets assume that the market value of a company is Rs 100,000 Crore and it has 100 Crore shares having a value of Rs 1,000 each but only 20% of it are available to the public for trade. The free float factor would be 20/100 or 0.20 and the free float market value would be .20 x 100,000 = 20,000 Crores. You need not calculate the free float market capitalization since its available straight on the BSE website Click this link to get it. NOW, LETS SE HOW THE SENSEX MOVES. Sensex value = Current free-float market value of constituents stocks/Index Divisor So, the numerator is available straight from the BSE site. Its the total of free float factors of 30 stocks x market capitalization. NOW, THE DENOMINATOR. The index divisor nothing but the present level of index. So, now, we have all the figures. Lets assume that the free-float market capitalisation is Rs 10,00,000 Crore. At that point, the Sensex is at 12500. What would be the value of Sensex if the free-float market capitalization is Rs 11,50,000 Crore?
(Those who cant find the answer may go back to the ratios and proportions chapter elsewhere in school text book) ..The answer is 14,375. What is nifty? How is it calculated? by J Victor on August 2nd, 2010
NIFTY In the last post, we discussed what Sensex is and how it is calculated. Just like the Sensex which was introduced by the Bombay stock exchange, Nifty is a major stock index in India introduced by the National stock exchange. NIFTY was coined fro the two words National and FIFTY. The word fifty is used because; the index consists of 50 actively traded stocks from various sectors. So the nifty index is a bit broader than the Sensex which is constructed using 30 actively traded stocks in the BSE. The methodology for calculating the Sensex was given in our earlier post. Nifty is calculated using the same methodology adopted by the BSE in calculating the Sensex but with three differences. They are: The base year is taken as 1995 The base value is set to 1000 Nifty is calculated on 50 stocks actively traded in the NSE 50 top stocks are selected from 24 sectors. The selection criteria for the 50 stocks are also similar to the methodology adopted by the Bombay stock exchange. LATEST LIST OF NIFTY STOCKS If you want the list of 50 stocks that have been included in the nifty, heres the direct link. Do stock indices tell the right story? by J Victor on August 2nd, 2010
Stock market indices, as we have explained earlier, gives you a snapshot of how the economy is going forward.Its just a snapshot. If you look at the total number of companies listed in the BSE, it is above 6500. The Sensex however, tracks only 30 of the most liquid stocks based on their selection criteria. Thats approximately 0.45% of the total companies listed. Similarly NIFTY tracks only 50 of the most liquid stocks based on NSEs stock selection criteria. So, the market index represents only a very small section of the stocks and these 30 or 50 companies unfortunately may not be a correct representation of the market. There are many niche sectors that are not represented in the index. The first eight companies in the Sensex have a weightage of more than 50% in the index. If these eight companies move in one direction, the index would be in green, even if all others dont perform. So if the index rises, it is not necessary that your investment would also rise. However, if you are holding shares in the exact ratio of an index (that is, if you have mimicked the index with a smaller amount) following the index may make sense. Hence, stock indices are unimportant to an ordinary investor. Whats important is to pick stocks that are fundamentally good. Fundamentally good stocks perform well in any situations. There are many stocks which steadily rise, unnoticed by many, when the market index is going no where. If you need a barometer to check the pulse of the market, there are some broader indices such as BSE 200 and BSE 500, which represents 200 and 500 companies respectively. These indices should be better than the Sensex and the nifty since, a lot companies from many wide sectors are included. If you want to track a particular sector, like banking or technology, Sectoral indices are available from the BSE and NSE. This too, works well. USES OF AN INDEX. Indexes are however, used a proxy for investor confidence in equity markets. Investors, who are not good in analysing fundamentals, but wants to put their money in the best companies around can track changes in the indices and take decisions. Those who feel that they cannot beat the index can invest in Index based mutual funds, which actually track the performance of the index and allocates money in the same ratio as the index. It is a good option for those who wants keep their money growing exactly like the index. Indices can be used to measure and compare the performance of individual stock portfolios. Last but not least, they can be used to check how the market reacted to specific events like terrorist attacks or earth quakes and that will help you to forecast how the market would behave , should such a disaster happen again. Bulls, Bears and Stags by J Victor on August 3rd, 2010
Hi there, Lets catch up with Bulls and bears. The two most commonly used terms in stock markets. A common story is that the terms Bull market and Bear market are derived from the way those animals attack. Bulls are supposed to be aggressive and attacking while bears would wait for the prey to come down. Another story is that long back, bear trappers would first trade in the market and fix a price for bear skins, which they actually dint own. Once the price is fixed , they would go hunting for bear skins. So eventually even if the prices go down, they will still be able to sell if for a high price. This term eventually was used to describe short sellers and speculators who sell what they do not own and buy it when the price comes down and makes money in the process. However, it was Thomas Mortimer,in his book called Every Man His Own Broker (1775) who first officially used the terms Bulls and bears to describe investors according to their behavior. BULL MARKETS When can you say its a bull market? When the prices of stocks moves up rapidly cracking previous highs , you may assume that its a bull market.If there are many bullish days in a row you can consider that as a bull market run. Technically a bull market is a rise in value of the market by at least 20%. BEAR MARKETS A bear market is the opposite of a bull market. When the prices of stocks moves crashes rapidly cracking previous lows , you may assume that its a bear market. Generally markets must fall by more than 20% to confirm that it a bear market. STAGS This is another category of market participant. The stags are not interested in a bull run or a bear run. Their aim is to buy and sell the shares in very short intervals and make a profit from the fluctuation. Its a daily tussle for stags in the stock market. MARKET TIMING The basic idea behind stock market investment is simple- Buy low, sell high and make money. So to make money, you buy stocks in a bear market when stock prices are low and sell stocks in a bull market when stock prices are high. However, knowing the exact time when a bear market would start or when a bull market run would come is not possible. Just when you thought the markets would go up, it may surprise you by trading low. Your strategy should be to pick up shares in the bear market and sell it when theres a bull market run. HERES THE CRUX.. Technically a bull market is a rise in value of the market by at least 20%.Anything less than 20% would be considered as a minor rally. A market launches into a bull phase when sentiment turns buoyant, which is usually because of a series of positive developments that beat expectations Reverse is also true. A 20% or more fall in value is considered as a bear market. Anything less than 20% would be considered as a correction. Bear markets occur when news flow tends to be worse than expectations, causing investors to sharply punish stocks or sectors. This has happened in the US where more bad news on the sub- prime front and US economy data has stifled even the briefest of market recoveries. To confirm a bear market, this weakness should persist for at least two months. In bear markets, liquidity is extremely tight, volumes tend to be low and market breadth tends to be poor Some experts believe that for emerging markets such as India, which tend to be more volatile, the correction needs to be steeper at 30-35 per cent. In every bear market, there tends to be bear market rallies or a bear market pullback, where the market rises 10-15 per cent only to decline yet again. The bounce-back usually occurs when some stocks or sectors are oversold, to borrow a term used by technical analysts. Worst bear market conditions are followed by great bounce backs. That covers Bulls, bears and stags. There is an old saying which would further give authenticity to our bear story- Never sell a bear skin unless you have one. How much money should you invest in stock markets? by J Victor on August 3rd, 2010
People often end up investing majority of their savings into stock markets, especially if they get a handsome profit on their first trade itself.They also commit more money to recoup all the loses they made earlier. Both these situations are dangerous. More than 80% of the retail investors in India have this problem of committing more. In the first case, they do it because they are excited about making more money quickly and in the second case they do it out of despair to somehow recoup the losses and get out of the market. Ask any broker whom you know personally he will have a list of hundreds of clients who came in opened de-mat accounts and vanished in a years time. HOW MUCH ? IS THERE A FORMULA? So what we are trying to give you is a set of two tips that would help you have control over your money invested in stock markets: First of all never try the daily money making process in stock markets. I know quite few of them who has tried playing in stock markets to make a daily income-and lost all their money. Secondly, There is a limit to which you should expose your money in stock markets. Theres no hard and fast rule as to how much should be exposed. However to help you out, heres a formula which gives you a rough calculation about how much money should go into stocks based on your age. It is: 90 (minus) YOUR AGE = % of income to be exposed In stock markets. So, if you are 35 years old , you can expose a maximum of 50% of your income into stocks. Ok. Fine. so does that mean you can expose 15% of your income at 75? May be not. Investments in stock markets ideally should be stopped at the age of 65 or 70 maximum. Again , as I said earlier , investing is entirely personal. If you have the money, health and will to invest at 70 or even at 90 , Go ahead ! ! Sir Warren Buffet is 81 years old now, and he hasnt stopped investing ! Clearly, when you are young , you can afford to take more risk and hence, you should be investing in stocks rather than debt funds. when you grow older, the proportion of money invested in stocks should be brought down and the the debt or fixed income potion in your investments should be increased. What drives the stock market ? by J Victor on August 3rd, 2010
WHAT DRIVES THE STOCK MARKETS? Basically, investors respond positively to good news from the government and corporate world and would stay back from the market when they face negative news. From the governments side, they would expect relaxed monetary polices and interest rates that would enable companies to expand, grow and do business. They would also expect the laws and regulations to be corporate friendly. From the corporates side, investors expect better results and profitability. Over the long term, the growth of the business and profitability is the concern of all investors. Since the current stock prices are nothing but the present value of expected future earnings, we can say that, in the long term, earnings drive stock prices. WHY EARNINGS? Investors buy stocks to get to sell it off at higher prices. Stocks will rise in price only if it is in great demand. Demand for a stock rises only if the investors feel that the company has the potential to grow and would increase earnings every year. The stock market is a discounting mechanism where its not the current earnings but, the ability of a company to generate earnings in the future keeps driving it. The present has already been discounted by the market 6 or 12 months ago. So, if investors expect a good season in the future, the stock prices will respond by an increase in price now. Should they expect the reverse, the stock price would tumble. This is a continuing process in the markets and will be so in the future. So if you ask us which is the best time to buy stocks, our answer is its when the earnings are declining and when the economy is in recession. OTHER FACTORS. Earnings are not the only factor that drives markets. Other factors that drive stock markets include sentiments, valuation, interest rates, inflation and the economic policies in general. In this, Sentiments has more to do with investors psychology. Sentiments represent a collective view of all the participants at a give point of time. The moment theres a change in stock prices, common investors would assume that its going to continue for a long time and would react accordingly. For example if the stock market responds with a 50 point slide due to increase in interest rates, investors negative sentiments may kick off a series of downfalls since, they would keep selling their positions expecting further damage. VALUATION Investors will be attracted to the option which appears cheap in valuation. Valuation can be relative valuation or absolute valuation. By relative valuation we mean comparing the stock market to other form of investments like gold or real estate. By absolute valuation we mean, valuating the stock itself with its past price and present and expected performance. MONETARY POLICIES AND INTEREST RATES If the interest rates are increased, it affects the borrowing costs of companies and hence, high borrowing cost would bring the earnings down and it will also prompt the companies to post pone their expansion plans. Changes in interest rates will also affect the rate at which future earnings are discounted by the market. Fixed income earning instruments like fixed deposits become more attractive at high interest rates and that would impact the markets negatively. Investors would move their money from the markets and will park it in fixed instruments since the rate is high. One major cause of high interest rates is inflation. As inflation in a country increases, the government will be forced to keep the interest rates high in order to restrict the money flow into the economy. As we said earlier, higher interest rates are not good for the stock markets. When the interest rates are low, fixed income instruments are no longer attractive and this would induce investors to enter stock markets. So the interplay of all these factors keeps driving the stock markets. What are Blue-chip shares? by J Victor on August 5th, 2010
BLUE CHIPS Blue-chips is one word that youd be hearing a lot of times once you start following the stock markets. So this post is about blue chips or bellwethers as it is sometimes called. Blue chip stocks are large companies whose shares are considered to be relatively safe than normal shares. It gains that status from its past record of being a high growth, high dividend paying company. These companies would be leaders in its field. For example-Infosys technologies is described by Medias as an IT bellwether. It reflects the investors confidence in that companys capacity to maintain its status as the leader of the pack and its past record of excellent management and of giving good returns to its share holders. The term blue-chip is coined from a game called poker where the chip with the highest value is blue in color. In stock markets, the term is used to describe the stock that has highest quality in terms of investor confidence. There is no hard and fast rule to find out which a blue chip company is and which one is not. A blue-chip typically would have stable earnings and dividend history, a strong asset position, high credit rating and an excellent record of being a leader in its field. These are huge companies in terms of market capitalization and revenues. All the 30 stocks in Sensex index can be considered as blue-chip companies. You can also see the Dow Jones list of Indian blue chips at http://www.bluechiplist.com/indices/dow-jones-india-titans-30/ ARE THESE SHARES SAFE FOREVER? No. These shares may be assumed to be relatively safer than others, provided, the positive factors that drive the company remain intact. Just like any other company, a blue chip company can also run into financial troubles and become dead one day. No one can guarantee you that a blue-chip will remain like that in future also. May be, some of the future blue chips are hidden in mid caps right now. If you have managed to spot them right now, you have a chance to become a millioner soon. SHOULD YOU INVEST IN BLUE-CHIPS? Of course, Yes! You must have some portion of your investments in Blue-chips. They bring the required solidity in your portfolio, since they do not fluctuate heavily like mid caps or small caps. Investing in blue chip also requires lot money because; typically these shares will cost more. Hence, there is a necessity to valuate it meticulously. Invest for a long term or short term? by J Victor on December 10th, 2010
Imagine the thrill when the stock you just invested in, zooms! What an easy way to make money! Are not good returns over a short period very tempting? Your next move: Identify other stocks that have this potential. From now on, all your energy will be directed towards making that quick buck, daily. You will find yourself taking tips from every trader, reading every available material on the subject, spending hours studying charts and sighing at every small fall in the indices. Yet, with all the time and energy spent on it, you may end up burning your fingers. This is a reality that every newbie has faced, I am sure.Not only newbies- I have seen most of the investors trying the same. If you have decided to invest money in stock markets, its always better to remain invested for a long term. Heres why: BENEFITS OF LONG TERM INVESTING Short term investments may have the potential to give you quick bucks, but long term investment has several significant advantages. Advantage #1:Compounding: Time can be investors best friend because it gives compounding time to work its magic. Compounding is the mathematical process where interest on your money in turn earns interest and is added to your principal. Advantage #2: Dividends: Holding a stock to take advantage of payouts from dividends is another way to increase the value of an investment. Some companies offer the ability to reinvest dividends with additional share purchases thereby increasing the overall value of your investment. Consistent dividend payout is a reflection of a companys overall business strategy and success. Advantage #3: Reduction Of The Impact Of Price Fluctuations: When you invest for a long term, your investments are less affected by short term volatility. The market tends to address all factors that keep changing in the short term. So a person involved in long term investment will not be affected as much by short term instability due to factors such as liquidity, fancy of a particular sector or stock which may make the price of a stock over or undervalued. In the long term, good stocks which may have been affected due to some other factors (in the short term) will give better than average returns. Long-term investors can ride out down markets without dramatically affecting his or her ability to reach their goals. Advantage #4:Making Corrections: It is highly likely that you could achieve a constant return over a long period. The reality is that there will be times when your investments earn less and other times when you make a lot of money in short term. There may also be times when you lose money in short term but as you are in quality stocks and have long perspective of investment you will earn good returns over a period of time. There are always times when some stocks do not perform and it is the wise choice to pull out of an investment. With a long term perspective based on quality stocks, it is easier to make decisions to change in a more timely manner without the urgency that accompanies short term and day trading strategies chasing volatile changes. Advantage #5: Less Time Spent Monitoring Stocks: day trading requires constant monitoring of stocks throughout the day to capitalize on intraday volatility. But, Long term trading can be carried out effectively using a weekly monitoring system. This approach is most often far less stressful than watching prices constantly on a daily basis. Moreover, long term investment strategy helps you to concentrate more on your job/profession. Advantage #6: Tax Effect: In India, short term capital gains (The profit you make by buying shares and selling it off anytime within a year) is taxable at 15% and there are no exemptions to it. Long term capital gains (The profit you make by buying shares and selling it off after a year) are totally tax free Advantage #7:Oppurtunity to average down: Suppose you invest in a blue chip like reliance at Rs.1000 and for some reason the stock falls unexpectedly to Rs 850. That gives you an opportunity to buy more shares and bring the average cost down. This can bring dramatic increase in profits in the long term. Advantage #8: Opportunity to make huge returns: Long term investments, if done after careful study of fundamentals, would give opportunity to create huge wealth over a period of time.Investors like Warren Buffet has followed this strategy to create wealth. Overall, investors that begin early and stay in the market have a much better chance of riding out the bad times and capitalizing on the periods when the market is rising. When you invest for a short term, you miss out all these advantages. Ethical Stock Investing by J Victor on January 2nd, 2011
ETHICAL INVESTING Ethical investing or socially responsible investing is also known as sustainable, socially conscious investing an investment strategy which seeks to maximize both financial return and social good. Some investors feel that there are no standards which can be created for ethical investing since each individual has their own set of values and morals. If no standards are created, however, then even the most harmful investments can be called ethical by some. Anyone who tries to invest responsibly faces the ethical investment dilemma. This dilemma really revolves around two simple questions. They are: What is or is not ethical? andWho decides? Fortunately, there are several basic values that most people share: Avoid Causing Illness, Disease & Death Avoid Destroying or Damaging the Environment Avoid Treating Honest People with Disrespect etc.. So, arms makers, polluters, tobacco companies, pesticides manufacturers, companies with poor management record such as Enron and satyam, oil companies are some examples of businesses which are generally excluded. In 2010, the OIC announced the initiation of a stock index that complies with Islamic laws ban on alcohol, tobacco and gambling. The Dow Jones Islamic Market World Index is another example. Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern. Critics of such initiatives argue that many firms satisfy mechanical ethical criteria, e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming seal of approval of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so market transparency and disclosure are the only long- term-effective paths to fair markets. ETHICAL INVESTING ENTERS INDIA There is growing market demand for Socially Responsible Investment (SRI) and more investors are willing to invest over the longer term in the organisations that contribute positively to sustainable development, public benefit and environmental protection.ABN Amro launched Indias first SRI fund (called ABN Amro Sustainable Development Fund). Global index provider Dow Jones indexes and Dharma Investments, a private investment company, in Jan, 2008 announced the launch of Dow Jones Dharma index for measuring the performance of companies selected according to the value systems and principles of Dharmic religions, especially Hinduism and Buddhism. This index has been put together by Wallstreet. Stocks will be screened on industry, environmental and corporate governance parameters before being included in the Dharma indexes. The index constituents would be reviewed on a quarterly basis. CONCLUSION Ethical investing depends on an investors views; some may choose to eliminate certain industries entirely or to over-allocate to industries that meet the individuals ethical guidelines. A good way to start with an ethical investing policy is to write down the areas you want to avoid as well as where you want to see your money invested. From there you can come up with an asset allocation plan and begin researching individual securities. Indirect way to invest in stocks Mutual funds. by J Victor on January 7th, 2011
What is it? The term itself gives some hint about its nature. Mutual means combined and Funds means money. So, mutual funds are the collective investment contributed by many investors and managed by professional individual or company (your fund manager). The fund manager invests this combined money in stocks, bonds, short-term money market instruments, and/or other securities Whats the advantage? You do not have to constantly keep an aye on the stock market. The fund manager will invest the funds wisely and in profitable companies. The funds are invested in various companies and that too by the professionals. So, you are not keeping all your money in one pocket. This minimizes the risk of huge loss investment loss. Even your Rs 5000 invested is diversified. You can plan and invest systematically. (That can be done in share markets to, but SIP process in mutual funds works well) Unlike companies, mutual funds will not close down. Rather they would be merged into another successful fund Normally the NAVs do not show a significant rise or crash Any Disadvantages? You dont have a say in deciding where your money is invested. The fund manager decides for you and he may be wrong, thus causing a loss You dont own shares directly, so you are not eligible for any rights due to the owner. Dividend is optional and if chosen will affect the value of your investment by the amount of dividend declared Scheme philosophy Whenever a mutual fund scheme is launched there is a specific mandate (philosophy of investing) based on which investing is done by that mutual fund. This mandate outlines the debt- equity mix and the type of instruments that the fund would invest.For example, the prospectus of a mutual fund will always mention the stock universe that fund invests in viz, large cap, mid cap, small cap, sector funds etc.. or it will have a theme for example energy opportunities fund or emerging leaders fund etc.. From the name itself,you could get a basic idea of where your money will be invested. Since Mutual funds offer a whole bouquet of products , you must first decide on the types of funds that would suit your needs. Only then should you start selecting the best funds within those categories.
NAV and its importance. Net Asset Value, or NAV, is the sum total of the market value of all the shares held in the portfolio including cash, less the liabilities, divided by the total number of units outstanding. Thus, NAV of a mutual fund unit is nothing but the book value. The NAV of the fund has no impact on the returns it will deliver in the future. For example Lets assume you plan to invest in an index fund and you have two choices - Fund A is a new fund with an NAV of Rs. 10, which will mimic the Nifty and a Fund B, which is an existing Nifty index fund with an NAV of Rs. 200. Suppose you invest Rs. 10,000 in Fund A and Rs. 10,000 in Fund B. You will get 1000 units of Fund A and 50 units of Fund B. After 1 year, if the Nifty has appreciated by 25%, it means that both funds would have also appreciated by 25%, as they are a replica of the Nifty. So after 1 year, the NAV of Fund A would become Rs. 12.50 and that of Fund B Rs. 250. But what is the value of your two investments? Fund A would now be Rs. 12,500 (1000 units * Rs. 12.50/unit) and Fund B also would be Rs. 12,500 (50 units * Rs. 250/unit). The bottom line is that dont bother about the NAV of a mutual fund, as you might do for the price of a share. Conclusion As with any investment, there are risks involved in buying mutual funds. These investment vehicles can experience market fluctuations and sometimes provide returns below the overall market. You may consider investing in those companies belonging to the top performing mutual fund companies. This gives you some security that the company is able to increase your capital investment. To know if the company is performing well you can ask for feedbacks, past performances etc. The Only 2 ways to buy stocks Primary markets & Secondary markets. by J Victor on November 30th, 2011
Hi there, So far what I have discussed is about share markets or secondary markets. I havent talked about primary markets in detail. Thats a basic topic which I should have discussed earlier. So lets catch up with the topic. If you recall our story on shares, in scene 3, the couple raises 52 lakhs by selling 40% of their shares to the public. When they did that, they tapped money from the primary market. Basically the primary market is the place where the shares are issued for the first time.
So, theres only two ways you can buy a stock. 1. Through stock markets those gigantic auction houses where millions of shares are exchanged. ( Also called secondary market) 2. IPOs or initial public offers ( Also called primary market) WHATS THE DFFERENCE? Companies raise money for expansion through initial public offers. As the name suggests, IPOs are fresh issue of shares to the public. The money you pay by subscribing shares goes to the company for its expansion plans.So when a company is getting listed for the first time at the stock exchange and issues shares this process is undertaken at the primary market.Existing companies, who have already issued shares, ,may require additional money for further expansion. If they wish, they can tap if from the primary market . Such share issues will be called follow on issues. When you buy shares in the secondary market ( stock markets) , the money which you pay goes to the seller of the shares and not to the company.Generally when we speak about investing or trading at the stock market we mean trading at the secondary stock market. It is the secondary market where we can invest and trade in the stocks to get the profit from our stock market investment. ISSUE OF SHARES: Face value vs Premium. When a company launches an IPO to the public, it can offer those shares at face value or at a Premium. Shares carry a fixed rate, as declared in the legal documents of the company. Its also called par value. For example, a company may issue 10 lakhs shares of Rs 10 each at par. Over and above the fixed rate, a company can issue shares at a premium from its subscribers if the management is able to justify the reason for such premium. For example, a company may issue 10 lakh shares of Rs 10 each at a premium of Rs 50. So the total cost of one share becomes Rs 60. WHY NOT AT DISCOUNT? Yes, theoretically speaking, shares can be issued at a discount also. Practically, nobody does that. Shares are either issued at par or at a premium. ITs NO EASY PROCESS To successfully complete the share issue process, a company will have to appoint a lot of intermediaries like Lead managers who would take care of all the paper work with SEBI and other regulatory authorities, with the stock exchanges, bankers, Underwriters, allotment of shares.. in short, everything from A to Z Bankers to the issue who would ensure the collection of funds from the public. Registrars to the issue who would scrutinize the applications, reject the disqualified ones and allot the shares to eligible allotees , transfer those shares to their demat accounts and refund the amount to unsuccessful applicants. Underwriters who would undertake to buy the shares that are not taken up by the public so that the IPO is complete. PRICING OF SHARE ISSUES. Shares issued through an IPO can be priced in two ways. First method is straight forward The company can decide the price at which it will offer its shares. The second method is The Company, in consultation with the lead managers, would fix a price band for the issue. The price band is nothing but a range. For example If the issue document says that the shares are issued in a price band of Rs 50 to Rs 75. It means, that the investors willing to subscribe the shares are free to bid for any price between that range. The lower end of the band is called the floor price and the upper end of the band is called the cap. The highest price at which there are maximum numbers of subscribers is taken as the issue price. All bids at or above this price are valid bids and considered for allotment. INVESTORS WHO CAN INVEST IN AN IPO The total issue of shares is divided into three parts for three categories of investors. These categories are: Retail investors For You, me, residents, NRIs and Hindu undivided families, whose share application size is less than Rs 1 lakh, 35% of the issue is kept aside. Qualified institutional bidders: For mutual funds, banks, insurance companies, foreign institutional investors etc 50% of the issue is kept aside. Non-institutional bidders individuals, companies, NRIs, HUFs, societies, trusts whose share application size is more than 1 lakh, the balance 15% is given. This being an article In our primary section, Im keeping things simple in a laymans language. We will take up the IPO issue process in our advanced lessons series. Bye for now.. Stock Market timings. by J Victor on December 5th, 2011
INDIAN MARKETS Trading on the Indian equities segment takes place on all weekdays. There is No trading on Saturday, Sunday and Published Indian Stock Market Holidays declared by the Indian Stock Exchange in advance. The Market Opens at: 09:15 hours and Closes at: 15:30 hours Pre open trade session will be from 09:00 ~ 09:15 hours Pre-open trade session is a 15 minute trade session from 9:00AM to 9:15AM on the 50 stocks of NIFTY index . Only 50 stocks of the NIFTY index can be traded during this time on both NSE and BSE. Normal trading for all other stocks will start at 9:15AM till 3:30PM. WHY PRE MARKET SESSION?
In case a major event or announcement comes overnight before market opens, such events are likely to bring heavy volatility on the next day when the market opens. Special events include merger and acquisition announcements, open offers, delistings, debt-restructurings, credit-rating downgrades etc which may have a deep impact on investors wealth. In order to stabilize this, pre open call auction is conducted to discover the right price and to reduce volatility. BREAK-UP OF 15 MINUTES The 15 minutes of pre open session is broken into 8 + 4 + 3. The first 8 minutes: During this session investors can place/ modify /cancel orders on the basis of which the exchanges would determine the rates at which trading would happen. Orders are not accepted after this initial 8 minutes. Limit orders will get priority over market orders at the time of execution of trades .All orders shall be disclosed in full quantity, i.e. orders where revealed quantity function is enabled, will not be allowed during the pre-open session In the next four minutes, orders are matched, executable price is discovered and trades are confirmed. The next 3 minutes is just a buffer period for transmission from pre-market session to normal market session. PRICE DISCOVERY The equilibrium price shall be the price at which the maximum volume is executable. That is, the price at which there are maximum number of buy orders and sell orders. In case of more than one price meets the said criteria, the equilibrium price shall be the price at which there is minimum order imbalance quantity (unmatched qty). Further, in case more than one price has same minimum order imbalance quantity, the equilibrium price shall be the price closest to previous days closing price. In case the previous days closing price is the mid-value of a pair of prices which are closest to it, then the previous days closing price itself shall be taken as the equilibrium price. In case of corporate action, previous days closing price shall be the adjustable closing price or the base price. If the price is not discovered in pre-open session then the orders entered in the pre-open session will be shifted to the order book of the normal market following time priority. The price of the first trade in the normal market shall be the opening price. Price band of 20% shall be applicable on the securities during pre-open session. In case the index breaches the prescribed threshold limit upon the closure of pre-open session, the procedure as prescribed in SEBI Circular Ref. No.SMDRPD/Policy/Cir-37 /2001 dated June 28, 2001 shall be applicable from the time continuous normal market opens. what the circular says is about circuit limits. In case of 20% movement in the index, trading will be halted for reminder of the day. There is also a 15 minute video on this topic by Dr. Sayee Srinivasan , Head Product Strategy, at BSE. Watch it here. REGIONAL STOCK MARKETS Apart from the BSE and NSE, there are 21 regional exchanges which open at normal hours 9:15 to 15:30 hrs. WORLD MARKET TIMINGS Apart from this, global trends in stocks also affect the Indian market when it opens. Heres a list of opening time of stock markets around the world. WORLD STOCK MARKET TIME ACCORDING TO IST. Shanghai stock exchange Opens at 7.30 Am Hong Kong stock exchange - Opens at 7.55 Am Tokyo stock exchange - Opens at 5.50 Am South Korea Opens at 5.50 Am NYSE, New York Opens at 8.30 Pm NASDAQ Opens at 8.30 Pm BOVESPA , Brazil Opens at 7 Pm Bogota, Columbia Opens at 7 Pm Dow Jones Opens at 7.30 Pm You can also get the market timing of any other stock or commodity exchange at marketclocks.com Understanding Annual reports. by J Victor on August 1st, 2010
What is an annual report? An annual report is a summary of all thats happened in the business in a financial year growth in revenues, new contracts, new milestones, changes in management team, new appointments of key personnels, future plans etc. It is prepared by the management and distributed to the shareholders, promoters, government authorities, general public and to anybody whos interested in the affairs of the company. Most annual reports are in the form of a book. It runs into many pages starting from a chairmans message to future plans and prospects. An annual report is presented in the annual general meeting. What is a financial year? A financial year is a period of twelve months or less ending on 31 st
march in India. It could be any other date-for example, for most of the European countries, financial year ends on 31 st December. What does an annual report contain? Typically an annual report would kick off with the letter to the shareholders from the Chief Executive Officer. It will also contain a list with contact numbers of all the key board members, auditors, company secretary etc Then, in the next pages, detailed financial reports like balance sheet, income statement, supporting schedules, a general report on companys operations, an independent auditors report etc are given. It will also contain details regarding the share holding pattern of the company, along with historical share prices highs and lows, a lot of pictures and graphs, displaying in visual form all the milestones and achievements the company has made. You will have to read his report with a shrewd mind because, generally, an annual report may amplify the positive aspects of the business and give less attention to the negative aspects. The chairmans report may indirectly contain apologies for targets missed. The best way to read the annual report is to read it in comparison with the previous one. When you connect the present report with the previous ones youll straight away get an idea about what targets have been missed during the year. That way, youll also get the first impression about the managements performance. It may take some expertise and patience to read and understand an annual report thoroughly. As an investor, it will be very beneficial for you to go through these reports since; it will give you more insights into that companys operations. Contents of an annual report: You should be able to find the following informations from an annual report: Letter from the CEO Summary of the operations-milestones, achievements, prospects. Past Annual summary of all financial figures. Management discussion and analysis of the performance of the company The directors report. The balance sheet The income statement Auditors report Subsidiaries, brands, addresses, registered office, head quarters etc.. Names of directors Stock price history Conclusion Annual reports are a collection of important informations that may be vital for the investor. Our next article would tell you on how best to read them and what to look for. How to read an Annual report. by J Victor on August 1st, 2010
An annual report, as mentioned in the last article, contains a wealth of information on any event that has a material impact on the company. We also said that you will have to read it carefully in order to dig out those negative remarks since; it will be generally written in a positive tone. The positive tone in which it is presented is not meant to deceive the shareholders or the general public in any way. But, thats the way it is presented amplifying the positive facts and muting the negative aspects. This piece of advice should be there in the back of your mind while going through annual reports. The form, layout, pictures, graphs and color of the annual report are of less importance. Whats to be collected is the content those figures, ratios, notes and other bits and pieces of information that youll be able to gather. If you know how to put everything together and fish out meaningful information, youre bang on target. Must reads in an annual report. You do not have to read the report cover to cover. Thats not practical also. The first few pages are colorful and it presents a non technical overview of the companys objective and how well it is meeting them. The front section will probably also tell you about the companys strategies, products and competitive positioning. The chairmans statement or message to shareholders will also be included here. The back portion of the annual report is usually filled with financial information about the company. The real meat of an annual report is in the financial statements and notes to accounts found in this portion. The balance sheet, income statements along with auditors comments and notes to accounts are must reads. Apart from these, the Directors address gives an overview of your companys operational and segment-wise performance, key initiatives undertaken during the year, achievements and a financial snapshot. The Directors report will give an overview of the initiatives taken during the year, other achievements, awards and a snapshot of whatever milestones the company could achieve in the past one year. Many items of expenditure or income may be disclosed in the financial statements in abstract figures for which break up will be given in the schedules. There will be a long list of schedules accompanying the balance sheet and income statements. The management will also discuss in detail about the industry, factors affecting the companys prospects, impact of policy changes by the management or the government, strengths, opportunities, threats, competitors and how well the company tackles all this. Other bits and pieces. A detailed study of the notes to financial statements, allow you to go beyond the numbers to understand some of the assumptions and accounting policies that underlie them. For this purpose, we must refer to the notes to accounts, given as an appendix to the balance-sheet and profit and loss account. Remuneration given to directors and other managerial personnel, dealing with sister concerns of the company etc may also find place in the notes to accounts. Notes can be divided into two parts. The first part describes the basis of accounting and presentation. It briefs you on estimates used and where foreign exchange earnings are involved, the basis of conversion. Some of the key points of information contained in the notes include the position of cash and cash equivalents, collateral given to various lending institutions and investments in sister concerns. The second part provides information on the assets and liabilities position. Here, related party transactions that show companys dealings with group companies and associates, are key sources of information. For manufacturing concerns, the production figures assume significance. The production figures compared with installed capacity could give you an idea of the efficiency at which the company is operating .This information is particularly pertinent if the company is planning further expansion For newly listed companies, the utilization of the IPO proceeds are disclosed in the annual report. Since financial statements are prepared by matching principle an analysis of the cash flow statement will show the actual flow of cash. So, next time you get an annual report, look beyond numbers. The financials are just one part of it. To get the bigger picture, consider reading and analyzing the above mentioned points. Introduction to financial statements by J Victor on August 1st, 2010
From the last two articles we know that financial statements are part of a broad report call annual report. Now we proceed to understand what financial statements are. Law requires corporate entities to keep correct financial records of all the transactions. This is because; the company does business with the money of the public (shareholders).In order make sure that these funds are utilized properly, law makes it mandatory for companies to keep systematic record of all financial transactions. From these financial records, the annual profit or loss from the business is ascertained by an independent qualified auditor. This audited statement forms part of the annual report. FIRST THINGS FIRST The very first point you have to understand is that apart from annual financial statements, these are also prepared on monthly , quarterly and half yearly basis so that the management has absolute control over whats happening and they are up-to-date with the financial position of the business. Quarterly statements will be published every three months, half yearly statements after the end of six months of operation and the final statement for the whole year will be published after twelve months of business. Out of these, the full year official audited statements (or annual financial statements) are the most important ones since, as said above, it presents the grand summary of business done in a year and its is also checked and certified by an independent financial auditor. This doesnt mean that quarterly and half yearly statements have no importance to the investor. They are important too. Since Quarterly / half yearly statements provide a summary of what has happened in the last 3/6 months, these figures are used by analysts to judge whether the companys performance is up to the mark as expected. Analysts may also make projected or estimated figures using these statements and predict about the probable performance of the company. Another important use of these quarterly statements is that it is possible to compare the performance from quarter to quarter. Such comparisons may reveal certain important aspects of the business- for example, the seasonal nature of the business. A companys ability to hit the estimates expected by the investors every quarter also affects the market price of its shares. For example If the quarterly financial result of a company exceeds investors expectations, you can witness a jump in its share price. So all these statements has its own importance. A WORD OF CAUTION: as said above, analyzing quarterly or half yearly statements are good. However, it doesnt not mean that you can rely on it totally. Thats because, its possible that a company that has shown promising results in the first quarter may face difficulties going forward. Uncertainty is a big factor in business. Predictions of all the market experts and brokers can go wrong. Why should we say about brokers? Those CEOs themselves can go wrong in certain cases. now that youve got an idea about financial statements in general, our next article will explain the components of financial statements in detail. The components of financial statements by J Victor on August 1st, 2010
THE COMPONENTS OF FINANCIAL STATEMENTS In the last article we said that financial statemenst are prepared on monthly / quarterly /half yearly and annual basis. Now, irrespective of the time period, financial statements ( or financials as it is called in common parlance) basically consists of three parts: Income statement or Profit and Loss account Balance Sheet Cash flow statement Most of the figures shown in the annual financial statements will be in a summarized form since for example the total of all the assets like machinery, buildings, plant, tools, vehicles, computers etc will be shown in the balance sheet as fixed assets. If you want to know about the details of fixed assets, you may have to refer to the schedule of fixed assets attached with the balance sheet. A big company may have many more schedules like the one mentioned above.
Apart from schedules, accounting rules allow accountants to calculate certain figures based on certain assumptions for example the company may have given a lot of goods on credit and based on past experiences, the accountant may write off certain percentage of debtors (amounts receivable from credit sales) as irrecoverable. Such assumptions made while preparing financial statements will be separately disclosed in a statement called notes to accounts. Apart from this, the independent auditor may also have his opinion about the correctness of the assumptions made and about the truth and fairness of the figures disclosed in the financial statements. He discloses his opinion and comments in a report called the audit report. So apart from the 3 components that comprise financial statements, the following three statements also form part of it as a sub category-they are- Schedules to accounts ( Part of balance sheet and income statements) Notes to accounts. ( Accountants disclosure about the assumptions made) Audit report (Independent auditors comments and opinion) So there are three components and three sub-components for any financial statement. Now we will explain in brief what those 3 statements are about. INCOME STATEMENT The income statement summarizes a companys sales (Also called revenues or turnover) and expenses. The final net figure is either profit (if total of revenues exceed Expenses) or loss ( if expenses exceed revenues).The profit or loss shown in this statement is essentially an estimate( we will tell you why, later ! ) For example if a company reports of having made a profit of Rs 300 Crore, it doesnt mean that it has Rs 300 Crore in its bank account. BALANCE SHEET A balance sheet summarizes a companys assets, liabilities and shareholders equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders. CASH FLOW STATEMENT Profit and cash are not the same. A statement that shows actual cash coming in and how the same has been used is called the cash flow statement. It deals with liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable. So to analyse the economic realities, cash flow statements are prepared. CONCLUSION Financial statements provide financial statistics of past events; but they are not forward looking. They dont provide key non-financial information like quality of revenues, types of customers and risk factors. Certain qualitative elements are not considered in the financial statements terms like the quality and reputation of the management team and employees because they are incapable of being measured in monetary terms. The figures provided in financial statements cant be attributed to future since future earnings depend on many more factors like local and global market conditions, inflation etc. Limitations apart, these are the numbers which an investor depends. The assumption is that ,a company which has given excellent numbers in the past is capable of delivering improved results in the future also. IN THE NEXT ARTICLES. We dig deep into each of these statements and try to understand what its all about. Understanding the three statements are absolutely necessary to analyse a company fundamentally
The Income statement : Basics by J Victor on August 21st, 2010
MANY NAMES OF INCOME STATEMENT we know that the income statement shows revenues, expenses and profit for a period of time, such as month, quarter or year. Accountants call these statements by different names 1. Profit and loss account or just P & L 2. Income statement 3. Trading and profit and loss account 4. Statement of income/revenues 5. Statement of operations 6. Operating results statement 7. Statement of operating results 8. Statement of earnings 9. Earnings statement 10. P & L statement 11. Statement of financial performance..etc
WHATS IN A NAME?
We cannot say that its the accountants call to put any name he likes. These statements assume different names according to the nature of business of the company. For example a company that has no trading activity ( buying and selling of goods) or a company involved in service oriented industry, will not have a trading and profit and loss account simply because, there is no trading activity involved. So a company like Infosys will have an income statement or a statement of revenues or a profit and loss account and a company like Reliance will have a trading and profit and loss account. In any case, the income statement displays the profit made. However, in the case of companies involved in trading, it makes two types of profits called - Gross profit and Net profit. Gross profit is the profit made from sales before deducting running expenses. The only item deducted from sales is the purchase cost of goods that was sold. The purpose of tracking gross profit is to know the actual trading margin in the business. Its important for companies to see that the percentage of gross profit never falls. Net profit is what the company makes after deducting all types of expenses. So, if the net profit falls, that means that somewhere the cost of operating the business has increased. In the case of companies not involved in trading, the Gross profit element will be missing in the income statement. Only the net profit will be shown. In fact, there is no gross profit for them since their business do not involve buying something for a lesser price and selling it at a margin. So, income statement will be prepared according to the nature of business and an appropriate name will be given that matches with the nature of business.In the case of a trading company, the income statement will show the gross profit and net profit separately.
MANY FEATURES OF INCOME STATEMENT
Thats not all. The income statement has many more features. Heres a point wise collection will help you to understand the income statement better. The format can be vertical or horizontal: Generally, the income statement is drawn in a vertical or horizontal format. In which ever way its drawn, the first item in it would be revenues or sales. This sales figure appearing on top of the statement is also called top line of the business. (Hope youve heard of analysts taking about the increase/decrease in topline of the company). In vertical format, each and every expense is deducted from the revenue figure and finally the net profit is arrived at. This net profit is also called bottom line in financial lingo since it appears as the last item in the income statement. In the horizontal format, the sales or revenues are shown on the right side and categorized expenses are shown on the left side and the difference between the two will be shown on the right side ( loss) or left side ( profit).Charitable organizations / clubs / non profit making voluntary organizations / association of persons that exist for the welfare of the society etc- may not have an income statement or revenue statement since they do not exist for making revenues. However, these organizations do have money flowing in the form of contributions. Hence, they prepare a statement called receipts and payment account and the resultant surplus money will be termed as excess of revenue over expenditure.Which ever way its presented, the basic idea of a revenue statement is to arrive at the profit. The form is not important. The time period you cannot draw a revenue statement unless you decide about the time period for which it is drawn. For example you can find the revenues, deduct all the expenses and arrive at the net profit for a year, for six months, for a quarter, for a month or even for a week. The time period has to be decided. Corporates prepare revenue statement for all quarters and of course, the official annual report. Projected and estimated statements: Accountants also prepare projected financial statements which shows the expected revenues and expenses in the coming years if the current trend continues. Accounting projections may be made for 5 or even 10 years forward depending on the use intended. Estimated financial statements are sometimes prepared to know the expected profits for the current year if the current trend continues. Projections are basically estimates. Stand alone and consolidated statements : Big companies (For example Tata group) which has many subsidiary companies under its control may publish consolidated financial statements to show the consolidated figures from all its businesses. Such business conglomerates will also have stand alone statements for each of their firms. Provisional and audited statements: In India, The companies Act and the Income tax Act requires companies to get their financial statements audited by professional accountants. A financial statement thats not audited is called provisional financial statements and the one thats audited is called audited statements. Whats important for an investor is to look at the audited financial statements. Audited financial statements are included in the annual report and that is the final official- legal profit and loss statement of the company. The audited financial statements will be made available to the share holders of the company. The audited statements of all the companies listed in the stock exchange are available in the stock exchanges website or various financial sites and newspapers. CONCLUSION The income statement is one of the three statements that a stock market investor should be familiar with. Whats important for an investor is to have a look at the audited financial statements. Projections, estimates or provisional statements are made for different purposes and involves a lot of assumptions. Even the actual financial statement we are talking about is not free from assumptions and estimates. To understand how income statements are made , we need to look at an important concept in accounting- called the matching concept. The Income statement : Understanding the matching principle. by J Victor on August 21st, 2010
Matching principle is one of the fundamental accounting principles followed by accountants worldwide. To understand matching principle, we will look at two business transactions first - Transaction 1- You run a whole sale super market. There is a 20% profit in every sale you make. There are many retailers who buy in bulk, mostly on credit. One such customer buys goods worth 5 lakhs on credit, on March 31 (last day of the financial year). Definitely, you have made a sale. Goods have gone from your go down and the stock reports will show goods worth 5 lakhs dispatched. Fine. But, on the other hand, the customer has not paid anything and hence the 5 lakhs sale will not bring in a penny to your bank account. There is also a probability that the customer can delay or default in his payments. In such a scenario, can we consider this as a sale in this financial year? If this is recorded as a sale, your revenue statement will show an additional 1 lakh as profit for which you are supposed to pay income tax. Whereas in reality, you have not got a penny. Transaction 2 On the very same day (March 31 st ) salary for the month is to be paid. There is a total of Rs 50,000 to be paid. It is an expense to be deducted from the profits of that accounting year. But, since salary is always paid on the 5 th of every month,the amount remains in your bank. Nothing has been paid. Should we add this as an expense of this year? If this is recorded as an expense, your expense will increase but at the same time you have not paid a penny from your bank account. Whats the right decision? In the first case, it is a sale and the transaction should be recorded. Thats because, if we look closely, we will understand that the profit has been already made although there is a delay in realizing the money. This sale was made due to the effort of your employees in the month of March. Hence, the second transaction should also be recorded in this financial year. The salary of 50,000 payable in March is an expense (payment delayed because due date is on 5th) against the profit of Rs 1 lakh made ( receipt delayed due to the credit policy of the company) . You actual profit is Rs 50,000, for which you have to pay tax. If we do not record both these transactions this year, there are two side effects- for the year ending march 31 , your records will show no sale or profit but at the same time, your stock records will show an outflow of goods worth 5 lakhs. Next month, even if you do not make a single sale and close down your business, your accounts will still show a receipt of Rs 5 lakhs and an expense of Rs 50,000. If this carries on, your accounts will finally become a jungle of complications. So, Accountants dont mind if the customer has actually paid the cash or not. They dont mind if an expense like salary is actually paid in cash or not. If it pertains to a particular period, they record it in that period itself. In the balance sheet ( where all receivables (assets)and payables (liabilities) of the company are recorded for the year) the accountant will show Rs 5 lakhs as an asset (cash) receivable and the unpaid salary as a liability to be payable. Now the picture becomes clear for anyone who goes through the revenue statement and balance sheet. The company has made a sale of 5 lakhs ( will be shown as revenue from sales in the income statement) against which 20% is the profit. So the balance 80% is the purchase cost which will be first deducted from Rs 5 lakhs to arrive at Rs 1 lakh as gross profit. But as they can see in the balance sheet, the entire 5 lakhs is pending to be received. An expense of 50,000 will be shown against this profit. At the same time, the balance sheet will show the expense as a liability payable. Subject to this, the company has made a profit of 50,000 for the year. Why do accountants do like that? The reason lies in a concept called matching principle. Matching principle says that appropriate costs should be matched to the sales for the period represented in the income statement. Knowledge of this concept is necessary to understand how accountants arrive at the profit of a business. Lets take another example. My business performs consulting service for a client and has billed Rs 50,000 in December 2010 and he pays my bill 3months later on April 2011. I do not have Rs 50,000 as my income because when I perform the service, I also incur some expenses in the form of salary, printing, electricity etc Lets assume that my expenses are Rs 15,000 in total. My profit for the year 2010 is Rs 35,000 and I have to pay tax for that amount- irrespective of the fact that my client has paid me Rs 50,000 in April 2011!! This might seem to be strange for Newbies. Think and youll understand. If I dont match my expenses of 2010 to revenues of 2010, my financial statements would never show the right picture in any year. It will show a loss of Rs 15,000 in 2010 and a profit of Rs 50,000 in 2011. Although I know the reason, nobody looking at my financial statement would be able to understand why I incurred a loss in one year and a huge profit in the next year. The above is case a very simplified example. Imagine what would be the result when you have huge volume of bills and number branches all over India? Even I may not understand what has caused too much volatility. The above discussion brings us to some realities- The sales or revenues or operating income you see in the income statement is the value of goods sold or services rendered in a particular year. For example sale revenue of Rs 300 Crores means that the company has actually sold or rendered services worth Rs 300 Crores. It doesnt mean that the company has received 300 Crores in their bank account. Some of the customers may have paid a portion of it. The profit shown in the financial statements is based on the above sales figure of Rs. 300 Crores after deducting the expenses incurred. Lets assume that the expenses (salary etc.) incurred by the company to generate Rs 300 Crores is Rs 140 Crores. The company has made a profit of Rs 160 Crores in papers. But in reality, since their clients have paid the whole amount, the profit thats displayed at the end of the revenue statement is basically an estimate. ( we said that earlier in our post components of financial statements that profit is an estimate). The customers have not paid yet, so the profit shown in the statements does not reflect real money. So, a company can be very profitable and still run out of cash!! Later, the profit shown in papers will turn into real cash when the customers start paying. Lets see one more application of the matching principle If the company buys a truck in 2010 that it plans to use for 5 years, the full cost of the truck will not be shown as expense in 2010 itself. Thats because, the company is availing the benefit of the truck for the next 5 years and hence, the cost of the truck has to be spread over the next 5 years and should be deducted from the sale proceeds of these 5 years equally. The profit and loss account, in fact, tries to measure whether the products or services that a company provides are profitable when each and every expense (whether paid or not) is considered. It has nothing to do with the companys actual cash inflow and outflow.
CONCLUSION
Thats matching principle for you. Now we proceed to discuss about the components of income statement. There are basically only 5 components in an income statement. These are 1. sales 2. Direct expenses 3. Gross profit 4. Indirect expenses 5. Net profit. If there are only 5 components, then why does an income statement look very complicated with lots of figures in it? Well try to understand all that in our next lesson. The Income statement: Understanding the components. by J Victor on August 22nd, 2010
THE 5 COMPONENTS Towards the end of the last post we wrote that the income statement has only 5 components, they are Sales ( or revenue or income ) Direct cost Gross profit (or it could be gross loss) Indirect cost Net profit (or it could be net loss) So the question that remained to be answered was Why does the income statement looks complicated if there are only 5 components? We will try to find the answer in this post. Before we explain that, we need to remember that Sales direct costs = gross profit Gross profit indirect costs = net profit. So, amoung the five elements, gross profit and net profit are single figures and will be displayed as such in the revenue statement. That leaves us with three figures sales, direct cost and indirect costs.The Sales figure should be less complicated when compared to direct and indirect costs. These statements look complicated due to the complex nature of businesses done by big business houses. For example a company like reliance has income from various sources like oil production business, oil refining and marketing business, petrochemicals etc.These different segments may be separately shown in their revenue statement and hence, the first item in their revenue statement sales would show four different figures and also the grand total of the four segments. When these figures are shown separately, it looks complicated. Such separate disclosure is essential for the reader to understand the proportion of income from different products. Separate disclosure can also be made based on geographical locations or any other viable separator. There will not be separate disclosure for credit sales and cash sales. (Recall the matching principle) COSTS AND EXPENSES There are two types of expenses. (1) Directly related to the sale and (2) Indirect expenses. All expenses direct or indirect will be deducted from the revenues. By directly related we mean that such costs are normally directly proportional to the volume of sales. Direct costs are also known as costs of sales or cost of goods sold. This figure will be shown separately in the income statement as a deduction from the Total revenues or total sales figure. The resultant figure after deduction is termed as gross profit. From the gross profit that the company has made, it needs to meet all its operational expenses like advertisement, salary to staff, rent etc.These expenses , which are not directly proportional to the sales are called indirect expenses. They are also known as overheads or operating expenses. Both direct costs and indirect cost also follow the matching principle and hence, those figures may not represent money actually paid. CASH AND NON-CASH EXPENSES At this point it is important for you to understand two more terms which are required to understand the profit and loss statement completely. They are: (1) cash expense and (2) non cash expense. Cash expense are expenses which are payable in cash. Non cash expenses are expenses for which there is no outflow of cash, but it will still be recorded as an expense. Thats because as far as an accountant is concerned the term expense has wider meaning and includes outflow of cash or outflow of other valuable assets or decreases in economic benefits or depletions of assets Regardless of whether an expense is cash or non-cash in nature, it will be shown as deduction from the gross profit in an income statement. So if asset like machinery is used in business, the proportionate cost of machinery will be deducted as expense. Technically its called depreciation. Its an expense. Precisely, its a non cash expense since there is no cash outflow. Expenses is it good or bad? If a revenue statement shows too much expenses which affects the profitability of the company, thats a bad sign. Its important for the management to find out areas where they can save costs and expenses so that it improves the companys profitability. Any such steps (for example spotting unnecessary down time in a manufacturing process) taken by a company is a positive sign. We now know that expenses can be classified as direct and indirect or as cash and non cash expense. Expenses can also be classified in many other ways for example it can be classified on the basis of controllability as controllable and un controllable expense or based on variability- as fixed and variable expenses. In a revenue statement, instead of showing all the expenses as one figure, accountants would show it in maximum detail as possible so that the users, especially investors, can get further insights into the way in which the company is operating. Now we hope you have understood why an income statement looks complicated at the beginning. Its because, additional details are provided for clarity and transparency. At the end, any income statement can be trimmed down to just those five elements. The Income statement: Profits by J Victor on August 22nd, 2010
So far we know that sales less all type of expenses results in profit. We know a little bit more we know that sales less direct expenses results in Gross profit and Gross profit less indirect expenses ( including taxes ) results in net profit. In this lesson we will introduce two more variations of net profit the PBIT , PBT and PAT. ( Profit before interest and tax , Profit before tax and profit after tax) Gross profit Companies need to generate a healthy gross profit to cover up indirect expenses, taxes, financing cost (all indirect costs) and net profit. But how much is healthy? That varies from industry to industry and from company to company. To analyse a companys gross profit , you need to do two things : 1. Compare the Gross profit ratio with competitors in the industry and 2. Compare the Gross profit ratio with the past 5 years ratio. Comparison with the peers will give you an idea about how competitive the company is and by comparing the last 5 years ratio will tell you whether the company is headed up or down. Operating profit or EBIT
Gross profit minus operating expenses results in operating profit. This operating profit is also know by another name EBIT. I.e., earnings before interest and tax (Pronounced as EE-bit). Some companies may write the same as PBIT (Profit before Interest and taxes). What has not been deducted is interest and taxes. Why? Because operating profit is the profit a business earns from the business it is in- from operations. Interest expense depend on whether the company has taken a bank loan or not and taxes dont really have anything to do with how well you are running the company. The EBIT will be displayed in the income statement of any company. EBT-or Earnings before taxes. Or profit before taxes (PBT). The term implies operating profit after deducting interest expense. PAT/EAT. Now lets get to the bottom line: Net profit. (Also called Profit after tax (PAT) / or Earnings after tax (EAT)]. PAT is what is left over after everything is subtracted- direct expenses, indirect expenses, interest and taxes. When the analyst says the companys bottom line has shown considerable growth what he means to say is that the companys PAT has gone up. Some of the key ratios used to fundamentally analyse a company such as Earning Per share and Price earnings ratio are based on this PAT. To analyse a companys PAT, you need to the same routine as you did in Gross profit analysis: 1 Compare the PBT ratio with competitors in the industry and 2 Compare the PBT ratio with the past 5 years ratio. Comparison with the peers will give you an idea about how competitive the company is and by comparing the last 5 years ratio will tell you whether the company is headed up or down. EBDITA- Before we close this section we need to look at one more important version of profit called EBDITA or Earnings before depreciation, interest, taxes and amortization.( Amortization is something we havent explained. For the time being understand that its non cash expenditure.) Some people think that EBDITA is a better measure of a companys operating efficiency because it ignores non cash charges such as depreciation. How to calculate these ratios have been given in the Fundamental analysis section. For you as an investor , its enough that you take out the EBDITA, PAT and PBIT figures. A comparison of these figures with the peers a for the past 5 years would give you a first hand impression about the company. The income statement : Difference between earnings and revenues by J Victor on August 22nd, 2010
lets catch up with the terms Earnings and Revenues- two totally different terms which may baffle a naive financial analyser. EARNINGS Earnings means Profits. Its that simple. Now, in business, there are different names for it. The most popular being bottom Line and net income. Its similar to the term net pay or net income or net earnings or net salary or take home pay on your pay slips. Just like your take home pay, earnings are the take home pay of a business. It represents how much money the company has left over, if any, after its paid the costs of doing business payroll, raw materials, taxes, interest on loans, etc. Earnings are arguably the ultimate measure of growth of a business. Analysts want to find companies that are growing their earnings because this is what they keep after theyve paid their bills. Thats why earnings results reports each quarter are eagerly awaited by stock investors. REVENUES Revenues means The total amount of money a company receives from sale of goods and services (i.e. receipts BEFORE deducting all expenses). Its also called top-line or Total sales or gross income. Its similar to the term gross pay or gross earnings on your salary slip. If you take an income statement, revenues or sales will be displayed on the left hand side of the statement ( Horizontal format) or on top of the statement ( vertical format). When you deduct all the expenses from revenues the resultant figure is called earnings. Arguably, top-line growth is more important, but also a more misleading figure than bottom-line growth. Its more important in the sense that any earnings growth is going to have to come from revenues. But its misleading because on its own it doesnt tell you what the company is actually making in profits. (Since the numbers dont reflect what the business has to pay out in expenses). FORMS OF EARNINGS We discussed earlier about earnings. Its a companys profit. The real issue is what goes into that income number. There are many flavors: EBT is earnings before taxes, EBIT is earnings before interest and taxes, EBDIT is earnings before depreciation ,interest and taxes, EAT is earnings after taxes and EBDITA means earnings before interest, taxes, depreciation and amortization. In other words, incomes before those costs have been subtracted. MEASUREMENT OF EARNINGS -EPS EPS is earnings per share, or the part of the companys profit that is attributed to each individual share of stock. EPS is a good indicator of a companys profitability, and is a very important ratio to look at while evaluating a certain stock. HOW IS IT CALCULATED? The formula for EPS is below. (Net income Dividends on Preferred Stock) / (Average Outstanding Shares) In Beginners lessons- Fundamental analysis we have given the formula (Net income Dividends on Preferred Stock) / Outstanding Shares).You may wonder why average outstanding shares is used as denominator instead of outstanding shares . The reason is that EPS is reported over a certain period of time, and the number of outstanding shares will likely fluctuate in that period, so you can get a more accurate result by using the average number of outstanding shares. WHY IS IT IMPORTANT? EPS is considered by most investors to be the single most important ratio to use when evaluating a stock. However, some aspects of EPS can be misleading when comparing two different companies. For example, one company could use twice as much capital to generate the same amount of profit as another, but it is obviously not utilizing its capital as efficiently as the other company. However, these numbers are not reflected in the EPS, so it is important to remember that EPS alone doesnt tell the whole story. POINTS TO NOTE When you analyse a company for its EPS, keep these points in mind: You should always compare earnings growth relative to previous years / quarters. A steady increase in earnings per share is a good indicator of genuine growth and reduces the possibility that the company just had one great quarter which might not be sustained in the future. Current quarterly earnings per share Earnings must be up at least 10-20%. Annual earnings per share These figures should show meaningful growth for the last five years. With that we complete our discussion on the difference between earnings and revenues. I said that quarterly earnings results influence stock prices. But Why? Why do results for a single quarter cause so much mayhem? To know the answer, you have read one more simple article: More about earnings quarter. The Income statement :Understanding Depreciation by J Victor on August 22nd, 2010
Depreciation One of the things that analysts and investors frequently look for while analyzing a company is the amount of depreciation written as expense in the profit and loss account. It is a term frequently used in finance that describes the loss of value over time. Depreciation is an expense; hence less of this expense would mean higher profits! Similarly, a steep rise in the depreciation would result in the companys earnings falling below the expected levels, however profitable their operations are. Depreciation is calculated as Cost (minus) estimated residual value / Life of the asset. A change in any one of these measures cost, residual value or life will result in a change in the amount charged as depreciation. There are also two methods of calculating depreciation straight line method and written down value method. a change in the depreciation policy can also bring in huge difference in the profits either positively or negatively. As an investor you need not dig deep into this topic. What you need to understand is the following points: Depreciation is an expense It is a non cash expense. That is, there is no outflow of cash from the company. The choices that a company makes in deciding how to amortize and depreciate and by what amounts will affect its overall appearance of financial health. The amounts will play probably a large part in determining the figures on the companys balance sheet. They will also affect the profit figures on the income statement. These two documents are enormously important in determining everything from shareholder/investor returns to credit worthiness. An increase in depreciation also means that the company has acquired new assets. High growth oriented companies, which are on an expansion spree may acquire lot of assets in the form of machinery and other fixed assets. So, to that extent its also a positive sign. A fall in profits due to increased depreciation expense cannot be taken as a negative sign if the increase depreciation figure is due to acquisition of fixed assets However, if the depreciation figures show material change due to factors like charging different depreciation rates or due to changes in the method of calculating depreciation etc You may better be careful. Since depreciation is an expense that depends on lot of factors, investors consider the Profit Before Deprecation and Taxes for valuation purposes. Amortization and depletion are other expenses similar to depreciation thats non cash in nature. Amortization is a process that is exactly same as depreciation, for an intangible asset. We said in our earlier chapters that the business may have tangible assets like machinery or intangible assets like patents and goodwill. When tangible assets are written off at a specific rate, its called depreciation and when intangible assets are written off, its called amortization. Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil wells setup costs are spread out over the predicted life of the oil well. Being non cash expense, these three items decreases the earnings figures of the company but helps in increasing the cash flow of the company. It can also have significant effects on tax burden. The less a company claims as depreciation/amortization, the more profitable the company seems and therefore the more it will be taxed. Choosing higher depreciation amounts can provide short-term tax relief. Where to look The best place to find information on all this is the schedules to the balance sheet and notes to accounts in the companys annual report or quarterly results. The schedule on Significant Accounting Policies will give the method and rates of depreciation, along with other accounting treatment specifically followed by the company. The notes to accounts explain the accounting treatment to give us an idea of how the depreciation of that particular year has been arrived at. The income statement : Revenues an important figure. by J Victor on August 22nd, 2010
Sales or revenue is the value of all the products or services a company sold to its customers during a given period of time. Profits of the company are based largely on the volume of this figure. Why this figure is important. More revenues means more profits. An increase in profits year on will have a positive impact in the stock price. So companies are always eager to show increased revenues in the profit and loss account. And, the sales figure is one of the easiest figure to manipulate. How do companies manipulate sales? Method 1. Sales to related parties The Company may sell its products to another company which may be owned by a director or any one who has substantial influence in the company. Method 2. Record fraudulent sales using fake bills. For example It was discovered that Mr. Raju of satyam computers created as many as 7,561 fake invoices during the period from April 2003 to December 2008. Method 3. Very Flexible terms for payment for the buyer by providing such a facility the company may boost up the revenues temporarily, but in the long run such arrangements pose an increased risk of the payment never being realized! Method 4. Including one time revenues like income from sale of fixed assets like unwanted machinery or scraped assets or even loan amount received in the sales figure and thus boosting the figure and profits. Method 5. Companies can adjust reported net earnings simply by changing accounting policies. These tend to be quite complex and difficult to understand, but the details are going to be found in the footnotes. For example, a company may change the way it values inventory, which in turn could have a big effect on calculation of the cost of goods sold and gross profit. Method 6. Converting reserve profits to income. This may also be difficult to understand for a newbie. Reserves are profits earned in the past years, kept aside for future expansion activities. Companies carrying large balance in reserves can manipulate current year outcome by simply reclassifying all or part of the reserve balance to income. Well, i am not here to list out fraudulent practices. that list goes on and on from least complex ones to complicated accounting tricks. The question is how to analyse a companys quality of revenues. HERES YOUR SIX POINT CHECKLIST. How can a company continue to earn profits year after year? By selling more and more every year. So, the first question to be answered is Does the company have a history of increasing revenues every year? Now the second question to be answered is Are the Revenues increasing at par or above the other competitors in the industry? Does the company have a unique product-line that will sell fast? You have to invest in companies whose products and business model you understand. Does the company have a unique branded product to sell? Branded products are easy to sell and if consumers love the brand, they do not mind paying a premium for its products & services. For example Maruti. Moreover, a company with a brand value can easily diversity into other sectors and instantly become successful For example Titan. They have diversified successfully into the eye wear and diamond jewelry sectors. Take the current assets section in the balance sheet. The amount of unrealized sale from customers will be given under the head accounts receivables or sundry debtors. Check if the receivables are showing a sudden jump. Co-relate with the revenue figure and see that the revenues and receivables are growing at the same pace. For example if you see the revenues growing moderately but receivables showing a sudden jump, thats a red flag! You need to be careful. You have to look for companys disclosures regarding related party transactions, sale to sister concerns , change in the assessment of customers ability to pay , extended payment terms offered to any particular client etc.. Calculate the price /sales ratio. Calculating the price/sales ratio is a simple matter of performing the maths. Lets assume that the company we are using as an example had revenue of 300 million rupees over the last four quarters. If we take the current market capitalization of 150 million rupees and divide it by the revenue of 300 million rupees, we arrive at a P/S ratio of 0.5. As with the P/E ratio, the lower this ratio is, the better the odds that this will prove to be a good investment. Balance sheet : what is it? by J Victor on August 23rd, 2010
Balance sheet is a statement that shows what a business owns and owes AT a particular point of time. (Remember, the income statement shows revenues and related expenses FOR a period of time , usually a year). ALL COMPANIES are statutorily required to come out with a final statement of accounts every year. The final statement of accounts consist of the balance-sheet, the profit and loss (P&L) account, supporting schedules, the auditors report, a statement of accounting policies and additional notes on account. The balance-sheet and P&L account are designed to give a birds eye view of the state of affairs of a company. Schedule VI of the Companies Act details the format and typical contents of the balance-sheet and P&L account. Companies are given the option to have their statements in either the `horizontal or `vertical format. Most companies follow the latter. Companies are also given the freedom to have the figures published in thousands, lakhs or Crores of rupees depending upon the scale and magnitude of operations. A typical vertical balance-sheets design is like this- The company gets its sources of funds from shares issues, loans borrowed etc.. and applies the funds to run the business in fixed assets, investments, stock etc.. Logically, at any point of time, the total of sources of funds would be equal to the total of application of funds. But law in India (Companies ACT) requires companies to disclose more facts about the deployment of funds and not just a summary. So, a typical balance sheet is accompanied by schedules, notes, bifurcations, tables, disclosures.. and hence, the whole things looks complicated at the beginning for a newbie. Balance sheet is also called statement of financial position Conclusion The balance sheet of a company reflects its financial position at a particular point of time. It shows what the company owns and owes after doing business for a year. So, analysis of balance sheet of a company becomes vital for an investor. To do that, you need to know what are the components of the balance sheet . More about that in our next lesson. Balance sheet components: Assets by J Victor on August 23rd, 2010
The hardest thing about the balance sheet is deciphering the vocabulary on it. Once you learn what a few things mean, the sheet is much easier to read. Before you can understand the individual accounts in each section, it is important to understand the three main sections on the balance sheet. Section 1 Assets (these may be again classified in the balance sheet as fixed assets and current assets). But for the time being, lets see what assets are- Assets are what the company owns. Example land, buildings, factories, machinery, vehicles, computers, furniture, cash, bank balance in companys account etc.. , it also includes receivable amounts from customers, tax authorities, government and other entities. A company can also have fixed deposits in banks. Thats not all , it can have deposits for various purposes like rent deposit, advance given to suppliers etc , it can invest in shares, mutual funds and bonds.. these amounts also form part of the companys assets. A company may also hold finished goods which are meant for sale. In some cases , work may be in progress. For example ,Lates take a car factory. As on the balance sheet date, the company will have finished cars ready for sale as well as partly finished cars. These are collectively called inventories. The value of finished goods (Fully made cars) and work-in progress (partly made cars) forms part of the assets of the company. Prepaid assets are another category of asset that may be seen in a balance sheet. In the course of every day operations, businesses will have to pay for goods or services before they actually receive the product. For example rent may have to be paid in advance for a year. Sometimes companies may decide to prepay taxes, salaries, utility bills, or the interest on their debt. These would all be pooled together and put on the balance sheet under the heading pre paid expenses or pre paid assets.By their very nature, Prepaid Expenses are a small part of the balance sheet. They are relatively unimportant in your analysis and shouldnt be given too much attention. Theres one more class of assets intangible asset ie, assets which appear in the balance sheet in the form of a value but which cannot be seen , touched or felt. These include copy rights, trademarks , intellectual property, patents goodwill etc.. So thats it for the first component in the balance sheet Assets. Add them all up and you get the total assets owned by the company. Simple. ASSET VALUE : MORE OF ESTIMATES AND ASSUMPTIONS One important point to take note here is that, the value of most of the asset components discussed above as shown in the balance sheet is derived based on certain estimates and assumptions. For example Property, plant and machinery, computers , furniture and fittings and all those equipments that the company use to operate business are accounted in the balance sheet at the purchase price in year one and in the subsequent years , a fixed rate of depreciation is charged on it and the balance is shown as the value. But in reality, nobody knows how much the companys real estate or equipment might be worth in the open market. The fact that companies must rely on purchase price to value their assets can create some anomalies. Lets discuss some examples here: you started a company 25 years back and bought land For 25 lakhs. The land could be worth 5 or 6 crores today but it will still be shown at 25 lakhs in the balance sheet. Since land does not wear out, depreciation is not charged on land each year. In the case of machinery and other fixed assets, depreciation is charged at a fixed rate by the accountants. So , when you buy machinery worth 25 lakhs, its shown in the balance sheet after charging a depreciation of say, 10% or 15%. Two years down, this machinery may not have a reliazable value at all due to various reasons for example technological obsolescence but, may still appear in the balance sheet at cost (25 lakhs) less depreciation charged (say at 15% for two years) at 18.06 lakhs. A company may have intangible assets ( goodwill, intellectual property, customer base , strategic strength, brand image etc..). These are assets which exists but you cannot touch or spend. Most of these assets are created over time and are not found on the balance sheet of the company unless an acquiring company pays for them and records them as goodwill. Your company launched a major advertising campaign.All the work is done in January and the cost comes to around 25 lakhs. The accountants may now decide that the benefit from this ad campaign will benefit the company for 2 years . So they will record an expense of 12.50 lakhs in the first year and show the balance 12.50 lakhs as prepaid asset. The value of 12.50 lakhs prepaid asset is actually an estimate since the company may receive the benefit of ad campaign for several years or the ad may not click at all ! Now its time to move on to the other side of the balance sheet where we have two separate components to discuss- Liabilities and Equity.More about that in our next lesson. Balance sheet components: Liabilities and Equity. by J Victor on August 23rd, 2010
We said earlier that the balance sheet shows what the company owns and owes. What the company owns are called assets and we have seen the various types of assets that a company holds. Now what the company owes is categorized into two (1) Liabilities and (2) equity. So in another way, the total of what the company owes shows how the company found money to buy the assets !!. Lets dig into the topic: Section 2- Equity and Liabilities. What the company owes is classified into Equity and Liabilities. Fine. But whats the difference between the two? The difference is Equity is that part of funds that the company raised by issuing shares. It also includes that amount the profits that has been made in all the past years and kept accumulated without paying it to the share holders. So, you and I, who gives money to the company by subscribing to its IPO forms the Equity. To that extend, we are the owners of the company. The equity ownership that we get can be sold in the secondary market if there are takers for it. That organized place where we sell equity ownership is called the stock market. Liabilities are outside borrowings, usually listed on the balance sheet from the shortest term to the longest term, so the very layout tells you something about whats due to be paid and when. Anything a company owes to people or businesses other than its owners is considered a liability. There are two types of liabilities Current liabilities and long term liabilities. In general, if a liability must be paid within a year, it is considered current. This includes bills, money you owe to your vendors and suppliers, employee payroll and short-term loans. A long-term liability is any debt that extends beyond one year, such as a mortgage loan or a term loan availed by the company to purchase machinery. Apart from long term and short term liabilities theres one more category called contingent liability. Contingent liabilities are estimated payments that the company may have to make if a future event takes place. For instance, suppose the excise authorities have imposed a heavy levy on the company, which has been disputed by the company on some justifiable grounds, but the authorities have gone on appeal against the company, it is a contingent liability. In the normal course, the company does not expect the liability to crystallize, but if the court verdict ultimately goes against the company, it will have to meet the liability. This is a contingent liability. Contingent liabilities are not actual liabilities and hence will not be displayed in the balance sheet figures. It will be shown as a note below the balance sheet.Thats why notes to balance sheet assume lot of importance to an analyst. So, logically, Equity (+) liabilities should be equal to Total assets. This will be true at any point of time. How and why it will always happen is something an accounting student should be learning , not you. Since your aim is to study and analyse the balance sheet to make investment decisions, a through knowledge of the frame work given in this session should be sufficient. Cash flow statement. An introduction. by J Victor on November 14th, 2011
CASH FLOW STATEMENTS. The Cash flow statement is the final component of a companys annual report. It throws light on the cash generating ability of a company. The statement records the actual movements in cash in an accounting period. All cash received (inflows) by the company, and spent (outflows) by the company will be shown in this statement. Cash flow statements may be a little bit difficult to understand than balance sheets and income statements. WHAT DOES IT SHOW? If you recall our article on matching principle, youd have understood that the expenses and revenues shown in the income statement are subject to lot of adjustment. Accountants do not consider the actual payment or receipt of cash and instead, follows the matching concept. hence, it would be impossible for anyone who analyses the companys financial statement to know the exact inflow and outflow of cash. for this, we need the help of a cash flow statement. CFS ( Cash flow statements ) shows the liquidity and solvency position of a company. It throws light on the ability of the company to generate cash from its core operations, and where from it sources funds for expansion. The CFS discloses the actual movement of cash. Hence, it is also a useful tool to gauge a companys ability to effectively manage cash. For example, while profit figures may not help a bank to analyse the loan repaying capacity of the company, an analysis of the cash flows will provide information on the funds available for the same. CLASSIFICATION OF CASH FLOWS. Cash flows are classified under three heads operating, financing and investing activities. The first two sections show the two ways the company can get cash. Operations means making money by selling goods and services; Financing means raising money by issuing stocks and bonds. The third section shows how the company is spending cash, Investing in its future growth. If youre interested in the stock of this company, youd like to see that they can pay for the investing figure out of the operations figure, without having to turn to financing. (Financing causes problems: issuing new stocks will lower the value of each individual share; issuing bonds commits them to making interest payments which will punish future earnings) Actual cash flows differ from profits. A company may be low on cash but reported good earnings and vice-versa. The CFS explains the reason for this divergence. Consider this case. A company that has sold its goods on credit (shown as sundry debtors in balance sheet ) may take time or have trouble realizing the cash. This may elongate the companys working capital cycle and force it to resort to other funding options to keep the production cycle moving. Similarly, a company may have produced goods but piled them up as inventory without quickly converting them into revenues. Here the cost of holding such inventory instead of converting it into cash would affect operations. Both these may also be indicators of a slowing demand (in case of inventory build up) or higher risk of debtors becoming bad. Thus, a study of operating cash flows may be a key indicator of a companys health or provide cues for any impending trouble in its business or financial position. In our next two lessons, we try to understand cash flow statements from the investors point of view and will also give tips to analyse cash. We will also look at how to analyse cash flow without actually looking at a cash flow statement which is a bit complicated to read. Understanding Cash flow statements by J Victor on November 15th, 2011
Profit is an estimate. Cash is a fact. Cash flow statement-Thats last of the three types of financial statements. I hope the very first sentence in this article has given you an idea about cash flows. The cash flow statement reports the actual solid cash generated and used during the time interval specified in its heading, unlike profit and loss statement which gives an estimate based on certain rules and assumptions, after deducting certain expenses like deprecation which does not require any cash outflow. The whole idea of cash flow statement is to show you from where the company got its cash whether its from its business operations or by sale of assets or issue of shares and how it used up those funds. This data is important because business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive.
THREE SECTIONS OF A CASH FLOW STATEMENT. A Cash flow statement split into three sections. It shows separately the cash flow from operating, investing and financing activities of the business. Operating cash flow is cash received or paid by a company in the course of its regular business during a specific time period. Operating cash flow items will usually have a correspondence to items in the companys income statement.A strong positive cash flow from operations is a good sign of the companys health Investing cash flows are cash received or paid out by the company associated with investment items. These can be investments in publicly traded securities, investments in other companies or investments in assets such as property or factories. Oftentimes, investing cash flows will not have a corresponding item on a companys income statement but the changes should show up on a companys balance sheet.The changes in cash flow form changes in equipment, assets, or investments are revealed here. Cash goes out to buy new equipment. Also cash comes into the company when an asset is sold or divested. Financing cash flows shows money received or paid out by the company associated with its capitalization. These items can be related to debt payments or new debt. Dividend payments would show up here. Stock buybacks or the issuance of new stock would also show up here. Most of these items would be unlikely to show up on a companys income statement (although interest payments would) but would show up on the balance sheet.The financing section shows how borrowing money affects the companys cash flow. WHAT DOES THE CASH FLOW TELL US? Its three sections gives us an idea about the quality of income that the company is generating. The cash flow statement may appear to be a complicated statement for a young investor, but a careful study along with the following tips would help him better understand it and enable him to take better investing decisions. Operating section The statement gives you details of cash from operating activities. Consistent cash generation thats greater than the net income of the company can be considered to be of a high quality. But If the cash from operating activities is less than net income, you may want to check why the reported net income is not turning into cash. When a company spends more than it receives, it is said to have a negative cash flow. Negative cash flows are often viewed as indicators of financial ill health by investors. To get a feel for whether a company is playing games with its earnings, compare net income on the income statement with cash from operating activities, which represents how much cash a companys operations generate or consume. Generally, the closer a ratio of those two numbers is to one, the higher-quality the earnings. If a statement consistently shows more inflows than outflows, it is an indication that it can increase its dividend payments, repurchase its stocks reduce its debt or acquire another firm. All these are signs of a firm that is in good standing and is considered to be of good value. If the firm consistently reports growth on its income statement, but has negative cash flow from operating activities, it may be lacking the ability to translate its growth into cash. These firms are more likely to face liquidity problems, or even default on their short term liabilities. A company that keeps Increasing its earnings and at the same time, suffers from negative cash flow is a red flag. Compare the rates at which net income and operating cash are growing. If the two normally move in lockstep but cash now lags, thats a caution signal for you. Negative cash flow from operations isnt always bad. Because of the high costs of growing a business, its normal for fast-growing companies to spend more cash than they generate. Typically, such companies may rely on bank borrowings or share issues to raise funds for expansion. In other words, they run a surplus in financing cash flows. Cash outflows towards customers for refunds may indicate that the customers are not happy with the companys products and services. Investing section Review the investing section of the cash flow statement. This section reveals the changes in cash due to equipment, assets or company investments. For example, cash goes out when new equipment is bought and cash comes into the company when an asset is sold. The cash flow from investing activities also indicates a firms ability to invest in non- current assets. If the company generates enough cash to invest continually in property, plant and equipment as well as other fixed assets, it is an indication that the firm aims at replacing technologically obsolete equipment to keep up with the latest trends. Any substantial increase in investing section of cash flow may also hint at possible attempt to take control of another company for diversification of business. Increase in fixed assets indicates capital expansion and future growth. Financing section The cash flow from financing activities should be carefully evaluated when interpreting cash flow statements. Investors should compare current debt financing with past periods to determine if the firm has reduced its debt over the years. While analysing financing activities, Issuance of common stocks at attractive prices (high stock price above book value) may indicate that the brand image and product of company is good. Issuance of preferred stock is not a good sign as it hints that the company is having problems in selling common stock. If company is resorting to debt financial then it is important for investors to analyze the debt equity ratio of company. Reduction of long term debts is desirable. CONCLUSION Cash flow is an important measurement and is best understood when you compare the results of a company to its peers and to the market. It is important because it focuses on actual operations and eliminates one-time expenses and non-cash charges. Remember- Cash is king ! More about cash flows. by J Victor on November 18th, 2011
If there is one investor who watches the flow of cash closely- thats Mr. Warren Buffet, one of the worlds richest stock market investor. Theres lot of books and videos explaining his method of investing, the way he analyses a company and about his investing philosophy. But if you watch closely, what buffet does is quite fundamental He targets long term investment appreciation He invests in businesses he understands He takes a closer look on cash flow.
WHY SO MUCH STRESS ON CASH? Cash is different! When you look at a companys balance sheet youre looking at what the company owns and owes recordically. The problem is that , assets like land are recorded at purchase price ( Now, land would be worth more than the purchase price) and assets like buildings and machinery are recorded at cost less a fixed depreciation rate as prescribed in law ( actual depreciation may be more or less than the depreciation charged). Similarly, debtors may not be fully recoverable. The figure is shown on the assumption that those are fully recoverable. So, in short what you see in the balance sheet is the value of the assets and liabilities as decided by certain rules, assumptions and estimates. This is not the actual picture. Same is the case with profit and loss account. The profit and loss accounts is made up with lots of estimates, accrual accounting method, non cash expenses etc..This distorts the actual picture of the company. But, when you look at the cash flow statement, youre indirectly looking at the bank account of the company. Buffet has been looking at cash all along. PROFITS AND CASH ARE DIFFERENT. Profits are not the same as cash. Cash may come in from different sources for a business. It can come in from banks in the form of loans or from investors. If you understood what you read in our matching concept you would remember that :- Revenues are booked at sale, expenses are matched to revenue and capital expenditures dont count against profits. In other words, revenues are recorded when ever the company deliver a product or service irrespective of whether the customer has paid for it or not, the expenses are matched to revenues implying that it does not represent the actual cash going out and capital expenditures ( or expense incurred to purchase a fixed asset like machinery ) is never recorded as an expense in the profit and loss account but, an amount technically called depreciation is charged against revenue. Hence - A COMPANY CAN REPORT PROFITS (and still be left out with no cash!!) Yes! Well illustrate how. For this exercise, let us go back to the imaginary company we created in our third chapter- say-it-with-flowers. The company now buys flowers from farmers at 30 days credit and delivers it to customers on 60 days credit. That means, it needs to pay its suppliers at the end of 30 days and it collects the sale proceeds from customers only at the end of 60 days. For every sale , it makes a profit of 40% from which it needs to meet it monthly expenses of 10 lakhs. Presently it has a bank balance of 130 lakhs. In January, it records a sale of 200 lakhs. So, the profit made is 40% that is 80 lakhs before expenses according to books. The accountant would look at his records and say that it has made a profit of 70 lakhs (200 120 -10). But, in reality it has not collected a penny since its customers pay at the end of 60 days. But at the end of the month, it has to pay its suppliers 120 lakhs and a monthly expense of 10 lakhs. So it takes out the 130 lakhs from bank, pays 120 lakhs to suppliers and 10 lakhs for monthly expenses. Now, the profit according to income statement is 70 lakhs, but in reality, bank balance is 0. How did we find out that the bank balance is 0? We looked at how the cash flowed. In February, say-it-with-flowers records a sale of 320 lakhs and makes a profit of 40% 128 lakhs. Deducting the monthly expenses due, the accountant would show from his income statement that it has made a profit of 118 lakhs in February and a total profit of 188 lakhs (70 in Jan + 118 in Feb.) But, reality is the company has received Rs 200 lakhs from sale made in January (customers pay after 60 days ) , it pays off 192 lakhs to its suppliers for flowers supplied in February , and is left out with just 8 lakhs in bank account. It has to borrow 2 lakhs from somebody to pay off the monthly expenses!! So- If we look at the companys income statement as given by the accountant, wed find that sales and profits are growing. If we look at the cash flow, wed understand that in reality, the company is in cash crunch. A COMPANY CAN REPORT LOSS (and still have plenty of cash!!) Now, lets look at an imaginary company called Dees fried chicken. Since the company sells fried chicken, it has a 100% cash based business. It gets chicken from suppliers at 60 days credit. Customers pay upfront and buy chicken fry. Theres no credit. However, monthly expenses are 90 lakhs- on the higher side due to high standards to be maintained. For sake of comparing, this company also makes 40% profits on sales and starts its business in January with 130 lakhs in bank account. In January, it records a sale of 200 lakhs. So, the profit made is 40% that is 80 lakhs before expenses according to books. The accountant would look at his records and say that it has suffered a loss of 10 lakhs (200 120 -90). But, in reality it has to pay only 90 lakhs at the end of the month, it need not pay its suppliers 120 lakhs since supply is at 60 days credit. The company has 240 lakhs (130 lakhs previous balance + 110 lakhs in January) in bank, after monthly expenses. Now, according to income statement the company is in loss, but in reality, bank balance is 240 lakhs. In February, Dees fried chicken records a sale of 320 lakhs and makes a profit of 40% 128 lakhs. Deducting the monthly expenses due, the accountant would show from his income statement that it has made a profit of 38 lakhs in February and a total profit of 28 lakhs (-10 in Jan + 38 in Feb.) But, reality is the company already has 240 lakhs in bank , it gets another 320 lakhs , pays off 120 lakhs to its suppliers for chicken supplied in January , pays monthly expense of 90 lakhs in February and has a balance of 350 lakhs in bank account !! So- If we look at the companys income statement as given by the accountant, wed find that sales and profits are not upto the mark. If we look at the cash flow, wed understand that in reality, the company is cash rich. Understanding this difference between profits and cash is the key to increasing your analytical ability. It opens a whole new perspective from which you would start looking at companies THE LINK BETWEEN PROFITS & CASH Cash flow statement. The most interesting fact about cash flows is that you can analyse it by looking at the income statement and two balance sheets. This is not a very complicated process; but its easy to get confused in the process if you dont understand the whole thing clearly. Heres a step by step guide to analyse cash. Look at every change from one balance sheet to the next Determine whether the change has resulted in an actual outflow or inflow of cash. Add / deduct the amount from the net income as per current income statement. More specifically Start with profits Non cash expenses: Add back all non cash expenses like depreciation. Assets Accounts receivable: If it has increased deduct from profits; if it has decreased add back to the profits. Inventory / closing stock: If it has increased deduct from profits; if it has decreased add back to the profits. Any other asset: If it has increased deduct from profits; if it has decreased add back to the profits. Liabilities Accounts payable: If it has increased add back to profits; if it has decreased deduct from the profits. Loans and debts: If it has increased add back to profits; if it has decreased deduct from the profits. Any other liabilities: If it has increased add back to profits; if it has decreased deduct from the profits. Others Dividends paid: deduct the payment from net profit CONCLUSION: Cash flow is the key to picking highly profitable companies. The analysis would help you to get insights into a companys actual financial health. Financial ratios. Introduction to financial ratios by J Victor on August 1st, 2010
Financial ratios are used to evaluate a company- Its Financial Strength, Management effectiveness, Efficiency and Profitability. Ratios look at the fundamental financial aspects of the company. It gives you an idea about The current financial position of the company where the company ranks among its peers and if it is properly priced by the market as reflected in its stocks price Overall, it helps you to decide if a particular company is worth getting involved with. Since, ratios look at companies from the fundamental level; ratio analysis is also called fundamental analysis. Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The ultimate goal is to determine the current worth and, more importantly, how the market values the stock. There are at least 12 financial ratios you should understand to evaluate a company. This article focuses on the key tools of fundamental analysis and what they tell you. Even if you dont plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms. It is enough that you understand all these ratios, its meaning, components and relevance. Most of the ratios need not be computed since these form part of the financial statements. All these ratios are available in the internet from various financial websites and magazines. Myfavoritesiteforpickingupratios To get all the non financial and financial datas of Indian companies, my favorite sites are - 1. Moneycontrol.com 2. In.Reuters.com List of key ratios : 1. Earnings per share or EPS 2. Price to Earnings Ratio P/E 3. Market capitalization 4. Price to Sales P/S 5. Price to Book P/B 6. Dividend Payout Ratio 7. Dividend Yield 8. Book value 9. Return on Equity 10. Interest coverage ratio 11. Current and quick ratios 12. PEG ratio Understanding Earnings Per Share (or EPS) by J Victor on August 2nd, 2010
Earnings means profits. Before you buy a share , this is the first figure that you need to check. An increase in earnings every year is a sign that the company in question is prima facie a good candidate for further analysis. Increasing earnings generally leads to a higher stock price. Most of the high earning companies also pay regular dividend to its shareholders. Analyzing Earnings is the first most important step for investors because they give an indication of the companys expected future dividends and its potential for growth and capital appreciation. The other names by which earnings are called are Profits , Income etc.. ( But not Revenues. Thats a totally different term !) THE BASICS. Earnings simply are the companys profit how much money did it make in any given period.How does a company calculate earnings ? Its by deducting the cost of sales , operating expenses and taxes from its total sales revenues. The term cost of sales is nothing but the total amount incurred of raw materials, labour and other expenses incurred in producing a product for sale. The term operating expenses means the cost incurred for operating the business such as salary to staff, legal expenses, advertisement etc.. and taxes are those payments made to the government on the income thats generated. POSITIVE EARNINGS. Investors expect established companies like Infosys to declare high earnings. If they report lower earnings for a quarter, the stock price would immediately tumble. New or Young companies, on the other hand, may go for years with negative earnings and still enjoy the favor of the market if investors believe in the future of the company. Companies are required to declare its earnings figures every quarter. In India, A financial year starts from 1st of April and ends on the subsequent march 31st. So the quarters are as follows- Quarter 1 -1st April to 30th June. Earnings for the quarter will be declared in July Quarter 2 1st July to 30th Sept. Earnings for the quarter will be declared in Oct. Quarter 3 1st Oct to 31st Dec . Earnings for the quarter will be declared in Jan. Quarter 4 1st Jan to 31st Mar . Earnings for the quarter will be declared in April. Companies also declare half yearly results clubbing two quarters. Investors, based on the given facts, try to figure out the expected earnings of the company. This expectation of the investors is what is actually reflected in the share price movements. So, in addition to the actual earnings, the expectation of earnings also play an important part in stock prices . Companies that fail to meet the expectations of the investors gets beaten by the market. Earnings (or growth towards positive earnings) tell you how healthy a company is. EARNINGS PER SHARE. The basic measurement of earnings is earnings per share or EPS. This measurement divides the earnings by the number of outstanding shares. For example, if a company earned Rs 150 Crores in the third quarter and had 75 Crore shares outstanding, the EPS would be Rs 2 (150 / 75). WHY EPS? The reason you reduce earnings to a per share basis is to compare it with another company. For example Two companies A and B has earned a profit of 150 crores each.Which one would you prefer? Both seems to be ok with you. Right? However, if I say that company A has 75 Crore shares outstanding and company B has 100 crore shares outstanding, which one would you prefer? Your answer lies in the EPS figure. Company A has an EPS of 2 ( 150/75) whereas company B has an EPS of just 1.5 (150/100). So you prefer the company A that pays you more profit per share. Its importants to note here that the EPS is helpful in comparing one company to another, assuming they are competing companies of the same category ( large cap or small cap etc..) in the same industry, but it doesnt tell you whether its a good stock to buy or what the market thinks of it. EARNINGS PERIOD. As said earlier, companies report earnings every quarter. April-June is Quarter 1 generally termed as Q1, July Sept is quarter 2 or Q2and so forth. Generally , the quarter results come out by the mid of the subsequent quarter. The market always approaches the earnings reporting day with caution.That day can be a time of some volatility, either up or down for particular stocks and/or sectors. TYPES OF EPS The numerator and denominator in an EPS equation can change depending on how you define earnings and shares outstanding. Lets try to crack the numerator (Earnings) first. There are three types of Earnings numbers: Trailing earnings last year end earnings figure. Current earnings current years number- part actuals,part projections based on the current performance. Forward Earnings future numbers which are pure estimates. EPS calculated with the last year end actual earnings figure is called trailing EPS. trailing EPS is the actual EPS figure. When Current earning estimates are used to compute EPS , its called the Current EPS and when Future earnings figures are used, its called forward EPS. Now, Lets see the denominator part. (ie Shares outstanding) Shares outstanding can be classified as either Basic or fully diluted Basic EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded. Basic Earnings per share (Basic EPS) tells an investor how much of the companys profit belongs to each share of stock. The number calculated this way excludes any possible dilution stemming from outstanding dilutive securities, such as options, warrants, convertible bonds, or convertible preferred stock. Diluted EPS reflects the potential dilution from such dilutive securities. The companies that dont have any dilutive securities, or the companies that report net losses, report only Basic EPS. In short, EPS computed can be Trailing EPS (Diluted or basic) or Forward EPS (Diluted or basic). Know it Earnings means Profits. The term should not be confused with Revenues which is a totally different term Companies report earnings every quarter i.e April-June (quarter 1 or Q1) Jul-sept (Q2) so on.. The stock market approaches each earnings report with caution. Markets will react positively on a company that declares positive earnings growth. The reverse is also true. The basic measurement of earnings is EPS EPS computed can be Trailing EPS (Diluted or basic) or Forward EPS (Diluted or basic). Price to Earnings ratio or P/E ratio by J Victor on August 3rd, 2010
Hi there .. In the last post I discussed about earnings and earnings per share. You learnt that Earnings per share is useful to compare two or more companies of the same category and industry. In this article we will look into a more important ratio called the P/E ratio. Thats the Price / Earnings ratio more commonly called the P/E ratio. The P/E Ratio is a widely used ratio for valuing shares prices. It also know by different term such as P/E multiple, earnings ratio , Price earnings ratio, P/E ratio etc.. WHAT IS IT? The P in the formula stands for the market price of the share.The E in the formula stands for the Earnings per share. If you see a stock trading at 50 per share on the market, and that stock had an EPS (earning per share) of 2.50, then according to this formula, the P/E Ratio of this stock is 20. HOW TO CALCULATE P/E The P/E looks at the relationship between the stock price and the companys earnings. You calculate the P/E by taking the share price and dividing it by the companys EPS as shown in the above example. WHAT DOES THE P/E TELL YOU ? The P/E gives you an idea of what the market is willing to pay for a share of companys earnings. The higher the P/E the more the market is willing to pay for the companys earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stocks future and has bid up the price. Conversely, a low P/E may indicate a vote of no confidence by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these sleepers before the rest of the market discovered their true worth. WHAT IS THE RIGHT P/E? There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the right P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your right P/E is all wrong. MORE TIPS ON P/E If a stock has a P/E of 15, that means the market is willing to pay 15 times its earnings for the stock. For this reason, P/E is sometimes referred to as a multiple. In the above example, the stock has a multiple of 15. Also denoted as 15x . Companies with good growth potential will have a higher P/E because investors are willing to pay a premium for future profits. High-risk companies will typically have low P/Es, which means the market is not willing to pay a high price for risk. IS THE P/E FORMULA PERFECT TO VALUE STOCKS? Unfortunately, P/E alone cannot be used as a single measure to value stocks. The reason is that an individual companys earnings figure can be skewed by accounting abnormalities which may temporarily inflate or deflate the actual earnings. A low P/E does not necessarily mean a stock is cheap and l a high P/E doesnt mean a stock is expensive! You have to compare apples to apples. You have to put a stocks P/E ratio into the proper context.So you cannot make a buy or sell decision strictly on P/E, but it can be used to get greater insights into a sector or stock price. Different industries have different P/E ratio ranges that are considered normal. For example in the recent years of IT boom, information technology companies had high P/E ratios compared to other sectors. P/E ratios are available are available sector wise. This helps in finding out which sectors are more expensive at a particular point of time.To know when a sector is overpriced, the average P/E ratio of all of the companies in the industry is compared to the historical average. If the average climbs far above the historical average, you get the hint that the sector as a whole is overpriced. You can use the P/E ratio to compare the prices of companies in the same sector. For example, if company A and company B are both selling for 50 per share, one might be far more expensive than the other depending upon the underlying profits and growth rates of each stock. Thats about P/E ratio. In my next post , i will detail more about the types of P/E ratio and some more tips on how to use it. More about P/E by J Victor on August 3rd, 2010
Hi there, Lets catch up with P/E ratio in detail. Before that, heres a re-cap of what P/E is all about. WHAT IS P/E RATIO? Price to Earnings ratio is jargon used by investors and analysts. P/E is one of the most commonly used valuation methods in the world of investment. It is used to measure how cheap or expensive a stock is. It has the ability to explain long-term return potential of a stock. P/E is market price of the share divided by earnings per share. It is the amount of rupees the market is willing to pay for one rupee of the companys earnings or to put it in another way, it is the number of times the share of a company is priced in the stock market compared with its earnings. The inverse of this ratio is known as the earnings yield. The commonly used time-frame to calculate price-earnings multiple is the trailing 12- month period.
DETERMINANTS OF P/E RATIO
The P/E multiple of a company is determined by many factors but the key determinants are (a) Expected Growth Rate (b) Current and Future Risk and (c) Current and Future investment needs. (a) Expected Growth Rate -Companies with a higher expected growth rate in business normally trade at a higher P/E multiple, as the earnings are expected to be more attractive in future. When the estimated EPS is higher, the forward P/E is lower compared with the current P/E. So, when the market gets this information, the share price goes up as then investors would be willing to pay a higher price for the stock. Therefore, companies with higher growth rates trade at higher P/E multiples. (b) Current and Future Risk -Companies perceived as risky usually trade at lower multiples, as the market expects fluctuations in their operating results. For instance, companies with higher operating leverage (higher proportion of fixed costs to total costs) and higher financial leverage (higher debt/equity ratio) are perceived to be riskier, by the market. (c) Current and Future investment needs-P/E ratio is also affected by the reinvestment needs/requirements of a company. For example, a company with higher reinvestment needs is perceived as riskier, as it would then require the company to borrow more funds. This may lead to a higher financial leverage or earnings dilution for existing shareholders depending on the method adopted to raise funds.
TYPES OF P/E
Trailing P/E Ratio Current market price divided by its last year EPS. Forward P/E Ratio Current market price divided by its estimated next year EPS. WHICH ONE TO USE? While these two are the most commonly used P/E ratios as both are based on actual earnings and hence the most accurate it is forward PE that holds more relevance to investors when evaluating a company.
PRACTICAL TIPS WHILE USING P/E
Tip 1.Note that the P/E multiple comes down drastically due to the steep increase in the forecast EPS; the opposite holds true for a steep decline in the forecast e EPS number. All the variants of P/E are based on the same numerator (i.e. market price per share) but use different denominators (i.e. earnings per share- historical, trailing, forward and future). You can also consider taking the 6 -12 months median market price of the share for computing the price to earnings multiples. Tip 2.Value investors tend to adopt a low PE as a rulebook for an investment. While a low PE multiple is desirable, it would be inappropriate to adopt this ratio as a stock- picking tool across industries. Technology stocks tend to quote at trailing 12-month PE multiples between 30 and 40 compared to basic industry stocks that usually have single- digit PE multiples. As such, investors would be better off adopting this tool for peer comparisons within the same sector. Tip 3.This tool bypasses investment opportunities in companies that are making losses and are on the verge of a turnaround. So thats another area to be careful about while analysing companies. Tip 4.Adopting moderate price-earnings multiple as a filter, an investor would also miss out on companies with substantial growth prospects. Tip 5. Companies that are just out of the red would be off the radar as they tend to command high PE multiples. Take the case of an investor who had adopted this tool in September 2003. SAIL, which traded at Rs 40, would not have been on his radar then as it quoted at about 60 times its trailing 12-month (standalone) earnings. Within a span of three-and-quarter years, the stock doubled to about Rs 80 (commanding an earnings multiple of 8). Tip 6.Going by a low PE would also filter out most stocks in the retail, media and technology space and leaving only those in the basic industries. A good number of stocks with a low PE are those perceived to have little opportunity for earnings growth or are highly volatile. Therefore, while the PE multiple is the most commonly used valuation metric, it cannot be the only one you use to decide on an investment Have a nice Day ! Measurement of size- market capitalization by J Victor on August 4th, 2010
Now Let us forget about ratios and concentrate on another important aspect.Size. If I tell you the price of two companies say, company A Rs 150 and company B Rs 75. would you be able to tell me which is the bigger one? Is it company A? No. why? because, you cannot guess the size of the company by looking at its share price. So, the question is how to measure the size.The answer lies in finding out something called Market capitalization of that company. Market capitalization or market Cap is calculated by multiplying the current stock price by the number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market. For Example: A stock trading at Rs 55 with 100,000 outstanding shares would have a market cap of Rs 5.5 lakhs. Since the per-share price keeps changing and since each company has a different number of outstanding shares, the market capitalization of a company keeps changing everyday. Heres an example: letss take tw companies A ltd and B ltd A Ltds Stock price: Rs 50 Outstanding shares: 50 Lakhs So , Market cap works out to : Rs 50 x 50,00,000 = Rs 2500,00,000 B Ltds Stock price: Rs 10 Outstanding shares: 3 Crores So Market cap works out to : Rs 10 x 300,000,000 = Rs 30000,00,000 This is how you should look at these two companies for evaluation purposes. Their per-share prices tell you nothing by themselves. This is exactly why Reliance industries with a share price of Rs 1100 is a bigger company than say, MRF Ltd whose share price is around Rs 7500. Having said that, let us look into how the companies are classified according to its market capitalization. LARGE CAP There is no standard definition of Large Cap and it varies from institution to institution. But as a general rule, in India, if a company has a market capitalization of more than Rs. 5000 Crores, it is considered as a Large Cap. A Large Cap company is normally a dominating player in its industry, and has a stable growth rate. It should be noted that almost all the Large Cap companies from India would be considered as Mid Cap or Small Cap companies in a global scenario, as globally, companies are usually classified as Large Cap if their market cap is more than $10 Billion (roughly Rs. 39,000 Crores). MID CAP If a company has a market capitalization of between Rs. 1000 Crores and Rs. 5000 Crores, it is considered as a Mid Cap A Mid Cap company is normally an emerging player in its industry. Such a company has a potential to grow fast and become a leader (a Large Cap) in the future. Mid cap companies can show very high growth rates (in percentage terms), because they have a small base since their size is small, even a small incremental increase in revenue / profits can be a big figure when expressed in terms of percentage. SMALL CAP If a company has a market capitalization of less than Rs. 1000 Crores, it is considered as a Small Cap A Small Cap company is normally a company that is just starting out in its industry, and has moderate to very high growth rate. Such a company has a potential to grow fast and become a Mid Cap in the future. CONCLUSION Focus on the market cap to get a picture of the companys value in the market place. Per share price may not give you the actual picture about the companys size . More about Market-caps. by J Victor on August 4th, 2010
Hi there, Market capitalisation or market cap is a simple indicator of the value placed on a company by the market at todays prices. The computation of market capitalization and its meaning has been explained in beginners lessons 3:Market capitalization. Now lets get into more details on market-cap. Stocks are classified into large, mid or small cap, based on their overall market cap. Indices such as the BSE Sensex and the CNX Nifty represent a basket of large-cap stocks. However, What was a small-cap stock a few years earlier may graduate to a large-cap status, as the company ramps up in size and gains greater recognition from the market.
WHERE SHOULD YOU INVEST?
Well, thats a difficult question to answer since much would depend on an investors attitude, age, financial capacity, investing aims and his ability to take risks. What I can do is to give you some pointers as to what you can expect by investing in these different caps. WHAT TO EXPECT FROM LARGE CAPS. 1.Steady growth: Large-cap stocks usually represent well-known companies with a sizeable scale of operations; they often carry the potential for steady growth in line with the economy. 2.Less volatility: Earnings of Large cap companies will seldom grow in leaps and bounds, but may exhibit fewer surprises from quarter-to-quarter or year-to-year, as they are tracked by a veritable army of analysts! 3.Darling of FIIs: Foreign institutional investors seeking to dip their toes into the Indian markets often make their first investments in large-cap stocks. If you are the conservative type, and would like to buy and hold for the long term, you should probably pick your investments from the basket of large-cap stocks. 4.Leader of the pack:Large-caps are usually the first to lead any market recovery, while mid- and small-cap stocks tend to join in later. 5.Above par performance in bullish market: Large-cap stocks will usually perform well than mid and small caps during bullish periods. 6.Dividends:large cap companies generally have the history of paying out regular dividends.Small and mid-cap companies may not pay regular dividend since they keep investing the surplus in more ambitious projects. WHAT TO EXPECT FROM MID CAPS AND SMALL CAPS. 1.High growth :Mid- and small-cap stocks usually represent companies that are in nascent businesses or those that are lower in the pecking order, within a sector, in terms of revenues or market share. 2.High volatility: Earnings of mid-cap and small-cap companies will grow in leaps and bounds and they may come up with surprises from quarter-to-quarter or year-to-year, resulting in high variation in stock prices. 3.Multi-baggers hide here: If you are hoping to find multi-baggers, you must invest in mid- and small-cap stocks. 4.High returns and high risk: Midcaps offer potential for higher returns because of their ability to register earnings growth at a faster pace. At the same time , you should be aware that they often carry higher risks than large caps. Their earnings could suffer bigger blips because of vulnerability to a downturn in the business. 5.Less liquidity: Small and mid-cap stocks are often not traded as actively as large caps, dwindling volumes could magnify the decline in prices of such stocks in the event of a market meltdown. It is, therefore, important to put your choice through a liquidity filter (check for the stocks historical trading volumes over a couple of years) before investing in mid- or small-cap stocks. 6.First to fall in a market crash: If you are booking profits on your portfolio because you expect a big correction, your mid- and small-cap stocks should probably go first, as they would be most vulnerable to any meltdown in prices. 7.Below par performance during uncertainty: Mid- and small-cap stocks will usually under- perform large caps during periods of high uncertainty. 8.Least preferred stocks during uncertainity:Global events impacting FII flows , political upheavals or financial instability often prompt a flight to safety which results in liquidity fleeing mid- and small-cap stocks into the tried-and-tested large-caps. TIPS FOR BALANCED APPROACH If you now have a grip on how large-, mid- and small-cap stocks behave, here are a few additional pointers on investing based on market cap: Tip #1:Maintain a balance: Maintaining a balance between large-, mid- and small-cap stocks in your portfolio is as important as spreading your investments across different sectors and businesses. Typically, you should have 60 % of your money invested in large caps, 30% in mid caps and 10% in small caps. Tip #2:Never stick to a single cap: Making investments only in small and mid-cap stocks could make for high volatility while sticking only with the large-caps could deliver modest results. Tip#3:Analyse your risk tolerance capacity: Decide on your allocations to each group based on your appetite for risk and to adhere to this, irrespective of market conditions. Tip#4:Do your home work: shift your allocations between large-, mid- and small-cap stocks based on market conditions. That would give you maximum results. But practicing such a strategy is not for beginners. It can be quite difficult and may require timing skills and analytical abilities. Understanding price to sales ratio by J Victor on August 5th, 2010
Hi there , We learned about P/E ratio in our earlier article. P/E ratio is useful for evaluating companies with adequate earnings. But in some cases, especially in the case of promising start up companies, earnings of the company may not be anything much to talk about. The reason could be high amounts spent for further expansion. In such cases, instead of P/E , P/S would be used. That is, we try to figure out what the market is willing to pay for a share of companys sales. The higher the P/S the more the market is willing to pay for the companys sales generated. HOW IS IT CALCULATED? Price to sales ratio relates market value of the company to its annual sales. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company. You can also calculate the P/S by dividing the current stock price by the sales per share. P/S = Market Cap / Revenues P/S is an alternative method to look at companies where P/E doesnt work. For example Price to sales are useful to value retailing companies. ADVANTAGES AND DISADVANTAGES Earnings is basically an accountants estimate of the profits made by a company. earnings can differ according to the accounting method used and the assumptions that has gone into computing it. So, a shrewd accountant can very easily manipulate the earnings figure of a company to please the share holders. But, sales figures are not subject to such high manipulation. The flip side is that, eventually, any company should come up with profits. A business may have higher sales but a lower profit margin than a competitor, indicating that its not operating efficiently. whats the benefit if a company generates crores and crores of sales but ultimately falls short when it comes to earning profits? Ultimately , earnings is what drives the stock price up. So, P/S is a tool that should be used very carefully in certain special circumstances. For example we need to take a decision between two similar retailing companies. Both the companies are identical in all respects- EPS, Debt (borrowings) etc. You can use P/S to evaluate which company generates more volume of sales with the borrowed money. so, if leverage ( technical jargon for borrowings) is similar across companies , P/S may become useful for the investor to make decisions. P/S can also be used to spot high growth companies of tomorrow which may not be reflected with P/E analysis. Companies with high potential for growth generally have low earnings due to heavy investments made in the initial years.If you assume that the future of the company is bright, P/S may be the measure you need to confirm that. CONTRADICTION BETWEEN P/E AND P/S Generally, P/E of a company and P/S move in the same direction. There could be situations where P/E of a company contradicts with the P/S ratio. For example , If a company has a low P/E but a high P/S, it can be a signal that there were some one-time gains. Thats about price to sales ratio .. bye for now ! Understanding price to book ratio by J Victor on August 6th, 2010
PRICE TO BOOK RATIO Hi there, before I begin my discussion on Price to book, a quick recap of some important terms. Book value is a concept we discussed at earlier stages.The Book Value is simply the companys assets minus its liabilities. That is the actual worth of the company. But if you want to acquire that company, you need to buy every single share at the current market price and that value (ie market price per share x total shares) is called market capitalization. i hope you remember those two terms book value and market capitalization or market value. PRICE TO BOOK RATIO Price to book ratio is computed as follows - Market capitalization / Book value OR Market price per share / Book value per share. Market price of the share and book values for any listed company are available straight from financial web sites. So there is no need to compute it.So lets try to understand the ratio and its significance. The P/B gives you an idea of what the market is willing to pay for a share of companys book value.The higher the P/B the more the market is willing to pay for the companys book assets. Some investors read a high P/B as an overpriced stock. P/B ratios should be used with caution. A low price to book ratio can mean the following- 1. That the stock is selling at a discount to its book value. That gives you a perfect buying opportunity. 2. Something is fundamentally wrong with the company. 3. That the book value of assets is over stated in the companys balance sheet MORE ON P/B Since market price is compared with book values, a distortion in the book value of assets of the company affects this ratio. For example, a company might have acquired land 10 years back. The value shown in the balance sheet would be the price paid at the time of acquisition, 10 years back. Naturally, the asset price would have shot up several Crores, but the same will not be reflected in the balance sheet. The price to book ratio of this company may look expensive, but in reality , it may be an undervalued stock. Companies like software firms, which rely on intellectual property may have very high price to book ratios. They are not capital intensive and hence invest little in solid assets. Their assets are the intellectuals they have and hence P/B are not suitable for valuing such stocks. Assets heavy companies like infrastructure, financial institutions, banks, manufacturing companies can be better valued with this ratio. The ROE and P/B are inter connected. A company with a higher ROE will have a higher P/B and vice versa. Understanding Dividend pay out & retention by J Victor on August 7th, 2010
DIVIDEND PAYOUT & RETENTION RATIOS Hi there, In this article, We look at two ratios that are connected with dividend payments. They are 1. the dividend payout ratio and 2. the retention ratio. The dividend payout ratio measures the portion of profits thats distributed as dividends. The Dividend Payout Ratio is calculated by dividing the annual dividends per share by the Earnings Per Share. So the formula is: Dividends Per Share / EPS or Alternatively, you can divide the dividend by net income to arrive at the same figure. For example, If the companys earnings per share is Rs 3 and it pays Rs 1 as dividend, the dividend payout ratio is 33%. That is, (Rs 1/ Rs 3) x 100 The next question is whether this 33% s good or bad. You may have to analyse the dividend history and the dividends declared by its peers to form an opinion. Generally companies that pay higher dividends are large cap or so called mature companies that doesnt have big expansion plans anymore. A company that has massive expansion plans retains the profits with them and will not pay out much dividends. RETENTION RATIO Retention ratio is the exact opposite of dividend payout ratio. Retention ratio becomes important to spot growth companies. The retention ratio shows how much is kept by the company from the profits made. It is assumed in analysis that whatever amount the company retains, will be reinvested for growth in the company. So, it follows that, a company that retains a large portion of its income, is planning to expand its business. Generally, high retention ratios are seen in young and growing companies. So, the formula for retention ratio is Net income dividends / Net income. Alternatively you can deduct the dividend pay out ratio from 100 to get the retention ratio. A high retention ratio is a sign that the company is in a massive expansion mode. A company that looks to sustain growth without any external financing would resort to increase the retention ratio. Understanding Dividend yield & Earnings yield. by J Victor on August 8th, 2010
DIVIDEND YIELD. Hi there, Dividend yield is another ratio thats connected with dividend payments. The yield ratio is particularly useful for investors who are looking to cash in on the dividends paid by a company. Dividend yield and dividend pay out ratios are different. If dividend payout ratio was the percentage of profit that was paid out as dividends, dividend yield ratio shows how much divided you received for the money you spend on your investment. Yield is a measure to calculate the percentage of return on an investment. With dividend yield, it becomes easier for you to compare between companies that pay high dividends. The formula for calculating the Dividend Yield is by taking the annual dividend per share and divide by the stocks price. So, the equation is- Annual dividend per share / the stocks price. For example: Two companies- A and B pay an annual dividend of Rs 15 per share. The share price of company A is Rs 100 and the price of company B is 150. Which stock gives better return? Company A , because it gives an yield of 15% for every Rs 100 invested in it whereas company B gives an yield of just 10% ( 15/150) The Dividend Yield Trap We talked about dividend yield s positive factors. However, Dividend yield can lead you into a trap if youre not careful. The trap is the denominator figure. The dividend payout is divided by the shares price. Since the share price keeps changing, the ratio will keep changing accordingly. So, if there is a sudden fall in a stocks price, the dividend yield ratio will show a higher figure. Thats one pint to be careful. EARNINGS YIELD. As I said before, yield is a measure to calculate the percentage of return on an investment. Earnings yield is another ratio thats similar to dividend yield. Earnings yield ratio shows how much earnings you received for the money you spend on your investment. This ratio becomes useful where the dividend payments are low. Earnings yield is calculated as follows: Earnings per share / market price per share or E/P That means, earnings yield is the exact opposite of P/E ratio. The convenience of earnings yield is that since it measures the return you received for the money you spend on your investment, its makes it easier for you to compare the companys return against alternative investment options such as bonds or fixed deposits. So, practically its more useful than a P/E. The only problem for E/P is that earnings are not properly defined. Benjamin Graham, the father of value investing, has recommended investors to buy a stock that has a P/E ratio equal or lower than the sum of the earnings yield plus the growth rate. That is , an investor should buy a share only id its P/E is less than the earnings yield + growth rate. P/E Ratio < Earnings Yield + Growth Rate For example, lets say you want to invest in shares of a company that has 7% earnings yield and was growing at 7%. You check he balance sheet and find that the companys fundamentals are good. Considering the history of the company, quality of the management and order book for the future, you expected the company to accelerate its growth from now on. In this case, if you could buy the shares at a price-to-earnings ratio of 14 or less, you would have a reasonable chance for very satisfactory returns (7% earnings yield + 7% growth rate = 14 P/E ratio maximum). However, it would be very difficult to get such investing opportunities where the P/E equals the earnings yield plus growth rate. Its a very conservative filter. I am sure that 95% of the stocks you scan would get rejected on this basis alone. (And, thats why its such a safe measure to valuate investments) Understanding ROE & ROCE. by J Victor on August 9th, 2010
RETURN ON EQUITY (ROE) Equity means shareholders funds. Share holders funds in a company includes the equity capital they invested + their share of earnings retained by the company for further expansion. Hence, return on equity means, the return generated by using shareholders capital. How does a company generate return from its capital? Its by investing in assets which are capable of producing returns. So, Return on Equity (ROE) is a measure of how efficiently a company uses its assets to produce earnings. ROE is the speed at which the company might grow without sorting to additional fund raising. The formula for computing return on equity is: Earnings / shareholders equity AVERAGE ROE Instead of taking the ROE figure of just one year and forming an opinion on that basis, its better to study the financial history of the company and find the average ROE of 5 or more years. This would give you a reasonable assurance about the rate of return that the company is capable of generating. An average ROE of 15% -20% is the preferred range for a company thats growing at a steady pace. THREE COMPONENTS OF ROE The ROE is not a simple equation as you saw above. Lets try to split and expand the equation and try to find what boosts the ROE of a company and why. Lets check the expanded formula. ROE= (Earnings / Sales) x (Sales / Assets) x (Assets / Shareholders equity) If you notice the equation carefully, youll take note that sales and assets are both the numerator and denominator and hence they get nullified. When we break the equation in this manner, the three components of ROE is revealed. They are; Earnings or profits Assets Leverage Earnings or profits: Profits, in simple terms, are the money left after all the expenses is met. So the first part of the equation (earnings / sales) shows the profit margin thats generated by the company from its sales. A low profit margin can mean many things including: Inefficient pricing policy Inefficient cost control ( hence a drop in profits) Unprofitable product ( hence it eats into the profits generated by other products of the company) Cut throat competition ( hence, the company is forced to sell at a low margin) A high profit margin, on the other hand, may mean that the company is enjoying a monopoly in its field. It also indicates that the company has a product or product range that has some brand image and quality and hence its possible for them to sell their products at a higher margin. Such companies are also capable of eliminating competition from new entrants by lowering the prices temporarily or by enhancing the quality of the product without enhancing the price. Assets: The second part of the equation is sales / assets. So that measures the sales generated from per rupee of assets invested by the company. Its also called asset turnover ratio. The asset turnover ratio of a company throws light into an important aspect. How much assets does the company need to generate the required volume of sales? If the company is capable of generating sales by investing heavily in assets, it could mean that the company is capital intensive in nature. The capital intensive nature of the company affects the ROE of the company negatively. Leverage or debt: The last part of the equation is assets / shareholders equity. It is basically a measure of leverage. Leverage is nothing but the amount of debt funds used by the company to sustain business. If the ratio is less, it shows that the company has resorted more to debt funds. If the ratio is 1 it shows that the company has built all the revenue producing assets from shareholders funds. if a company raises funds through to do business through borrowing rather than issuing stock it will reduce its shareholders equity. A lower equity means that youre dividing earnings by a smaller number, so the ROE is artificially higher. So, higher the debt, higher the ROE. So, earnings, assets turnover and debt are the three factors that boost the ROE of a company. Hence, ROE = Net margin x asset turnover x financial leverage. In general, Its important to screen companies for a higher earnings, higher assets turnover and a lower debt. SECTION 2
RETURN ON CAPITAL EMPLOYED (ROCE) ROCE is different from ROE we discussed above. ROCE is the ability of the company to earn return from all the capital it employs. The term All the capital means that it includes debt funds like loans and preference capital as well. The equation for computing ROCE is: Return (before interest and Tax) / capital employed. Debt funds are included in the denominator; logically the numerator should be the earnings before deducting the interest paid on debts. For a company to remain in business over the long term, its important to generate an ROCE which is higher than its cost of capital. Cost of capital is nothing but the compensation that the company should pay to each category capital contributors. That is, for using debt it has to pay interest, for preferred capital it has to pay a fixed return and for ordinary equity holders it has to pay what the equity holders expect something above the risk free return rate and average return they expect from any other stock investment. Since the proportion of equity, preferred capital and loan funds would be different, the weighted average of all is taken as the cost of capital of a company. The higher the ROCE, the better it is. So thats about ROE and ROCE. Understanding interest coverage ratio by J Victor on August 10th, 2010
INTEREST COVERAGE RATIO This ratio relates the fixed interest charges to the income earned by the business. It indicates whether the business has earned sufficient profits to pay periodically the interest charges. It is calculated by using the following formula. Interest Coverage Ratio = Net Profit before Interest and Tax /Fixed Interest Charges What it shows is: 1. The amount of interest expense the company bears in a current year due to loan funds and its impact on profitability. 2. The profit of the company in terms of number of times the interest obligation. This information would show the financial strength of the company. A company which merely manages to generate the required income to pay interest obligations is prone to severe liquidity crisis. 3. An interest coverage ratio of less than 1 is an indication that the company is not generating enough cash to pay its interest obligations. 4 . Any improvement in interest coverage ratio is a good sign. On the same lines, any decrease in the interest coverage ratio of the company is a red flag. WHAT KNID OF DEBTS ARE TO BE INCULDED? All kind of Debts of a company- long term, short term, bank loans, bonds, debentures, notes payable.. In fact, any form of debt for which there is an obligation on the part of the company to pay interest should form part of this calculation. ICR- A part of debt ratios. The ICR is in fact, the smallest form of debt ratios. The big brother is debt ratio which measures the total debts against the total assets. The equation is: Total debt / Total assets. The debt ratio gives us the big picture about the companys debts and the proportion it bears to the total assets. There is also one more ratio called the debt equity ratio which measures the amount of debt in relation to the total equity share capital. Debt equity ratio is calculated as follows: Debt / equity A high debt equity ratio shows that the company has larger amount of debts and hence the risk of running into financial difficulties is much more. Thats about debt ratios Evaluate debt-Understanding Current and quick ratios by J Victor on August 11th, 2010
MEASUREMENT OF DEBT There are several measurements you can use to gauge whether a company may be carrying too much debt. Both come off the balance sheet if you want to do the math yourself or you can find the ratios on several online services. We need two definitions before we move on: CURRENT LIABILITIES AND CURRENT ASSETS Current Liabilities are bills that will come due in the next 12 months. These include the companys normal operating expenses such as salaries, utilities, and so on. Long-term debt, such as mortgages would not be included, however that portion of payments due in the next 12 months would be included. Current Assets are marketable securities, cash and other assets that can be easily converted to cash within 12 months. Land and real estate do not fall into this category because it often takes longer than a year to sell property. The term debt includes short term liabilities, such as accounts payable, creditors for expenses and taxes payable.These are short term liabilities generated on arent really considered as debts. Basically, these kind operational liabilities would be there for all companies. QUICK RATIO The first ratio is the Quick Ratio. This ratio gives you an idea how easily the company can pay its current obligations that is those bills due in the next 12 months. The Quick Ratio is cash, marketable securities and accounts receivable divided by current liabilities (those due in the next 12 months). However, not all Current Assets are included in this ratio excluded are doubtful accounts receivables and inventory. Basically, you are saying if all income stopped tomorrow and the company sold off its readily convertible assets, could it meet its current obligations? A Quick Ratio of 1.00 means the company has just enough current assets to cover current obligations. Something higher than 1.00 indicates there are more current assets than current obligations. It is important to compare companies with others in the same sector because different industries operate with ratios that may vary from one sector to another. Some industries such as utilities, for example carry much more debt than other industries and should only be compared to other utilities. So, quick ratio is : Current assets doubtful debtors and inventory / Current liabilities. Its also called acid test ratio since it takes into account only those assets of the company that can be converted to cash immediately. Thats why even doubtful debtors or debtors which may delay payment are excluded. CURRENT RATIO The second ratio is the Current Ratio. The Current Ratio is very similar to the Quick Ratio, but broadens the comparison to include all Current Liabilities and all Current Assets. It measures the same financial strength as the Quick Ratio that is a companys ability to meet its short-term obligations. Some analysts like the Current Ratio better because it is more real world in that a company would convert every available asset to stay afloat if needed. The Current Ratio measures that better than the Quick Ratio. Current ratio is computed as follows: Current assets / Current liabilities. Like the Quick Ratio, a current ration of minimum 1.00 or better is good, and you should always compare companies in the same sector. CASH RATIO Talking about liquidity ratios, there is another ratio commonly described in academic texts called cash ratio which measures the liquid cash in hand against the current liabilities of the company. cash ratio is computed by the equation- Cash balance as shown in balance sheet / current liabilities From the investors pint of view, only the current ratio is relevant, because nobody is interested in the very short term liquidity measurements of the company. In the very short term, stock movements are more influenced by the demand, supply and sentiments of the market participants. However, It would be nice to know whether the company is sitting on huge cash reserves or not. CONCLUSION These three ratios, which you can find on any Web site that offer quotes, tell you a great deal, about how a company may or may not weather tough times. Low numbers in these ratios should be a red flag when you are evaluating a stock Understanding PEG ratio by J Victor on October 6th, 2010
PEG RATIO Popularized by the legendary Peter Lynch, Its a ratio that will help you look at future earnings growth You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings. PEG = (P/E) / (projected growth in earnings) For example, a stock with a P/E of 20 and projected earning growth next year of 10% would have a PEG of 20 / 10 = 2. WHAT DOES IT SHOW? Consider this situation; you have a stock with a low P/E. Since the stock is has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value? To find the answer, PEG ratio would help. Now, if the PEG ratio is big (or close to the P/E ratio), you can understand that this is probably because the projected growth earnings are low. This is the kind of stock that the stock market thinks is of not much value. On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason. WHAT IS THE RIGHT PEG? There are no hard and fast rules regarding the right PEG ratio. Normally, A PEG Ratio of 2 or below is considered excellent. A PEG Ratio of 2 to 3 is considered OK. A PEG Ratio above 3 usually means that the companys stock is over priced. Technically speaking If PEG ratio=1, it means that the share at todays prices is fairly valued. If PEG ratio>1, it indicates that the share is possibly over-valued. PEG ratio<1, it indicates that the share is possibly under-valued. PROBLEMS WITH PEG. The first problem is the P/E itself. Which P/E should be used for this? Is it the trailing P/E or the forward P/E? What ever P/E you may use, the E factor in P/E is a number not fully trusted by analysts due to the estimates that go with it. Second, difficult part is the estimation of growth rate figures. Flaws in estimating both these figures would affect the results obtained by the PEG analysis. What Peter Lynch has said in his one up on wall street is that the P/E ratio of any company thats fairly priced will equal its growth rate. Therefore, according to him, a properly priced company will have a PEG of 1. But what if the growth rate is 0? So, the ratio doesnt work well for all stocks . It works for a stock with normal rate of growth and earnings. CONCLUSION. The two most important numbers that investment analysts look at when evaluating a stock are the P/E ratio and the PEG ratio. The PEG is a valuable tool for investors to use. It reveals whether the high price of a stock is justified based on whether earnings will grow enough to continue to drive the stock higher. Stock investing strategies Technicals vs Fundamentals. by J Victor on September 22nd, 2011
Before you invest, investigate. William Arthur Ward (1921-1994) author, educator Two schools of thought. Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. Technical analysis looks at the price movement of a stock using chart and uses this data to predict its future price movements. Fundamental analysis, on the other hand, looks at various economic factors like Balance sheets, income statements, ratios etc and tries to figure out companies worth investing in. Our section on financial ratios and value investing intends to cover fundamentals. An investor who follows the fundamentals tries to find the actual value of a company and invests when the market price is lower than the actual value. Technical investor believes that all the fundamentals factors are accounted for in the current stock price and hence there is no need to further investigate into the fundamentals. Hence, they look out for the trends using price charts and volume analysis. Basics of technical analysis are covered in our technical analysis sections. Who is right? A common dilemma facing anyone who invests in the stock market is whether one should buy shares based on the fundamentals of the company, or one should follow the momentum of stocks as indicated by technical analysis. Fundamentals are very important. Without fundamentals the markets would not move. Fundamental analysis focuses on understanding the underlying enterprise which involves analysing a companys financial statements, management competence, market share, competitorsetc and then valuing its shares based on an estimate of the future cash flows it could generate. i.e. Fundamental analysis uses historical and current data to estimate future stock returns and takes into consideration economic data releases, events such as political elections as well as individual company announcements that causes the prices to move up and down or stay the same. Technical analysis focuses exclusively on the study of market action. Technical analyst assumes that all of this information is already included into a stocks price, so all a trader has to do is find out trends in share price movements and volumes to make speculative decisions. Technical analysis studies prices and volume by utilizing charts whereas fundamental analysis is more concerned about whether the company is a sound enterprise to invest in. What should you do? If your intention is to invest for a long period, say 5 years or more, value or growth or GARP investing strategy would work perfectly for you. All these strategies use fundamental analysis as its base. If your intention is to make as much profit as possible from your investments over a short period of time, say 1 year, then you need an investment strategy that takes into account both the fundamental soundness of a business as well as the expected movement of the shares of the company over the near term. Fundamental analysis would help you to spot companies that are doing well and technical movement of its share price would help you to predict the movement of shares over the near future. If your intention is to invest for a very short period, better rely on the technicals of fundamentally good companies. When you look at the markets through technical eyes, you can quickly spot changes in direction that arent obvious in fundamental terms. The more longer the time frame, the more you rely on fundamentals. Stock investing strategy-Fundemental investing by J Victor on September 22nd, 2011
FUNDAMENTAL INVESTING As mentioned in the earlier posts, fundamental investing is all about investigating the financial health of the company and its competitive advantages. The financial health is judged by analysing the earnings growth, revenues, debts, quality of management, profitability ratios, cash flow etc..Apart from company specific data, they would also study the macro economic factors that affect the company. Once the financial position of the business is satisfactory, the fundamental analyst would do a process called valuation and based on the results he would proceed to fix a value for the companys share. This value would be taken as the benchmark for judging whether the stock is undervalued or not. Fundamental analysts believe that when the overall markets decline, fundamentally good stocks also decline below what its actually worth giving rise to investment opportunities.
THE PROS AND CONS OF FUNDEMENTAL INVESTING Fundamental analysis is good for long-term investors ie, those who are willing to wait patiently for their funds to grow. This time taken to grow itself is its greatest disadvantage. Its difficult for most of the investors to keep holding on to investments especially when the markets are crashing. We said its difficult- not impossible! A thorough grasp of fundamental analysis can ensure that we stay calm and composed during market volatility. Fundamental analysis may offer excellent insights, but it can be extraordinarily time- consuming. Analysing a company fundamentally may take a lot of time. So, quick decisions may not be possible. This delay in forming opinions may result in missing favorable chances to buy stocks. This methods ability to increase your odds of success for a selected security is greater than other methods. The relationships between financial figures are tested by sound mathematical and statistical methods. Hard and fast financial ratios are laid down by analysts to find how sound a company is. Those that fail the ratio tests are discarded, while those that pass are perceived as being credible. There is no room for personal predilection or bias. Hence, when you pick a fundamentally good share, your chance of success in investing is also greater. The usage of mathematical and statistical methods in fundamental analysis also means that considerable amount of data is required to test the significance of variables. Such data are often not easy to acquire. Fundamental analysis also requires a considerable amount of human labor time and energy. Great investors like Warren Buffett and John Neff are champions of fundamental analysis. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power. One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. The advantage is that, the investor from there on, would be in a position to quickly grasp the impact of laws, rules and regulations, business agreements and changing business scenario on the share price of the company. FUNDEMENTAL ANALYSIS APPROACHES. There are basically two approaches to fundamental analysis. Top-down approach: Bottoms up approach. In Top-down approach, an analyst investigates both international and national economic indicators, such as GDP growth rates, energy prices, inflation and interest rates. The search for the best security then trickles down to the analysis of total sales, price levels and foreign competition in a sector in order to identify the best business in the sector. In the second approach, an analyst starts the search with specific businesses, irrespective of their industry/region. In short, fundamental analysis is all about analyzing the company to the roots. Stock investing strategy: Technical investing by J Victor on September 22nd, 2011
TECHNICAL INVESTING Technical investing is the exact opposite of fundamental investing. The word technical is used because, this school of stock analysis believes that all the fundamental factors that affect a company would be reflected in the share price at any point of time. The price movement is purely technical and has nothing to do with the fundamentals of the company. If this assumption hold true, then there is no need to analyse the stocks fundamentally. So, what remains to be analysed is the demand and supply levels of the stock. For this, a technical analyst has something called price charts in which the daily price movement of the stock along with the volume is recorded. This school believes that emotions, reactions, and psychology of individuals regarding economic events and news influence the demand and supply of stocks and in turn, it is that demand and supply forces that keep the market ticking.
Apart from charts, technical analyst employs a lot of tools like Fibonacci numbers, moving average crossover divergence (MACD), Williams %R, stochastic oscillators, momentum, directional movement, on-balance volume (OBV), relative strength index (RSI), and moving averages. EFFICIENT MARKET THEORY. Technical investors fundamentally believe in the efficient market theory: It believes that all information on the markets, economy and on individual stocks are known and are priced into the securities, and that securities are fairly valued at all times. The advantage of this system is that its easy to understand and use. Unlike fundamental analysis which requires a detailed understanding of financial and accounting terms, technical analysis focuses on trends graphically depicted on charts and graphs. Its easy to understand those graphs. Its easy to find whether a stock is moving up, down, or sideways. Technical indicators can sometimes point to the beginning / end of a trend before it shows up in the market. We believe that technical indicators can be used by short term investors because; in that case, what matters are the trend and the volume of activity. Both these are reflected more accurately on technical charts. Stock investing strategy- Value investing by J Victor on September 22nd, 2011
In a nut shell. In Value investing approach, Investment decisions are made based on the basis of valuation of a share. That is, the Actual value of the share is found out by certain calculations and the figure you get is compared with the current market trading price. If the particular share is undervalued it signals a good investing opportunity and if the share in question is overvalued, it is better to stay off from investing in that share. Whenever a share is undervalued by the market, analysts call them value shares. This is the strategy of investing is followed by masters such as warren buffet. Value investing is discussed in detail in a separate chapter. Where did value investing come from? Value investing was started by a man named Benjamin Graham. (1894 -1976). He was Warren Buffets mentor and author of some great investing books. He is considered to be the father of Value Investing. Whats the concept all about? Investors that follow this strategy believe that there are two values to a stock. The current market price (which is influenced by market forces and investor sentiments) and the actual or fair price (called intrinsic value). Value Investors actively look out for shares of companies that they believe have been undervalued by the market that is the current market price below the intrinsic value. But why should a companys share price be less or more than what it is really worth? The answer is The market overreacts to good and bad news, causing sharp movements in prices that do not correspond with fundamentals of the company. This results in stock price movements that do not correspond with the companys long-term fundamentals. The result is an opportunity for Value Investors to profit by buying when the share price is low. What does a Value Investor look for in a stock? The Value Investor looks for stocks with strong fundamentals including earnings, dividends, book value, and cash flow that are selling at a bargain price, given their quality. The Value Investor seeks companies that seem to be incorrectly valued (i.e. undervalued) by the market and therefore has the potential to increase in share price when the market corrects its error in valuation. Value investors collect certain Financial and Non-financial datas about the company, and by using those data, they derive at a conclusion as to whether the share price is undervalued or not. Typically, they look at stocks with high dividend yields, high book value or low price-to- earnings multiple or a mixture of all three. It basically fundamental analysis. Value the defensive strategy. Value investors focus on the inherent strengths/weaknesses of individual companies and as such market gyrations and macro-level changes do not matter to them. The margin of safety approach ensures that the downside risk to investment is limited. However, value investing should be applied with caution. Everything that appears cheap may not be a good bargain. Is a low priced share a value share? Value Investing doesnt mean just buying shares in a company where the price is declining. Its important to distinguish the difference between a value company and a company that simply has a declining price. A sudden drop in the share price of the company does not mean that the share is selling at a bargain. The drop in price could be a result of the market responding to a fundamental problem in the company. What are the sources to find value shares? The best method is to do your own research. Those who do not have time may try to locate them from the indexes or from 52 week lows list. You may also validate shares of Industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term and try to spot one. When can I find value shares? Anytime. You have to keep analysing selected companies one by one. But its hard to find value bargains in a bullish market. Value investors go on an investing spree when the markets are down. They stay away from the market when everyones in and they enter the market when everyones washed out. Why is this approach not used by everyone? Only very long term investors can use the value investing approach. The reasons are The length of time that may be required to find a target Once invested, an investor should probably hold for years to come. This means that an investor needs to have enough capital to not be forced to sell a holding for other reasons An investor who follows and operates this method needs to have considerable patience. Waiting on the sidelines for a long time (probably many years) or holding on to an investment for a long time (sometimes a decade!) before proving your skill is not an easy trait to display Value investment is a method of analysis that is very logical and rational and therefore rather seductive to potential investors. But the extreme dedication required to actually practice it makes it a method that is only really used by professionals. Are value stocks the best way to ensure capital preservation in equities? By their very nature as deeply discounted on sale securities, value stocks are safer than most other equities. If you pick the wrong stock, you dont lose as much as other investors because the stock is already scraping bottom. At times, the fall in a stocks price may be on account of impending events such as a change in industry dynamics that are not captured in its current financials. Investors who buy such a stock thinking it to be a value pick may end up with a dud. What are the Pros and cons of value investing? Pros: Less risky approach. Hot stock tips, hype, and mass hysteria do not affect the decisions of a value investor. Produces steady, consistent gains that regularly outperform the Market Index Cons: On the negative side, the potential returns for value investing are smaller than those of growth investing Stock investing strategy Growth investing by J Victor on September 23rd, 2011
In a nut shell. Growth investors, invest in companies that exhibit signs of above-average growth. They dont mind if the share price is expensive in comparison to its actual value. Signs of above-average Growth is what growth investors try to spot. These signs gets revealed when you study the fundamentals. This is the exact opposite of value investing approach. In a nutshell, the difference between value investing and growth investing lies in the methodology adopted by the investors. While the value investor looks for undervalued shares, the growth investor looks for shares with higher growth potential. What exactly is growth? Benjamin Graham defined a growth share as a share in a company that has done better than average in the past, and is expected to do so in the future. Any company whose business generates significant positive cash flows or earnings, which increase at significantly faster rates than the overall economy, can be categorized under growth. A growth company tends to have very profitable reinvestment opportunities for its own retained earnings. Thus, it typically pays little to no dividends to stockholders, opting instead to plow most or all of its profits back into its expanding business. Software companies are examples of growth oriented companies. Whats the concept all about? Investors who follow this strategy look for companies that exhibit huge growth in terms of revenues and profits. Typically, this set of investors looks for those in sunrise sectors (those in the early stages of growth) hoping to find the next Microsoft. A growth investor may look into the past years data to recognize the past growth rates and based on his studies about the industrys potential and companys prospects; try to estimate the future growth of the company. Investors look to spot a company that grows at minimum 15% annually. If a stock cannot realistically double in five years, its probably not a growth stock. Thats the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stocks price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years. What does a Growth Investor look for in a stock? Low dividend yields, high price-to-earnings ratio or high sales-to-market capitalisation ratio or a mix of all. For identifying stocks with high potential, growth investors look at key variables such as rate of growth in per share earnings over the last five-10 years, expected growth in earnings over the next five years or so, operating and net profit margins and business efficiency. A growth investor would target a company thats growing at 15%-40% year on. On a macro level, factors such as the stage in business cycle in which the industry operates, its relative attractiveness, and the positioning of the company in the competition matrix form part of the investment analysis. They then look at the current price and determine if it reflects the growth potential of the companys business. Growth the risky strategy. As growth investing often involves taking exposure to companies that trade at high valuation levels, the downside risk is relatively high. Sometimes, owing to their unproven business models, these companies could be sensitive to changes in market movements and business cycles. Is a sky rocketing share a growth share? Not necessasarily. Share prices can move up due to various reasons including fraudulent practices. High price is never a criteria for spoting a growth share. What matters is the rate of growth in the past years and the future prospects of the industry in which the company is in. What are the sources to find Growth shares? The best method is to do your own research. Most growth stocks can be spotted in the small cap and mid cap indexes. It is the growth rate that finally makes them large caps. Try to spot new companies that come up with innovative ideas for example in medical Pharma industry. Watch companies that have grown from small cap to mid caps. Watch companies that breach all time high levels. Investigate why the prices sky rocketed. You may also validate shares of Industries that are currently facing market overreaction to a piece of news affecting the industry in the short term and try to spot one. Is this approach popular? Yes. If warren buffet is popular for his value investing strategies, Peter lynch is one of the greatest growth investors. Both he strategies are being used by investors according to market conditions worldwide. What are the Pros and cons of Growth investing? Pros:The biggest advantage of this approach is Potential for incredible returns in a short period of time Cons:On the negative side, these shares carry the potential for huge losses. Market downturns hit growth stocks far harder than value stocks. Failure to relate the stock price to the company value leads to purchasing overvalued stocks Hot stock tips, rumors, hype, and market hysteria are not reliable sources of information to act upon Which is better? Value or growth? Both has its pros and cons as mentioned in our lessons. In value investing, the investor has to ensure correct stock valuation as well as the right time of entry both being equally vital as he would not like to get too early into a stock. In growth investing, it is essential for the investor to identify businesses that face little threat of erosion so that earnings growth of those companies is not impacted. Growth investors are generally in for short time frame compared to value investors. In general, value stocks tend to hold up better during stock market downturns. An investor having a high-risk appetite is more likely to choose a growth strategy. While a defensive investor would choose to take the value investing route. Stock investing strategy- GARP by J Victor on September 24th, 2011
GARP investing was popularized by legendary Fidelity manager Peter Lynch. Growth at Reasonable Price (GARP) is a combination of both growth and value investing. While a growth strategy is more focused on a companys earnings growth and value investing seeks companies having their prices below their intrinsic value, growth at reasonable price as a strategy, hunts for stocks that have both a growth potential and are also trading at a reasonable price. A typical GARP investor seeks to invest in companies that have had a positive performance over the past few years, and also have positive projections for the upcoming years. What Is an Ideal GARP Stock? In fact, the ideal GARP style stock would be one with above average growth potential in earnings and revenue for the future, greater than its peers in its industry group, but would also happen to be trading at a value or lower price than its fundamental analysis valuation target. A GARP investor would buy stocks that are priced lower (but not as low as possible) than their fundamental analysis target but that also have good future prospects of growth in cash flow, revenue, earnings per share and so on. In other words, a GARP investor tries to find stocks that will rise in value for two specific reasons: Stock is priced under valuation target: One, if a stock is priced under its fundamental analysis valuation target, then over time, the stock should rise to that consensus target of what it is intrinsically worth, or its intrinsic value. Stock has above average earnings potential: Second, if the stock has above average potential for earnings or revenue growth in the future, then the price of the stock should rise as the company grows in value, makes more sales, and increases its revenue and earnings per share in the future. PEG and ROE ratio- The benchmarks for a GARP investor. A solid benchmark to spot a GARP stock is PEG ratio or price/earnings growth ratio. The PEG shows the ratio between a companys P/E ratio (valuation) and its expected earnings growth rate over the next several years. A GARP investor would seek out stocks that have a PEG of 1 or less, which shows that P/E ratios are in line with expected earnings growth. This helps to uncover stocks that are trading at reasonable prices. Another ratio thats relevant for a GARP investor is the Return on Equity percentage. Finding companies that have a consistently high ROE generally shows that you are dealing with good management and a strong business. GARP is all about finding rapidly growing companies that are available for low PE multiples. If an investor gets it right, this strategy could yield multi baggers in due course of time because of two factors. One, the growth of the company and its per share earnings would increase over a period. Two, because it shows sustained growth over many years, its price to earnings ratio would get re-rated. Advantage GARP. A GARP investor will have a hybrid investment style that allows for some of the principles of a value investor and some of the principles of a growth investor-Truly the best of both worlds. In value investing, one might miss a potentially good quality stock trading at reasonable valuations; one is more likely to spot the opportunity under the GARP style of investing. Owing to the strategy employed by GARP, an investor is more likely to see his returns to be more stable than those of either a pure growth or value investor. In a bull trend, it is the growth investor who will stand to benefit the most, followed by GARP and value investor. In a bear run, the growth stocks will see big falls in their value than the GARP or value stocks. Thus irrespective of the market movements, the GARP investor would strike the golden mean. His investments would yield reasonable returns Conclusion. GARP is a balanced approach to investing. It tends to combine the positives of value and growth strategies. A GARP investor wants a stock thats not priced too high or too low, but one that is slightly priced lower that perhaps it should be and that also has good prospects for future growth but not so much that the stock is overpriced or the future projections are too high. Stock investing strategy- Index investing by J Victor on September 27th, 2011
INDEX INVESTING You know what a stock index is. Sensex, Nifty etc are stock indices. Index investing is all about having the same combination of shares in the same ratio as the target index so that it replicates the index itself. A change in holdings happens only when a company enters or leaves the index. The biggest attraction of this strategy is that it is a humble approach. Thousands of companies are listed in the stock exchange. If you were to start analysing the fundamental aspects of each and every company or even a selected group of companies, it would be a daunting task. Quite difficult even for experienced investors. Research and analysis takes a lot of time and hard work. In such a scenario, Index investing works as a much easier way to invest in stocks. It provides the opportunity to invest in a diversified portfolio which would give you some decent returns. This strategy will not beat the market returns, but makes sure that you do get at least the returns offered by the market. Its essentially a passive form of investing.
WHATS THE ADVANTAGE? A stock, to be included in the index has to pass through various quality filters set by the securities exchange board. So when you invest in an index, the quality of stocks is almost assured. Your money goes into investing in some of the largest companies in the economy. The liquidity factor is high. All segments of investors trade in the index in cash or in the derivatives segment and hence there is no lack of liquidity. And, of course, you need worry about the timing of your entry. Its easy to track an index. All you need to know is about the macro economic factors and enter when the index has hit a reasonable low. However, there are some negative sides also. For example, the best performing stock may not the one thats included in the index. So you miss the opportunity of not investing in a high performance company. When you compute the opportunity cost, it might be on the higher side. A second disadvantage is that, within the index, certain large corporations dominate. A group of 3 or 4 companies may have a combined weight of more than 40% of the index. For example ITC, Reliance, Infosys, HDFC and ICICI bank constitute approximately 40% of the Sensex. So, if these 5 companies dont perform, the index strategy will suffer. WHERE TO START? You need not make long list of stocks that are included in the index, find out the percentage of weight and then invest your money in the same ratio of the index which you are going to follow. Thats not the idea behind index investing. Index investing works in a different way. It works through the mutual funds route. There are many index mutual funds in the market and one can subscribe to any one of them to follow this strategy. For example The Franklin India NSE Nifty tracks and invests in the nifty stocks, the Kotak Sensex ETF tracks the Sensex stocks. There are many more index funds in the market. The combination of stocks in the index decides where the fund would be invested by the fund manager and hence the index fund managers job is only to adjust the funds according to changes in the Index. The NAV (Net asset value) of a well managed Index scheme should be directly proportional to the index they follow. If not, it means that there is some sort of tracking or fund managing errors. So, if you do not have the time or patience to analyse stocks but want to participate in the growth of the markets, index investing is for you. You are assured of approximately the same returns of an index. Stock investing strategy-Momentum investing by J Victor on October 6th, 2011
What is it? Simply put, it assumes that prices tend to trend in one direction, even if there is no fundamental reason for it to do so. It works similar to a roller coaster ride, when a roller coaster falls down a steep slope it tends to build up momentum, so it can do things like spinning around in loops without actually having to use any mechanical help. The momentum alone is able to push the cart. Stocks move in a similar way, some good fundamental news can push the stocks up and start an upward trend. The pure momentum of that trend can push the stock higher and higher, well above what the true value of the stock actually is. Successful traders such as Nicholas Darvas (who turned $10,000 into $2,000,000 in 18 months), Jessie Livermore and Ed Seykota (Who has made an average of 60% over a 10 year period) all made their amazing gains following this strategy of momentum.
Why Does momentum investing Work? The reason why momentum strategy works is that no one wants to be left out. When a stock starts trending up, investors and mutual fund managers fear that they are going to miss the next big move so they start jumping in. This pushes the stock even higher and so on. Is it practical for you? Momentum investing relies on technical data rather than fundamentals. Momentum investing can work, but it is may not be practical for all investors. When you purchase a stock that is rising or sell a stock that is falling, you will be reacting to older news than the professionals at the head of momentum investing funds. They will get out and leave you and other unlucky folks holding the bag. If you do manage to time it right, you will still have to be more conscious of the fees from turnover and how much they will eat up your returns.
Conclusion Momentum investing is not necessarily for everyone, but it can often lead to impressive returns if done properly. Stock investing strategy-CAN SLIM by J Victor on November 22nd, 2011
Hi there, CAN SLIM is a stock investing strategy developed by William ONeil. ONeil reportedly has made millions by consistently using this approach. He was the youngest person ever to have a seat on the New York Stock Exchange; he founded the U.S. brokerage firm William ONeil + Co and he also started the business newspaper Investors Business Daily. His strategy is called CAN SLIM. Given below is my explanation of the method. I have kept things simple as possible.
WHAT IS CAN SLIM? CAN SLIM is a stock picking strategy that combines both technical analysis and fundamental analysis. CAN SLIM is an acronym. Each letter stands for a quality that a potential stock should pass. It trys to identify stocks that are likely to rise in price and have a high potential for profits. Its basically a growth investing strategy, works well in bull markets. Basically the technique boils down to the following three steps- Follow the overall market trend, buy when it is going up Search within the best industry groups and narrow to the top stocks within each group fundamentally and technically. Control your asset allocation and buy the best stocks when they break out. Use a 7% to 8% stop loss. THE 10 STEPS. T0 pick a stock using CANSLIM method, there are 10 calculations to be made. Those are: (1) EPS growth last quarter vs. a year ago. (2) EPS growth prior quarter vs. a year ago. (3) Sales growth last quarter vs. a year ago. (4) Annual EPS growth rate of 3 years (5) Long term EPS growth estimate. (6) Annual cash flow per share vs actual earnings per share. (7) Price as a percentage of 52 week high. (8) 52 week relative strength percentile. (9) Number of Institutional share holders. (10) NET institutional share purchased. Those stocks which meets the criteria as mentioned below using the above 10 figures are considered to be potential candidates for investment according to this method. HOW TO PERFORM CAN SLIM STOCK SCREENING.
C = Current Quarter Earnings There are 3 figures to be used in this section. Those are the first 3 figures as mentioned in the list above. All three are connected with earnings and revenues. Earnings should be up by 18-20% over the same quarter 1 year ago. And, there must be positive earnings in this quarter excluding special one time events. It is important to compare with the same quarter a year ago. For example- this years second quarter to last years second quarter. The reason for doing this is that many firms have seasonal patterns to their earnings. As already said, remember to exclude one time events which may distort the actual trend in earnings and make the company performance look better or worse. Look for increasing RATE of growth in quarterly EPS (consider selling stock if it has a slowing growth rate for 2 quarters in a row). Same quarter sales growth greater than 25% (or at least accelerating over the last 3 quarters) Earnings growth rate from quarter 1 year ago compared to latest quarter should be higher than similar quarter 1 year earlier. A = Annual Earnings There are 3 figures to be used in this section. Figures 4 , 5 and 6 are connected with annual earnings of a company. The benchmarks are: Annual EPS must increase in each of last 3 years The method also recommends an annual growth rate of 25% over last 3 years for a stock.Consensus earnings estimate for next year should be higher than actual earnings of current year. ROE of 17% or better preferred. Look for annual cash flow per share greater than the actual earnings per share by atleast 20%. N = New Products, New Management, New Highs The next two sections are basically qualitative analysis section. Those stocks which have passed the C and A are further checked for the following qualities: Stock should be within 10% of 52 week high price.( figure 7) Stocks that hit new highs on big volume worth looking at. Stocks that hit new high after undergoing a period of price correction and consolidation are interesting candidates. Look out for companies with a major new product or service or new management which is positive for the industry. S = Supply and Demand Stocks with a good percentage of ownership by top management are good. Companies that announce stock buy back plans are good. Look for companies with a lower debt-to-equity ratio or companies lowering the debt to equity ratio over the last few years. It implies that the company generates enough cash to pay off part of its debts every year. When choosing between two stocks, stocks with a reasonable number of shares outstanding will in all probability out perform older large capitalization stocks. L = Leader or Laggard Figure number 8 from the above list is used here. Buy among the best 2 or 3 stocks in a group. Relative Strength of 80% or better. I.e. the price performance for a given time and their percentage ranking among all stocks. Buy among best 10-15 groups out of nearly 200. I = Institutional Sponsorship Figures 9 and 10 are to be used here- Numbers of shares purchased by institutions should be greater than or equal to the number of share sold by institutions over the last quarter Look for companies that have at least 10 institutional investors invested in it. Look for stocks with increasing number of institutional investors. Always be careful not to consider stocks with a very large single institutional ownership. M = Market Direction Do NOT fight the trend. Determine if you are in a BULL or a BEAR market. Understand the general market averages every day. Try to be 25% in cash when market peaks and begins major reversal. Heavy volume without significant price movement MAY signal a top. Follow market leaders for clues on strength. Divergence of key averages/indexes point to weaker/narrow market movement. Now, the Final rule do NOT buy breakouts in a BEAR market. CONCLUSION A stock that meets all the requirements as mentioned above is an ideal candidate for investing. Thats CAN SLIM for you. Stock investing strategy: Contrarian Investing. by J Victor on November 25th, 2011
Following a strategy of going against the current views of the majority investors is called contrarian investing. Why do such investors take a contrary view? Because, they believe that certain consensus among investors can lead to wide mispricings in securities markets. For example: A wide spread negative news or rumors about a stock may send the prices of that stock crashing. These investors try to spot such stocks and invest in it resulting in above average returns.
CONTRARIAN -THE BOLD APPROACH A true contrarian is neither bullish nor bearish on securities. A contrarian investor takes a bold approach. The goal of a contrarian investor is to profit from the mispricings that an irrational market creates. Something similar to value investing. The only difference here is that, this approach relies more on market sentiments and investor behavior. Contrarian investing has more opportunities in markets which are emerging out of a bear phase. Typically, in such markets many stocks, which have a strong growth potential, quote at attractive valuations primarily because investors widely extrapolate news flow and performance of the recent past. MISPRICED STOCKS Contrarian investing works because of the psychology of market participants. During the beginning of a trend, buyers are cautious, and the more seasoned players are the primary participants. As the trend gains traction, more and more investors become aware of it, deploying more capital to take advantage of the markets strength. Then at the end of the trend, when everyone whos interested in buying into the trend already had with no more available capital to sustain the already inflated prices, its incredibly easy for a panic to make stock prices tumble down. A perfect example of this was the 2008 market crash. The trend started and it continued till all those who were interested in buying into the trend has put in their money. Then, Stocks sold off hard, all the seasoned players made money and the crowd was left with stocks purchased at higher prices. The prices of stocks tumbled and the crowd, unable to hold on, sold their stocks suffering heavy financial loss. At this point, the smart guys step in again and then, dramatically the stock regains much of that lost ground in 2010. This was a classic case of the crowd dramatically shifting sentiment. Those who thought opposite to what the crowd thought would have definitely made lot of money. DOES IT WORK IN INDIAN MARKETS? Emotions play a huge part in Indian stock markets. Right from horoscopes to palm reading and tarot cards, theres lot of shastras that Indians rely on to take financial decisions. Otherwise, the stock market wouldnt have crossed 21000 in January 2008, tumble to 7600 points in October 2008 and then again cross 21000 in November 2010. More than earnings data, sentiments played a major role in this huge fluctuation. According to Mr. Ved Prakash of Tata mutual fund, The strategy of contrarian investing works in most markets. Contrarian investing focuses on looking at companies with a long-term potential who are out of favour either because they are misunderstood or because their short-term expected performance is below market expectations or there is short-term negative news flow which is clouding the otherwise strong potential of the business. So, where emotions or expectations are high, contrarian approach works well. The crowd will always be caught on the wrong side when the market turns upside down. SPOTTING THE TURNING POINTS So, then, if turning points are where the crowd is wrong, the biggest challenge is spotting them. You can spot turning points through fundamentals or technicals or by studying the general economic indicators. 1. Valuation The theory behind valuation is simple. Buy when stocks look fundamentally cheap. Sell when the stock is expensive. Valuation, however, is not an easy process. It requires a strong understanding of fundamental analysis; it also requires its practitioner to attempt to make an objective decision about a subjective topic like value. 2. Technical Analysis Another option for contrarians is to use technical analysis to spot reversals. Momentum, trend breaks, volumes, RSI all come into play here. 3. Quantitative and Economic Indicators The last method skips looking directly at a securitys price and looks at broader economic indicators such as volatility index to spot turnarounds. CONCLUSION. Tracking these indicators- not any one of them but all of them together, may help you to take a contrary position before the market starts to correct itself. Successful contrarians realize that turning points are key. So next time, I hope this little advice would help you to avoid getting trapped in a market crash and at the same time help you to spot turnarounds and profit from it. Technical Analysis I Technical Analysis by J Victor on November 3rd, 2010
MEANING Technical analysis is a completely different approach to stock market investing- it doesnt try to find the intrinsic value of a company or try to find whether a share is mis-priced or undervalued. A technical analyst is interested only in the price movements in the market. So, it all about analyzing the demand and supply or a price volume analysis. TECHS VS FUNDAS Technical analysis is a study of supply and demand in a market to determine what direction, or trend, will continue in the future. Investors who follow fundamentals try to spot shares that has the potential to increase in value, while investors who follow technical analysis buy assets they believe they can sell to somebody else at a greater price. Although technical analysis and fundamental analysis are seen by many as polar opposites many market participants have experienced great success by combining the two. There are distinct advantages for both the schools of thought. its better to be versed with the pros and cons of both and take advantage of both the schools. The purpose of mentioning technical trading tools here is to help you understand the relevance of technical terms used by experts in the stock recommendations. Technical analysis requires special charting software to accumulate data and convert it into information. Generally, online trading software offered by leading brokers has options to do technical analysis. CHARTS -WORKING TOOLS OF A TECHNICAL ANALYST. A technical analyst works with the help of charts. A chart is nothing but a graphical representation of the current price movement of a stock. There are various forms and styles of charts and it represents graphically almost anything and everything that takes place in the stock market. BASIC ASSUMPTIONS Technical analysis is based on three assumptions: MARKETS DISCOUNTS EVERYTHING. Technical analysis assumes that, at any given time, a stocks price reflects everything that has or could affect the company including fundamental factors. Technical analysts believe that the companys fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market. PRICE MOVES IN TRENDS In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction unless something happens to change the supply -demand balance. Such changes will take time and are usually detectable in the action of the market itself. Most technical trading strategies are based on this assumption. HISTORY TENDS TO REPEAT ITSELF Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves. we check more about technical analysis in the next series of articles.. Types of Charts by J Victor on November 4th, 2010
We said in the first section that Charts are the working tools of the technical analyst and they have been developed in various forms and styles to represent graphically almost anything and everything that takes place in the stock market. There are three main types of charts that are used to analyse price movements. They are the line chart, the bar chart and the candlestick chart. LINE CHART Line chart is the simplest of the three charts. A simple line chart draws a line from one closing price to the next closing price. When strung together with a line, it reveals the general price movement of a share over a period of time. BAR CHARTS The most basic tool of technical analysis is the bar chart. This chart displays basic market price data over a defined period of time. Daily bar charts note the open, high, low and closing price of an asset. Rising vertically, the bar marks the high and the low of a given time period, with the starting price marked by a horizontal line, or tick, to the left and the ending or closing price marked by a tick to the right. Structure of a bar chart
CANDLESTICK CHART Another type of chart used in technical analysis is the candlestick chart, so called because the main component of the chart representing prices looks like a candlestick, with a thick body and usually a line extending above and below it, called the upper shadow and lower shadow, respectively. The top of the upper shadow represents the high price, while the bottom of the lower shadow represents the low price. Patterns are formed both by the body and the shadows. Candlestick patterns are most useful over short periods of time, and mostly have significance at the top of an uptrend or the bottom of a downtrend, when the patterns most often signify a reversal of the trend. While the candlestick chart shows basically the same information as the bar chart, certain patterns are more apparent in the candlestick chart. The candlestick chart emphasizes opening and closing prices. The top and bottom of the real body represents the opening and closing prices. Whether the top represents the opening or closing price depends on the color of the real bodyif it is white/ blue/green, then the top represents the close; black / red or some other dark color, indicates that the top was the opening price. The length of the real body shows the difference between the opening and closing prices. Obviously, white/green/blue real bodies indicate bullishness, while black/red real bodies indicate bearishness, and their pattern is easily observable in a candlestick chart. Structure of a candlestick chart
CONCLUSION What we know so far is about the types of charts. While line charts are the simplest form of charts, candlesticks are more advanced and they reveal stories not detected with other charts. Whether you use a line chart or candlestick chart, you need to draw trend lines to find out direction of the stock prices. More about that in the next section- trend lines. Trendlines by J Victor on November 5th, 2010
TREND Trend in technical analysis means direction. It is one of the most important concepts in technical analysis. After plotting the stock prices on a chart, a line is drawn through the price movement to identify the direction of price. Its called trendline and it could slope either downwards or upwards. A principle of technical analysis is that once a trend has been formed, it will remain intact until its broken. When there is little movement up or down its a sideways or horizontal trend .If you observe financial magazines or channels you might recall experts saying about sideways movement in stocks A sideways trend is actually not a trend on its own, but a lack of a well- defined trend in either direction. In any case, the market can move only in these three ways: up, down or nowhere.
LENGTH OR TIME FRAME OF A TREND Trend lines can move in a same direction for any length of time until something major happens in the market that brings a change in the demand -supply balance and hence a change in price direction. A trend of any direction can be classified as a long-term trend, intermediate trend or a short-term trend depending on the time frame we are talking about. In terms of the stock market, a major trend (long term trend) is generally categorized as one lasting longer than a year. An intermediate trend is considered to last between one and three months and a near-term trend is anything less than a month. A long-term trend may be composed of several intermediate trends, which often move against the direction of the major trend. If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the correction is considered to be an intermediate trend. The short-term trends are components of both major and intermediate trends. See the graph below: As explained earlier, a long term trend is one which lasts for a year or more .So in order to analyze the long term direction of a stock you need to take the stock chart of a year or more. Similarly to analyze a medium term trend you need to check the graph for a 6 month period or so. Short term trend can be analyzed by taking the graph for a short period ,say 10 or 30 days . In short, a stock chart should be constructed to best reflect the type of trend being analyzed. DRAWING A TREND LINE Drawing trend lines are the basics of technical analysis. The explanation on how to draw may be confusing to a learner, but in actual practice its no big deal. In an uptrend analysis, draw a line from the lowest low, up and to the highest minor low point preceding the highest high, so that the line does not pass though prices between the two low points. This when completed will be an upward trend line similarly , To draw a downward trend line , draw a line from the highest high, down and to the lowest minor high point preceding the lowest low, so that the line does not pass though prices between the two low points . You may also refer to the figure given above. The blue line starts from the lowest low and up to the highest minor low point preceding the highest high and the downward trend line represented by the red line starts from the highest high and down to the lowest minor high point preceding the lowest low point. Thats about trend lines. Drawing trendlines is just the beginning. To move further, you need to learn something called support and resistance levels more about that in our next section. Support and Resistance by J Victor on December 1st, 2010
Hi there, As i said in my last article, the next major concept is that of support and resistance. These are two terms that are used very frequently by stock analysts. To put in very simple terms -Support is the price level below which a stock is not expected to fall. Resistance, on the other hand, is the price level which a stock is not expected to surpass. You also need to go thru the next topic on volume to fully understand the concept of support and resistance. SUPPORT AND RESISTANCE Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic is that, when the price declines, there will be more demand for the particular share. By the time the price reaches a particular level (called support level), it is believed that demand will overcome supply and prevent the price from falling below support Resistance is just the opposite of support. A Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic behind the theory is that , as the price advances , sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches a particular level (called the resistance level) it is believed that supply will overcome demand and prevent the price from rising above resistance. In the book Trading for a Living, Dr. Alex Elder gives a simple, but effective image of support and resistance A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance is like a floor and a ceiling, with prices sandwiched between them. When a stocks price has fallen to a level where demand at that price increases and buyers begin to buy, this creates a floor or support level. When a stocks price rises to a level where demand decreases and owners begin to sell to lock in their profits, this creates the ceiling or resistance level. Shown below is a typical share price movement on a chart. The two lines drawn horizontally are called trendlines. The red arrows illustrate resistance or ceiling. As you can observe, the price fails to pass above that particular level. Similarly the blue arrows illustrate support level or floor beyond which the price fails to fall.
HOW TO RECOGNIZE SUPPORT AND RESISTANCE. You can identify support and resistance levels by studying a chart. (See the chart above) Look for a series of low points where a stock falls to this level, but then falls no further. This is a support level. When you find that a stock rises to a certain high, but no higher, you have found a resistance level. The more times that a stock bounces off support and falls back from resistance, the stronger these support and resistance levels become. It creates a self-fulfilling prophecy. The more often it happens, the more likely it is to happen again. The more those historical patterns repeat themselves, the more traders know, and the more confident they become in forecasting the future behavior of the stock. ROUND NUMBERS One type of universal support and resistance that tends to be seen across a large number of securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and 1,000 tend be important in support and resistance levels because they often represent the major psychological turning points at which many traders will make buy or sell decisions. Buyers will often purchase large amounts of stock once the price starts to fall toward a major round number such as Rs 50, which makes it more difficult for shares to fall below the level. On the other hand, sellers start to sell off a stock as it moves toward a round number peak, making it difficult to move past this upper level as well. It is the increased buying and selling pressure at these levels that makes them important points of support and resistance and, in many cases, major psychological points as well. THE IMPORTANCE OF SUPPORT AND RESISTANCE Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times but never broken, he or she may decide to take profits as the share price moves toward this point because it is unlikely that it will move past this level. THE PSYCHOLOGY BEHIND SUPPORT AND RESISTANCE To understand the psychology behind support and resistance, we need to first categorize market participants. Market participants can typically be classified into: 1) The longs -traders who have a BUY position and stand to profit if prices increase. 2) The shorts -traders who have a SELL and stand to profit if prices decrease. 3) Traders who got out of their previous positions prematurely. 4) Traders who are undecided on which side of the market to be on and are looking for entry points either on the short side or the long side. Assuming now, that prices start advancing from a support area, the longs who bought around this area would have regretted not buying more. So, every time prices come back to the support area, they would likely decide to buy more. Traders on the short side however, would have likely realized that they are on the wrong side of the market and they would be hoping for prices to come back to the support area where they entered their short positions so that they can get out and at least break even. The traders who had previously got out of their long positions at the support area would likely be annoyed at themselves for getting out too early and would thus be looking for a chance to get into a position again at or around the support area. The traders who were previously undecided on which side they wanted to be on would likely decide to want to enter the market on the long side after observing the advance in prices. As such, they would be looking to enter whenever there is a good buying opportunity, which is at or around the support area. These traders now all have the same resolve to buy should a good opportunity present itself and should prices decline to the support area, there would be buying taking place by all four groups which would result in prices being pushed up. ROLE REVERSAL Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level may become resistance. If the price rises above a resistance level, it may often become support. As the price moves past a level of support or resistance, it is believed that supply and demand has shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance. In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels. NUMERICAL WAY TO CALCULATE SUPPORT AND RESISTANCE There are many ways to calculate levels of support and resistance (Pivot point method, Moving averages, Fibonacci numbers etc). One of the most common is to use a series of formulas to calculate pivot points, described herein Calculate the pivot point as follows, using the previous days high, low, and close: Pivot or P = (High + Low + Close) / 3 Calculate the first support point (S1) = (P x 2) H Calculate the second support point (S2) = P (High Low) Calculate the first resistance point (R1) = (P x 2) Low Calculate the second resistance point( R2) = P + (High Low) Adjusted Pivots Many traders adjust their value for P as follows: O = Todays Opening Price P = O + (H + L + C) / 4 (where H, L & C are from the previous days stock details) Pivot points are short-term indicators, and ultimately it is the traders responsibility to use them wisely, in conjunction with other confirming indicators. Pivot points keep changing everyday since its based on daily data. Thats about support and resistance. in the ent article we will discuss about the importance of volume in technical analysis. Importance of Volume in Technical Analysis by J Victor on December 2nd, 2010
VOLUME Volume is simply the total number of buyers and sellers exchanging shares over a given period of time, usually a day. Higher the volume, more active the share. The data regarding volume of a share will be readily available on your online trading screen. Most financial sites carry data about volume. For example if the Stocks volume for the day was 1,500,000 shares that means 1,500,000 shares were sold by someone and bought by someone on that day. Volume as such may not be an attractive piece of information. But try to combine the volume data with support and resistance levels youll get the real picture. For example Say stock A ltd broke a resistance level and went up further. Also since it broke through a critical level we would expect it to go up even more in the near future. Now, let us also consider the volume traded on that day say 3 lakh shares were exchanged. On a normal day 1o lakh shares are traded. That means, Volume was way below average for that day. So, all the big investors were not trading. They could come in the very next day and decide they are bearish on the stock. They sell and cause a panic. So the stock goes down the next day. This is the importance of volume. Most traders will not buy a stock when it breaks a critical level unless volume is high. The reverse is also true. If a stock goes down with little volume it could mean the same thing. The majority of investors were not trading. When they come back they could see this stock and decide it is too low. So they buy it and the price goes up. In short, Volume is a critical factor in technical analysis. Any support and resistance level is not valid unless it is backed by adequate volume. Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end. TIPS ON VOLUME ANALYSIS Investors must always look at price patterns in conjunction with their associated volume pattern, never alone. A stock may appear to go up but the volume pattern must confirm that analysis Careful analysis of the volume of selling that occurred above current resistance will help you estimate how long a stock will stall at that level Well-above-normal volume is essential when separating a true from a false breakout above resistance. If a stock is truly in a healthy uptrend, then volume should rise as prices rise. If this is the case, then the volume indicates that buyers are chasing the stock. This increases the probability that the uptrend will continue. Hope you are now clear about volume and its importance. In our next series of posts, we will look at some basic price chart patterns and their meaning. A study of chart patterns by J Victor on December 8th, 2010
One of the basic assumptions of technical analysis is that- history repeats itself, mainly in terms of price movement. Chart patterns are graphical representations of historical price movements of stocks. So, when you analyse those price movements on chart , it reveals certain repeating patterns .It shows where the prices have been, where the buyers and seller lurk and often times the trading psychology at work in the market. If human emotions drive buying and selling behavior, then careful analysis of the chart patterns can help to determine where such emotions may next surface. Chart patterns depict trading psychology in motion. However it should be remembered that identifying chart patterns and their subsequent signals is not an exact science. While there is a general idea and components to every chart pattern, in our opinion, the price movement does not necessarily correspond to the pattern suggested by the chart. TYPES OF CHART PATTERNS There are two basic types of patterns continuing patterns and reversal patterns. A continuing pattern indicates that the prior trend will continue onward upon the patterns completion. A reversal pattern signals that a prior trend will reverse on completion of the pattern. The main patterns are discussed below. Types of continuing Patterns Flag, Pennant Triangles- Symmetrical Triangle , Ascending Triangle and Descending Triangle Cup with Handle Types of reversal patterns Double Top and Double Bottom Head and Shoulders and Inverse Head and Shoulders. Falling Wedge and Rising Wedge Rounding Bottom Triple Top and Triple Bottom Continuing patterns 1 : Flag & Pennant by J Victor on December 9th, 2010
A continuing pattern indicates that the prior trend will continue onward upon the patterns completion. The Flag and pennant are two short-term continuation chart patterns that are formed when there is a sharp price movement followed by a generally sideways consolidation. The price then moves sharply either upwards or downwards but generally in the same direction as the move that started the trend. By using the term Flag it doesnt mean that the trend formation would look exactly like a flag. The basic characteristic of a flag pattern is that it will have two trend lines sloping generally in the opposite direction of the initial price movement The buy or sell signal is formed once the price breaks through the support or resistance level, with the trend continuing in the prior direction. This breakthrough should be backed by heavier volume to improve the signal of the chart pattern. EXAMPLE
You may notice the following There are two trendlines drawn, both sloping downwards e in the opposite direction of the initial price movement. Through the trend lines you see certain price level beyond which the stock prices neither fall nor rise. These points are support and resistance levels in the flag pattern. Once the price breaks out of the resistance level, the stock prices continues to move in the initial direction ie upwards. PENNANT The pennant is slightly different from the flag pattern. Here the two trendlines converge towards each other and the direction of the pennant is not important as in the case of flag. EXAMPLE
The attributes of the flag and pennant are similar and it can be summarized as follows: SHARP PRICE MOVEMENT It all starts from a prior trend. There should be evidence of a prior trend either upwards or downwards. Such a price movement should be backed by heavy volume.Such moves may also contain gaps (well discuss the theory of gaps later). Such a move usually halts or pauses temporarily causing sideways movement for sometime, resulting in a flag or pennant formation. DURATION The sideways movement (flag/pennant) can last from 1 to 12 weeks. There is some debate on the timeframe and some consider 8 weeks to be pushing the limits for a reliable pattern. Ideally, these patterns will form between 1 and 4 weeks. Once a flag becomes more than 12 weeks old, it would be classified as a rectangle. A pennant more than 12 weeks old would turn into a symmetrical triangle. The reliability of patterns that fall between 8 and 12 weeks is therefore debatable. BREAKING THE FLAG/PENNANT For a bullish flag or pennant, a break above resistance signals that the previous advance has resumed. For a bearish flag or pennant, a break below support signals that the previous decline has resumed. HEAVY VOLUME Volume is the key. Volume should be heavy during the advance or decline that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. An expansion of volume on the resistance (support) break lends credibility to the validity of the formation and the likelihood of continuation. Well take up triangles in our next article. Continuing patterns 2 : Triangles by J Victor on December 9th, 2010
Whenever there is a convergence of two trend lines flat, ascending or descending with the price of the security moving between the two trendlines, it takes shape of a triangle. A triangle formation can be any of the following types : Symmetrical Triangle , Ascending Triangle and Descending Triangle. All the three are continuing patterns, meaning that it signals a period of consolidation in a trend followed by a resumption of the prior trend. Symmetrical triangle formation: it is formed by the convergence of a descending resistance line and an ascending support line. The two trendlines in the formation of this triangle should have a similar slope converging at a point known as the apex. The price of the security will bounce between these trendlines, towards the apex, and typically breakout in the direction of the prior trend. that is , if preceded by a downward trend, the focus should be on a break below the ascending support line. If preceded by an upward trend, look for a break above the descending resistance line. As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the tightening consolidation before the breakout. The symmetrical triangle can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months. Symmetrical triangle is a neutral formation. The future direction of the breakout can only be determined after the break has occurred. Attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case .A break in the opposite direction of the prior trend should signal the formation of a new trend. Example :
Ascending Triangle: The ascending triangle is a bullish pattern, which gives an indication that the price of the security is headed higher upon completion. The pattern is formed by two trendlines: a flat trendline being a point of resistance and an ascending trendline acting as a price support. The ascending triangle indicates that the sellers are now less interested in the stock and the buyers volume is increasing. Once the demand increases, the price naturally will tend to go up and break the resistance levels and resume the upward trend.
Descending Triangle: Descending triangle is just the opposite of ascending triangle. If an ascending triangle was a bullish pattern, a descending triangle is a bearish pattern .In a descending triangle formation, the two trendlines drawn will show a flat support line and a downward-sloping resistance line. Indicating that the prices will fall further. As the pattern develops, volume usually contracts. When the downside break occurs, there would ideally be an expansion of volume for confirmation. Volume confirmation is important.
Continuing patterns 3 : Cup with handle by J Victor on December 10th, 2010
As its name implies, there are two parts to the pattern: The cup and the handle. A cup-and- handle pattern resembles the shape of a tea cup on a chart. This is a bullish continuation pattern where the upward trend has paused, and traded down, but will continue in an upward direction upon the completion of the pattern. The cup is a bowl-shaped consolidation and the handle is a short pullback followed by a breakout. There should be a substantial increase in volume on the breakout above the handles resistance. The stronger the volume on the upward breakout, the clearer the sign that the upward trend will continue. The Shape of the cup itself is also important: it should be a nicely rounded formation, similar to a semi-circle. Example of a Cup with handle:
Reversal Patterns 1 : Double tops and double bottoms by J Victor on December 14th, 2010
Introduction Reversal implies a change in direction. Thus, reversal patterns are chart formations that tend to reverse the direction of the trend. These patterns can be spotted on the daily, weekly or monthly charts. The Existence of a prior trend is the most important prerequisites in analyzing trend reversal patterns. Many a time, a pattern that appears on the chart resembles a reversal pattern. However, if there were no major prior trends before the occurrence of this pattern, it becomes suspect. If on the other hand, one finds that a downward reversal pattern is being formed on the chart when the market has appreciated considerably, that reversal pattern is of significance and should be studied carefully. The second point to be studied carefully is the volume. Volume can provide insights in trend reversals. It should be used as a corroborative evidence of a trend, not as primary evidence. Volume can also be used to confirm price changes. When a trend starts, and there is no pick up in volume activity, that may mean that the trend is weak and does not have commitment. Volume precedes the price. If there is a pick up in volume, then that may mean that a change in price may be approaching. The direction of the movement during this increase in volume can be indicative of the upcoming action. In the following sessions we explain some important reversal patterns Double tops and double bottoms: Double top and double bottom formations are also called M and W patterns. A double top is simply two peaks. The pattern forms when the share price makes a run up to a particular level, then drops back from that level, then make a second run at that level, and then finally drop back off again resulting in a M shaped formation. It is a reversal pattern. For confirmation that a double top has actually formed and that a reversal in the uptrend is at hand, a common strategy is to look for declining volume going into the second peak and rising volume on a break below the bottom of the trough which has formed between the two peaks (support).Here too, volume plays an important part. Example of Double top:
Double Bottom This is the opposite chart pattern of the double top as it signals a reversal of the downtrend into an uptrend. The pattern forms when the share price makes a run down to a particular level, then trades up from that level then makes a second run down to at or near the same level as the first bottom, and then finally trades back up again, resulting in a W shaped formation. For confirmation that a double bottom has formed and that a reversal in the downtrend is at hand , a common strategy is to look for declining volume going into the second trough and rising volume on the break of the peak which has formed between the two troughs (resistance). Example of double Bottom:
Reversal Patterns 2 : Head and Shoulders by J Victor on December 15th, 2010
The head-and-shoulders pattern is one of the most popular and reliable chart patterns in technical analysis. And as one might imagine from the name, the pattern looks like a head with two shoulders. A Head and Shoulders pattern forms when one peak, followed by a higher peak, which is then followed by a lower peak, and finally a break below the support level established by the two troughs formed by the pattern. The head-and-shoulders is a signal that a share price is set to fall.. As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume and the new high of the head, together, serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder Inverse Head and shoulders Pattern: The second version, the inverse head and shoulders, signals that a share price is set to rise and usually forms during a downward trend. As the name indicates, it is a mirror image of the head and shoulders pattern signaling that the price is set to raise .Needless to say, volume plays an important role here too. Without the proper expansion of volume, the validity of any breakout becomes suspect. Head and Shoulder
Inverse Head and Shoulder
Reversal Patterns 3 : The Wedges by J Victor on December 17th, 2010
The wedge pattern is more like a symmetrical triangle pattern, the only difference is that it has converging trendlines which slat in either upwards or downward direction. There are two main types of wedges falling and rising. A falling wedge slopes downward-it is a bullish pattern. In a falling wedge, the upper (or resistance) trendline will have a sharper slope than the support level in the wedge construction. The lower (or support) trendline will be clearly flatter as you can see in the figure given below. The stock prices tend to move between the resistance and support lines formed with a downward bias. The price movement in the wedge should at minimum test both the support trendline and the resistance trendline twice during the life of the wedge. The more times it tests each level, especially on the resistance end, the higher quality the wedge pattern is thought to be. The buy signal is formed when the price breaks through the upper resistance line. This breakout move should be on heavier volume, but due to the longer-term nature of this pattern, its important that the price has successive closes above the resistance line. Example of falling wedge:
Conversely, a rising wedge is a bearish pattern. A rising wedge slopes upward. The upper (or resistance) trendline will have a flatter slope than the support level in the wedge construction. The lower (or support) trendline will clearly slop sharp as you can see in the figure given below. The stock prices tend to move between the resistance and support lines formed with a upward bias. The price movement in the wedge should at minimum test both the support trendline and the resistance trendline twice during the life of the wedge. The more times it tests each level, especially on the support end, the higher quality the wedge pattern is thought to be. Example of a Rising wedge:
Reversal Patterns 4 : Rounding Bottom by J Victor on December 18th, 2010
The rounding bottom is a long-term reversal pattern that signals a shift from a downtrend to an uptrend. The pattern resembles the cup and handle pattern but, without the handle. Volume is one of the most important confirming measures for this pattern where volume should be high at the initial peak (or start of the pattern) and weaken as the price movement heads toward the low. As the price moves away from the low to the price level set by the initial peak, volume should be rising. The way in which the price moves from peak to low and from low to second peak may cause some confusion as the long-term nature of the pattern can display several different price movements. The price movement does not necessarily move in a straight line but will often have many ups and downs. What is important is the general direction of the stock price. Example of a rounding bottom pattern:
Reversal Patterns 5 : Triple tops and Triple bottoms by J Victor on December 21st, 2010
Triple top is a bearish reversal pattern formed when a share price that is trending upward tests a similar level of resistance three times without breaking through. When the stock fails to move past the resistance level three times, it is assumed that the stock price would come down. This pattern is difficult to spot in the earlier stages of formation. In the triple-top formation, each test of resistance at the upper end should be marked with declining volume at each successive peak. And again, when the price breaks below the support level, it should be accompanied by high volume. Example of triple top pattern:
Triple bottom is a bullish reversal pattern formed when a share price that is coming down tests a similar level of support three times without breaking through. When the stock fails to move past the support level three times, it is assumed that the stock price would resume the up trend. In this pattern, volume plays a role similar to the triple top, declining at each trough as it tests the support level, which is a sign of diminishing selling pressure. Again, volume should be high on a breakout above the resistance level on the completion of the pattern. Example of triple bottom pattern:
Summary of Chart Patterns by J Victor on December 28th, 2010
Heres the summary of what we have discussed so far: Charts Chart analysis is the technique of using patterns formed on a chart to get an idea about the price movement of a share. There are two types of chart patterns: reversal and continuation. A continuation pattern suggests that the prior trend will continue upon completion of the pattern. A reversal pattern suggests that the prior trend will reverse upon completion of the pattern. Flag and Pennants: Flags and pennants are continuation patterns formed after a sharp price movement. The move consolidates, forming a flag shape or pennant share, and suggests another strong move in the same direction of the prior move upon completion. Triangles: There are three main types of triangle patterns symmetrical, descending and ascending, which are constructed by converging trendlines. A symmetrical triangle, which is formed when two similarly sloped trendlines converge, typically suggests a continuation of the prior trend. A descending triangle, which is formed when a downward sloping trendline converges towards a horizontal support line, suggests a downward trend after completion of the pattern. An ascending triangle, which is formed when an upward sloping trendline converges towards a horizontal resistance line, suggests an uptrend after completion of the pattern. Cup with handle: A cup-and-handle pattern is a bullish continuation pattern that suggests a continuation of the prior uptrend. Double tops and Double bottoms: A double top is a bearish reversal pattern, which suggests that the preceding up trend will reverse after confirmation of the pattern. A double bottom is a bullish reversal pattern, which suggests that the prior downtrend will reverse. Head and shoulders: A head-and-shoulder suggests a reversal in the prior uptrend. An inverse head and shoulders suggests a reversal in the prior downtrend Wedges: A wedge chart pattern suggests a reversal in the prior trend when the price action moves outside of the converging trend lines in the opposite direction of the prior trend. Rounding Bottom: A rounding bottom is a long-term reversal pattern that signals a shift from a downward trend to an upward trend Triple tops and triple bottom: A triple top is a reversal pattern formed when a security attempts to move past a level of resistance three times and fails. Upon failure of the third attempt the trend is thought to reverse and move in a downward trend. A triple bottom is a reversal pattern formed when a security attempts to move below an area of support three times but fails to do so. Upon failure of the third attempt below resistance the trend is thought to reverse and move upward. Theory of Price Gaps by J Victor on December 29th, 2010
What is a Gap in technical analysis? A gap is an area on a price chart in which there were no trades. It is easy to see gaps if you take candle stick charts. Let us try to understand gaps in another way. The fluctuations in stock prices are coherent in nature. That means that the price rises or falls gradually. Thus, in rising scrip, if on one day the low was Rs 100 and the high was Rs 135, on the next day the low would be Rs 130 and the high Rs 140. Here, the low for the next day falls within the high-low range of the previous day. But suppose for the second day, the low was Rs 145 and the high Rs 150. Then, the low for the next day has fallen above the previous day High-Low range, or it was higher than the previous days high. So, when one draws bar charts showing High-Lows every day, there would be a discontinuity, termed as a Gap in technical theory. An interesting feature of Price gaps is that it gets filled within a short amount of time. That is, the price would come back to fill the price gap of Rs 140 Rs145, where there was no trade in the previous days. In simple terms-a gap occurs when the current bar opens above the high or below the low of the previous bar. On a price chart, a space appears between the bars indicating the gap. Types of price gaps Gaps can be subdivided into four basic categories: Common Gaps Breakaway Gaps Runaway Gaps and Exhaustion Gaps. Commongaps: Common gaps are common and uneventful. If a Gap is formed when the markets are moving in a narrow range, it is called a Common Gap. BreakawayGaps: A breakaway gap ends a consolidation pattern and happens as prices break out. Often, they would be accompanied by huge volumes. Break-out Gaps are generally not filled for a long time, i.e. in the case of an uptrend, the price does not fall back to wipe off the gains. They may be filled as and when the prices retrace after a substantial up move. If the breakout happens to be a downtrend, the prices may not rise soon to wipe off the loss. RunawayGaps: Runaway gaps are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous days close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. Runaway gaps can also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell but sell to whom? The price has to continue to drop and gap down to find buyers. So, in either case, runaway gaps form as a result of panic trading. ExhaustionGap: An exhaustion gap occurs at the end of a price move. If there have been two or more gaps before it, then this kind of gap should be regarded very skeptically. A genuine exhaustion gap is filled within a few days to a week. It is generally not easy to distinguish between the Runaway and Exhaustion Gaps. Experience in reading charts will help in due course. The best clue available is that Exhaustion Gaps are not the first Gaps in the chart, i.e. they follow the Runaway Gaps and usually occur when the runaway Gap is nearing completion. Exhaustion Gaps do not indicate whether the trend will reverse, they only call for a halt in the price movement. This completes our discussion on gaps. I hope it has filled in some gaps in your trading knowledge. Here are some additional hints :- A gap has relevance only to a daily or short term trader. On spotting a gap in a daily chart, immediately question yourself as to which of the four kinds of gaps it is. Generally, short-term trades should be in the direction of the gap. The larger the gap and the stronger the volume, the more likely it is prices will continue to trend in that direction. A breakaway gap provides an immediate buy point, particularly when it is confirmed by heavy volume. The third upside gap raises the possibility of an exhaustion gap. Traders should look for the gap to be filled in approximately one trading week. If the gap is filled and selling pressure persists, then that issue should be shorted. If the gap is the third one to the downside, then traders should be alert for a buy signal. Gaps are powerful signals to make profits if used intelligently. They should not be acted on in isolation. View the gap within the context of the other technical results. Technical analysis II Introduction to technical indicators by J Victor on January 11th, 2011
What is a technical indicator? In stock market analysis, a technical indicator is nothing but a tool that provides an indication about the condition or direction of the economy. Indicators take the form of calculations based on the price and the volume of a security and measures factors such as volatility and momentum. They are also used as a basis for trading as they can form buy-and-sell signals. Indicators provide an extremely useful source of additional information. Technical analysis is broken into two main categories:- 1. Chart patterns (discussed in technical analysis part 1) 2. Indicators and oscillators ( discussed below) What does it offer? Some technical indicators, such as moving averages are derived from simple formulas and the mechanics are relatively easy to understand. Others, such as stochastic, have complex formulas and require more study to fully understand and appreciate. Regardless of the complexity of the formula, technical indicators can provide unique perspective on the strength and direction of the underlying price action. Types of indicators: There are basically two types of indicators based on what they show users: 1. Leading indicators 2. Lagging indicators. Leading indicators, as their name implies, are designed to lead price movements. That is-the indicators move first and price action follows. Some of the more popular leading indicators are commodity channel index, Momentum, relative strength index, stochastic oscillators and Williams %R. The advantage of using leading indicators is that the signals act as warning against a potential strength or weakness. Leading indicators are more sensitive to price fluctuations. Lagging indicators as their name implies, follow the price action and are commonly referred to as trend-following indicators. It has less predictive qualities. The usefulness of lagging indicators tends to be lower during non-trending periods but highly useful during trending periods. This is due to the fact that lagging indicators tend to focus more on the trend and produce fewer buy- and-sell signals. This allows the trader to capture more of the trend instead of being forced out of their position based on the volatile or sensitive nature of the leading indicators. Moving averages and Bollinger bands are examples of lagging indicators. Where to find these indicators? Most of the common indicators and oscillators are available readily on your online trading platform screen. Know it: Always remember- Technical Indicators are sources of additional information. The purpose of indicators is to indicate. This may sound very straightforward, but sometimes investors ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger? Weaker? Indicators should be studied in context of other technical analysis tools. An indicator may show a buy signal but the chart pattern and fundamentals may be weak. There are two types of indicators leading (one that leads the price change) and lagging indicators(one that follows the price action) How does a technical indicator work ? by J Victor on January 12th, 2011
How does a technical indicator work? Technical indicators are derived from technical charts which are graphical or pictorial representations of the market activity in terms of upward or downward movements in stock prices over a period of time. Mathematically, a technical chart is a plot of a set of price data (on the vertical axis) as a function of time (on the horizontal axis). The price data can include a stocks opening price, closing price, days high or low price, average price, or a combination of these. The plotted data points on the chart can show as individual points or as small bars. When all the data points on the chart are joined, a wave-like pattern is obtained. This pattern is then subjected to technical analysis by experts, who apply standard mathematical formulae to these price movements in order to arrive at technical indicators, from which they can predict the future market price of a stock or its market trend (upward/downward movement). Types of signals- Crossovers and Divergence The indicators show the signals in one of the two ways- through crossovers or divergence. Crossover indicators are constructed with an upper limit and a lower limit. When the limits set are breached, it signals that the trend in the indicator is shifting and that this trend shift will lead to a certain movement in the price of the underlying security. Divergence means the direction of the price trend and the direction of the indicator trend moves in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing. Divergence is a key concept. Divergences can serve as a warning that the trend is about to change. There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances. The concepts of crossovers and Divergence would become clear to you once you learn more about indicators and oscillators. How do technical indicators help the investor/trader? If you have watched the stock market action on a computer screen, you would have noticed that stock prices keep fluctuating almost every second and it is impossible to make head or tail of the pattern if all the price movements are planted on a chart. So, to smooth out the data, technical analysts plot any one of the high/low/open/close/average prices on the charts. This also helps in understanding the movements of an extremely volatile stock and then predicting its future price movement. Technical indicators also help an investor in the following. 1. They determine support and resistance levels. Even an amateur technical chartist can determine important technical levels, which when breached will take a stocks price lower (support levels) or higher (resistance levels). 2. Some indicators can help determine the future price of a share. 3. Technical indicators help in establishing trends (upward or downward), which are critical for both traders and investors. 4. Technical indicators always alert a technical analyst of any major price action/volatility is about to occur in a stocks price. Even you will be able to interpret the alerts once you are through all the articles featured in this topic. Next we need to look at something called oscillators. more about that in our next lesson. Oscillators by J Victor on January 15th, 2011
What are oscillators? Oscillators are technical indicators that measure a stocks momentum as it oscillates between an overbought and an oversold zone and then give a buy/sell signal. Oscillators have recently caught the fancy of most traders. Oscillators give out crossover model signals to indicate a change in trend. Oscillators are typically plotted in two ways. 1. Banded oscillators: Plotted within a range between 0 and 100, in this method, the zone between 0 and 30 is considered the oversold zone while the zone between 70 and 100 is considered overbought. When the oscillator reaches an extreme value in any end, either up or down, the implication is that price has moved too fast and too far. This would warn investor to be ready to face a sudden reversal or a period of consolidation or sideways movement. Investors should typically buy when oscillators feature in the lower end of the range and sell when the oscillator line reaches the upper end of the range. 2. Centered oscillators: The other way to plot oscillators is on either side of a zero line and the oscillator moves between positive and negative values. Called centered oscillators, they fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a securitys move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line. MACD (discussed later) is an example of a centered oscillator that fluctuates above and below zero. What are oversold and overbought conditions? Oversold is a condition where it appears that a stock has declined to the point where the selling is over and buyers will likely step in and push the stock higher. Over bought is a condition where it appears that a stock has reached a price peak and is now likely to turn down. However, overbought is not meant to act as a sell signal, and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators. An example of relative strength index (RSI) , one of the most commonly used oscillators is given below.
The blue line on the picture above is the stocks RSI which moves within a band of 30 -70. When ever the RSI breaches the 30 mark it signals an oversold situation and the stock bounces back. The zone above 70 is considered as overbought. Note that the stock price has shown a drop in price after it breaches the upper limit of the band at 70. Afewwordsofcaution Too Many indicators and oscillators! The best technical indicators are those that have in the past been tried, tested and proven successful. Nowadays, every other technical analyst develops a new technical indicator or oscillator regularly. There are hundreds of oscillators available. In fact, you will be confused as to which one would give you good signals. Our advice to you is to follow the tried and tested indicators. Also, keep in mind the following points: Do not attempt to master all technical indicators and oscillators. Just pick up knowledge in about three of them. Do not analyse stocks price by applying just one indicator use about 2 or 3 complementary indicators, as using just one indicator may give you a false signal. Using 23 indicators can confirm the signals given by one indicator, but if you get a different signal from another complementary indicator then you must not rush into the trade. Take your time to study. With time you will develop the art of judging profitable trades using technical indicators. Do not expect to morph into an expert on day one and carry out trades based on a knee-jerk assessment. First put your new found knowledge to test and begin trading only if youre proven correct most of the time. Types of indicators/Oscillators by J Victor on January 18th, 2011
Before moving on to the next lesson, heres the summary of the last three lessons: Technical indicators are tools that provide an indication about the condition or direction of the stock market. These indicators are generally used as additional information before one takes a decision to buy or sell a share. They provide unique perspective on the strength and direction of the market. Oscillators are a type of technical indicator. Most of the indicators work on the principle of averages. For technical indicators, there is a trade-off between sensitivity and consistency. In an ideal world, we want an indicator that is sensitive to price movements, gives early signals and has few false signals (whipsaws). Sensitiveness of an indicator/oscillator to price movements in the market would depend on the time interval for which the indicator is constructed. For example a 5 day RSI would be more sensitive than a 14 day RSI. The 5 period RSI would have more overbought and oversold readings. It is up to each investor to select a time frame that suits his or her trading style and objectives. The shorter the period selected, the more sensitive the indicator becomes. If we increase the sensitivity by reducing the number of periods, an indicator will provide early signals, but the number of false signals will increase. If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but the signals will lag and this will skew the risk reward ratio. From here on, for ease of understanding, we will discuss the prominent types of technical indicators/oscillators from the point of view of what exactly it measures. Whether it is leading or lagging and whether its signals are crossovers or not would be discussed at appropriate places. Prominent indicators/oscillators. Indicatorsthatshowthetrend Moving average MACD (Moving average convergence/ divergence) Average directional index. Indicatorsthatshowmomentum RSI (relative strength index) Stochastic oscillator Williams %R Indicatorsthatmeasuresvolatility Average true range Bollinger bands Before moving further, I would also like to explain in brief about the difference between trend, momentum and volatility. Momentum- It measures the degree of acceleration in a stock price. It is a short term measurement. In other words, Momentum measures the speed of price change and provides a leading indicator of changes in trend. When momentum slows, this is taken to mean that there might be a change in direction. Momentum is significant because it signals the strength of price trends Trend A trend can be defined as the general direction in which the market is moving in. A trend can be either upwards (bullish trend) or downwards (bearish trend) or sideways (lack of direction). Volatility The relative rate at which the price of a stock moves up and down If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility. In other words, Volatility refers to the amount of uncertainty about the swings in price of a stock. A higher volatility means that a stocks value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a securitys value does not fluctuate dramatically, but changes in value at a steady pace over a period of time. Understanding Moving average by J Victor on January 20th, 2011
An average that moves! As its name implies, a moving average is an average that moves. They do not predict price direction, but rather show the current direction with a lag. Moving averages are based on past prices, which mean they will lag behind current prices. It will be presented in graphical form on your online stock trading terminal. Moving averages form the building blocks for many other technical indicators and overlays, such as Bollinger bands and MACD (explained later in this section). Most analysts use the 50 day, 100 day and the 200 day moving averages. The 200-day moving average is the important moving average. Example: To begin calculating a 200-day moving average of Infosys, the closing prices of Infosys over the last 200 days would be added together, and then divided by 200. That provides the average price at which Infosys was sold over the last 200 days. That point would be marked on the chart today. To make the average move, each subsequent day the same process is repeated, and the new point is added to the chart. After a few weeks you have the 200-day moving average moving along the chart where its relationship to Infosyss price each day can be seen. Note that in calculating the moving average each day, the oldest of the 200 closes is dropped and the new days close is added (Only the prices over the most recent 200 days are added together and divided by 200 each day). So, the 200-day moving average is simply a shares average closing price over the last 200 days. The 200-day moving average is perceived to be the dividing line between a stock that is technically healthy and one that is not. Furthermore, the percentage of stocks above their 200- day moving average helps determine the overall health of the market. Many market traders also use moving averages to determine profitable entry and exit points into specific securities. Purpose of moving averages: Primary function of a moving average is to identify trends and reversals, measure the strength of an assets momentum and determine potential areas where an asset will find support or resistance. Moving averages are easier to see and analyse on a chart. There are different types of moving averages-simple moving average (explained above) and exponential moving average. The Exponential Moving Average differs from a Simple Moving Average both by calculation method and in the way that prices are weighted. The Exponential Moving Average (shortened to the initials EMA) is effectively a weighted moving average. With the EMA, the weighting is such that the recent days prices are given more weight than older prices. The theory behind this is that more recent prices are considered to be more important than older prices, particularly as a long-term simple average (for example a 200 day) places equal weight on price data that is over 6 months old and could be thought of as slightly out-of-date. A moving average can be a great risk management tool because of its ability to identify strategic areas to stop losses. What is the right moving average? Moving averages come in various forms, but their underlying purpose remains the same: to help technical traders track the trend of financial assets by smoothing out the day-to-day price fluctuations. There is nothing called right moving average. A 50-day moving average should be right for the intermediate term and 150 or 200-day moving average should work well for a long term investor. Understanding MACD by J Victor on January 28th, 2011
Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence (MACD) is one of the simplest and most effective indicators available. The two components of MACD. The MACD indicator is comprised of two exponential moving averages (EMA), covering two different time periods, which help to measure momentum in the security. The two exponential moving averages are the 12 period EMA and the 26 period EMA. The MACD is the difference between these two moving averages. A 9-day EMA of MACD is plotted along side to act as a signal line to identify turns in the indicator. MACD is all about the convergence and divergence of the above said two moving averages. Histogram Another aspect to the MACD indicator that is often found on charts is the MACD histogram. Thomas Aspray added a histogram to the MACD in 1986. The MACD-Histogram represents the difference between MACD and its 9-day EMA, the signal line. The histogram is positive when MACD is above its 9-day EMA and negative when MACD is below its 9-day EMA. Whats said above would be clearer if you follow the MACD signal given below. The idea behind this momentum indicator is to measure short-term momentum compared to long-term momentum to help determine the future direction of the asset. Note that the red line is the 9 day average of the MACD (and not of the stock price).
MACD signal is available on any standard online trading screen. Your online trading screen will have the option to select the MACD signal from the choices of technical indicators. The exact location of this operation varies between trading screens, but will almost always be titled technicals ,indicators, studies, oscillators or analysis. It may be a button on the chart, an option available by right-clicking on a chart or a menu above the chart. MACD signal will be displayed below the stock price chart. It generates three meaningful signals for the investor: They are 1. Crossover signal 1- MACD line crosses the signal line. 2. Crossover signal 2- MACD Line crosses the line Zero(center line) 3. Divergence signal- MACD line ( or histogram) and the price of the stock (as seen on the price graph) diverge (i.e. moves in the opposite direction) Understanding Average Directional Index (ADX) by J Victor on February 10th, 2011
Introduction: Average directional index evaluates the strength of the current trend, be it up or down. The ADX is an oscillator that fluctuates between 0 and 100. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend. A reading above 40 indicates that the trend is strong and a reading below 20 indicates that the trend is weak. An extremely strong trend is indicated by readings above 50. What does it measure? ADX does not indicate trend direction, only trend strength. It is a lagging indicator; that is, a trend must have established itself before the ADX will generate a signal that a trend is underway. ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and moves above 20, it is a sign that the trading range is ending and a trend is developing. The ADX indicator does not provide buy or sell signals for investors. It does, however, give you some perspective on where the stock is in the trend. Low readings and you have a trading range or the beginning of a trend. Extremely high readings tell you that the trend will likely come to an end. Overall, what is important to understand is that this indicator measures strong or weak trends. This can be either a strong uptrend or a strong downtrend. It does not tell you if the trend is up or down, it just tell you how strong the current trend is. Construction of ADX. We will not go into the formulas for the Indicator here. However what we need to know is that: ADX is derived from two other indicators The first one is called the positive directional indicator(sometimes written +DI) and the second indicator is called the negative directional indicator(-DI) The +DI Line shows how strong or weak the uptrend in the market is. The -DI line shows how strong or weak the downtrend in the market is. ADX is the average of the above two lines and hence, it shows the strength of the current movement. On screen, the ADX appears below the stock price chart. The +DI (normally a green line) and DI lines (red line) would accompany the ADX (Black line). So you see three lines as shown in the figure below.
More tips: When the ADX starts rising from a low level it signals the beginning of a trend. The trend is confirmed when the ADX has risen above the 20-25 value and the +DMI line has crossed the DMI line (in case of an uptrend). The ADX signal generally does not move above 60 or 70. ADX above these levels are considered to be over bought levels. When the ADX has reached an overbought level and starts consolidating it can signal the end of the current trend. The decline of the ADX signals the consolidation or indecision of the market. When the ADX drops below 10, the current trend is virtually dead. Be ready for the beginning of a new trend bullish or bearish. Dont assume that since your current position has given you an ADX reading of 10 (or lower) implying that your trend is over and that the subsequent ADX move above 20 will take you in the opposite direction. Thats a terribly wrong assumption. An ADX reading above 20 implies the beginning of a new trend; whereas; a rise above 25 implies a trending market; even a bearish market. So, know this it is possible to have a reading of 35 and the market can be falling like a rock. An upward moving ADX does not specify market direction only market trend. This is a very important point to note. That completes our lesson on ADX. More about indicators in our next lesson. Understanding RSI (Relative strength Index) by J Victor on February 12th, 2011
Introduction The name Relative Strength Index is slightly misleading as the Relative Strength Index does not compare the relative strength of two securities, but rather the internal strength of a single security. Relative Strength Index (RSI) is a very popular momentum indicator. What does it measure? RSI measures the speed and change of price movements. RSI oscillates between zero and 100. When the RSI line moves higher, it is understood that price is enjoying increased strength and as the RSI line moves lower, it is understood that the price is suffering from a lack of strength. However, technical analysts believe that a value of 30 or below indicates an oversold condition and that a value of 70 or above indicates an over bought condition. When Wilder introduced the Relative Strength Index in 1978, he recommended using a 14-day Relative Strength Index. Since then, the 9-day and 25-day Relative Strength Indexes have also gained popularity. The most popular is the 14 day RSI. Shown below is an example of how the RSI would be displayed below your stock prices chart
Tips for Using the RSI Indicator As with all technical indicators, RSI is a way of measuring odds its not a full-blown, fool-proof system to gauge price trends. It is usually best used in conduction with other indicators. Though considered an oscillator, the relative strength index has qualities of momentum indicators, and can be used in that capacity. For instance, some investors interpret a cross of the 50 level (the mid-point of the scale) as a signal of momentum bullish or bearish in itself. If the stock has been trending up, but the relative strength indicator starts to trend down, there is a divergence and you would prepare to enter a bearish trade (down direction). Its the vice versa for bullish trades. Once the stock becomes overbought (RSI reaches the point 70) or oversold (RSI at 30), or has price divergence you should always wait for some type of confirmation that a price reversal has indeed occurred. RSI should not be used in isolation. It must be used in combination with other indicators to help build a clear picture. The RSI oscillator should not be confused with another trading tool unfortunately called the Relative strength. The other tool compares a stocks or indexs performance to other stocks or indices in a group, and ranks that stock or index, assigning a relative strength score. The other tool is powerful too, but is unrelated to the RSI indicator discussed here. RSI is a versatile momentum oscillator that has stood the test of time. Hope you have got information about RSI and how it can be used to take decisions. Understanding Stochastic oscillators. by J Victor on February 19th, 2011
Stochastic indicator: The Stochastic oscillator is a technical indicator that shows the momentum. It is designed to oscillate between 0 and 100. Low levels mark oversold markets, and high levels mark overbought markets. Overbought means prices are too high, ready to turn down. Oversold means prices are too low, ready to turn up. Technical analysts believe that a value of 20 or below indicates an oversold condition and that a value of 80 or above indicates an over bought condition. This indicator was popularized by George lane decades ago and is now included in most software packages. What does it measure? The Stochastic oscillator measures the capacity of bulls to close prices near the top of the recent trading range and the capacity of bears to close them near the bottom. Bulls may push prices higher during the day, or bears may push them lower, but the stochastic oscillator measures their performance at closing timethe crucial money-counting time in the markets. If bulls lift prices during the day but cannot close them near the high of the recent range, the stochastic oscillator turns down, identifying weakness and giving a sell signal. If bears push prices down during the day but cannot close them near the lows, the stochastic oscillator turns up, identifying strength and giving a buy signal. An example of how Stochastics appears below the stock price chart is shown below:
Fast & Slow Stochastics: There are 2 main types of setting, the Fast Stochastic and the Slow stochastic. Fast Stochastics: use shorter Time Periods, and Shorter Averages this creates more fluctuations but conversely also more false alarms Slow Stochastics: use longer time periods and longer average periods this creates a smoother flow and gives the ability to see trends clearer, the drawback is the Indicator lags price and is less responsive. How is the indicator plotted? The term stochastic refers to the location of a current price in relation to its price range over a period of time. The stochastic is plotted as two lines %K, a fast line normally represented by a blue line and %D, a slow line, normally red. These two lines have the following characteristics: The default setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or an intraday time frame. The %K line is basically a representation of where the market has closed for each period in relation to the trading range for the 14 periods used in the indicator. The %D line is a 5 period moving average of %K. Sounds very complicated, isnt it? Dont worry. You dont need to learn about how combustion engine works to drive a car. What you need to do is to follow these simple rules. Rule 1- Use the stochastic oscillator just like RSI to identify overbought and oversold levels in the market. When the lines that make up the indicator are above 80, it represents a market that is potentially overbought and when they are below 20, it represents a market that is potentially oversold. The developer of the indicator George Lane recommended waiting for the %K line to trade back below or above the 80 or 20 lines as this gives a better signal that the momentum in the market is reversing. Rule 2- Watch for a crossover of the %K line and the %D line. When %D is below the 20 mark and the faster %K line crosses the slower %D line, it is a sign that the market may be heading up and when %D is above the 80 mark and the %K line crosses below the %D line this is a sign that the market may be heading down. Rule 3- The third rule is to watch for divergences where the Stochastic trends in the opposite direction of price. As with the RSI this is an indication that the momentum in the market is waning and a reversal may be in the making. For further confirmation many traders will wait for the cross below the 80 or above the 20 line before entering a trade on divergence. Rule 4- Never rely solely on Stochastics or any other technical indicator for that matter. Always use technical indicators as additional tools. Stochastics uses the Price Open, High, Low and Close for the period, so it can be used well in conjunction with RSI, which uses only Close Price as the input. That completes our lesson on Stochastics. The nicest thing about the stochastic is that it can keep up with fast moving, volatile or even trading range markets. Understanding Williams %R by J Victor on March 1st, 2011
Williams %R is a simple momentum oscillator explained by Larry Williams for the first time in 1973.It shows the relationship of the close relative to the high-low range over a set period of time. Typically, Williams %R is calculated using 14 periods and can be used on intraday, daily, weekly or monthly data. The time frame and number of periods will likely vary according to desired sensitivity and the characteristics of the individual security. The scale ranges from 0 to - 100 with readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold. This momentum indicator is, in fact , the inverse of the Fast Stochastic Oscillator. The default setting for Williams %R, as said above, is 14 periods, which can be days, weeks, months or an intraday timeframe. A 14-period %R would use the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods. The indicator would appear below the price chart on your trading screen. An example of how Williams %R would look is given below.
Reading W %R signals. Heres a collection of pointers you should be following in order to interpret William %R signals correctly. Williams %R moves between 0 and -100, which makes -50 the midpoint. A Williams %R cross above -50 signals that prices are trading in the upper half of their high-low range for the given look-back period. Conversely, a cross below -50 means prices are trading in the bottom half of the given look-back period Low readings (below -80) indicate that price is near its low for the given time period. High readings (above -20) indicate that price is near its high for the given time period. Williams %R makes it easy to identify overbought and oversold levels. Readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold. However, It is important to remember that overbought does not necessarily imply time to sell, and oversold does not necessarily imply time to buy. A security can be in a downtrend, become oversold and remain oversold as the price continues to trend lower. Once a security becomes overbought or oversold, traders should wait for a signal that a price reversal has occurred %R can be used to gauge the six month trend for a security. 125-day %R covers around 6 months. Prices are above their 6-month average when %R is above -50, which is consistent with an uptrend. Readings below -50 are consistent with a downtrend. In this regard, %R can be used to help define the bigger trend (six months). Like all technical indicators, it is important to use the Williams %R in conjunction with other technical analysis tools. Understanding Average True Range. by J Victor on March 4th, 2011
The Average True Range (ATR) is an indicator that measures volatility. A stocks range is the difference between the high and low price on any given day. It reveals information about how volatile a stock is. Large ranges indicate high volatility and small ranges indicate low volatility. Average true range is built on this principle of range. To understand ATR, you must first try the concept of true range. What is True range? True Range is the greatest of the following three values: 1.The difference in price between todays high and todays low of a stock. 2.The difference in price between yesterdays close to todays high. 3.The difference in price between yesterdays close to todays low. True range is always a positive number (negative numbers from the calculation above are to be ignored). Average true range is simply an average of the true range- usually 14-days. Calculating the Average True Range Indicator is slightly complex, though it is possible with a spreadsheet. Fortunately, most of the trading screens provide the average true range indicator as a part of their service. Care should be taken to use sufficient periods in the averaging process in order to obtain a suitable sample size, i.e. an average true range using only 3 days would not provide a large enough sample to give you an accurate indication of the true range of the securitys price movement. A more useful period to use for the average true range would be 14. What does ATR indicate? The value returned by the average true range is simply an indication as to how much a stock has moved either up or down on average over the defined period. High values indicate that prices are changing a large amount during the day. Low values indicate that prices are staying relatively constant. The ATR (Average True Range) indicator also helps to determine the average size of the daily trading range. In other words, it tells how volatile the market is and how much does it move from one point to another during the trading day. ATR is not a leading indicator means it does not send signals about market direction or duration, but it gauges one of the most important market parameter price volatility. The logic behind ATR is that over the last several days on average, if the stock price has moved X points, we could safely assume that unless some shocking market news comes along, this range will remain relatively consistent. In short, ATR indicator is a tool for short term traders.Since it shows the average price range of a share, traders also use it to place stop loss orders. Understanding Bollinger Bands. by J Victor on March 7th, 2011
What are they? Introduced by John Bollinger in the 1980s, Bollinger Bands are a pair of trading bands representing an upper and lower trading range for a particular market price. A stock is expected to trade within this upper and lower limit as each band or line represents the predictable range on either side of the moving average. Generally, 80-85% of the price action happens within these bands. All trading softwares will have options to display Bollinger bands. Bollinger Bands consist of a set of three lines drawn in relation to securities prices. The middle line is a measure of the intermediate-term trend, usually a simple moving average that serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility. The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band. Why use them? Finds support and resistance levels: The upper band usually indicates a resistance level while the lower band usually indicates a support level. If you take a close look at any Bollinger band, you will find that the price usually bounce off the Bollinger band whenever it touches the upper or lower band. With this observation, you can use the upper and lower bands as support and resistance when planning your trade. Helps to find where to Enter and Exit: Bollinger Bands can be very useful trading tools, particularly in determining when to enter and exit a market position. For example: entering a market position when the price is midway between the bands with no apparent trend, is not a good idea. Generally when a price touches one band, it switches direction and moves the whole way across to the price level on the opposing band. If a price breaks out of the trading bands, then generally the directional trend prevails and the bands will widen accordingly. Gauges volatility: The Bollinger Band is an indicator that helps you to measure the volatility of the market. It can tell you the current situation of the market by using its upper and lower band. Whenever the market has low volatility, the bands will be narrow and whenever the market has high volatility, the bands will be wide. Shows Breakoutsone of the lesser known uses of Bollinger bands is the prediction for breakouts or gaps. As the bands squeeze a share price, the price range grows very narrow. Some trading systems identify that this is a prime time for the price to breakout of this range. Usually a large price gap is the result. The difficulty is to know the direction of the price breakout. Before Picking up stocks.. Can you measure management effectiveness? by J Victor on March 23rd, 2011
Hi there, The success or failure of an organization depends on how effective the management is. The management team of a company is responsible for propelling the future growth in the right direction. It also responsible for administering and controlling the business activities and accounting for the results. An ineffective management at the top results in failure of the company. Such is the importance of management. So, one has to measure the effectiveness of the management before purchasing a stock. Its all about finding answer to one single question- Are they doing the right thing? How do you go about finding answer to that question? To be more specific, how would you assess whether the management utilizing the available resources in the best possible way? How well is the company being run relative to others in its sector and the market as a whole? The answer lies in finding three important ratios - .Return on assets Return on investment ( ROCE) Return on equity ( ROE) ROE and ROCE was discussed in the earlier posts, so I dont want to repeat the whole thing here. What remains to be explained is return on assets. RETURN ON ASSETS Return on assets is calculated by taking the net income and dividing it by the total assets. ROA = Net Income / Total assets ROA is a very effective tool . For example If the total assets of Company as per the balance sheet is Rs 10 million and if it has earned a net income of Rs 20 million , the ROA would be 2 (20 / 10) . It means, for every Rs 1 in assets, the company has made a profit of Rs 2. So , higher the ratio, the better it is. This ratio should be only used to compare companies in the same industry. The reason for this is that companies in some industries are more asset-insensitive i.e. they need expensive plant and equipment to generate income compared to others. Their ROA will naturally be lower than the ROA of companies which are low asset intensive like IT service industry. A single period ROA of a company will not tell you the whole story. You have to check the ROA for the past years and check if its showing an increasing trend. An increasing trend of ROA indicates that the profitability of the company is improving. By measuring the managements effectiveness, you will be able to make reasonable comparison between the company and its peers from the same industry or sector. Before I close, heres some more thoughts about using ROE, ROCE and ROA. In order to make a clear view of the companys management effectiveness use all the three ratios mentioned. With ROE you get an idea about how the management is using the money given by the shareholders. ROCE would reveal how the management is utilizing the total capital employed, which includes loans and other debt funds. ROA is a totally different take. It measures the number of times earnings generated using the assets of the company. The basic balance sheet equation is assets = liabilities + Equity. So, if there were no liabilities in a companys balance sheet , the ROA and ROE would be same. In other words, If the ROA and ROE of a company are different, the reason is the presence of liabilities or loan funds in the balance sheet. If a company has loan funds, ROE would be more than the ROA. How? A company buys more assets by taking loans, but since equity = assets liabilities, a company decreases its equity by increasing debt. So, when debt increases, equity shrinks, and since equity is the ROEs denominator, ROE, gets a boost. Hance the presence of debt in a companys balance sheet boosts the ROE in relation to ROA. Thats about measuring management effectiveness. Using price and volume to find market trends. by J Victor on March 26th, 2011
Hi there, In this post im going to talk about two vital pieces of information that you have to keep a close watch. They are price and volume. Both these figures are important and it gives a quick idea about the direction of the stock price. WHAT DOES IT TELL? Volume tells you whether there are buyers or sellers for this stock in the market. Price tells you which direction. RELATION BETWEEN PRICE AND VOLUME. If the number of shares traded is high and the prices are also moving higher- thats a positive signal. You are probably looking at a large group of people investing heavily in that stock. On the other hand, If the number of shares traded is high and the prices are coming down thats something to be careful about. You are probably looking at investors backing out from that stock. Several combinations of price and volumes are possible. Lets look at the most common scenarios: A price advance with steady increasing volume This indicates continuing upward momentum. As the price is climbing, more and more buyers are getting attracted until the stock gets into a stage of euphoria that usually indicates the end of the price advance. A slowing pace of buying with decreasing volume Slow pace in buying also means that there are not many sellers for the stock, which is a good sign. It also indicates that the price is almost at its peek and a further up move is unlikely immediately. Since the sellers are in short, the stock might move higher after a pause. A relatively big volume increase during the price advance with lower volume on the pullback. This indicates a continuing uptrend. The lower volume during the pullback indicates that there are not enough sellers in the market to drive the stock down. Big buying volume without the price going higher This indicates distribution, which means resistance. A big seller is likely in the market. There is no way to tell yet if the buyers will win this battle and are able to drive the price higher, or if they will give up and the stock eventually reverses. A slow and steady movement upward with consistent volume This indicates continuing upward momentum. There might be a buyer in the market who is steadily buying shares while trying to not attract too much attention. CONCLUSION Tracking on price and volume for a few days will give you an idea about general direction of the market and with some expertise, you can spot the warning signs that a change in direction/trend is coming. Thats about price and volumes Bonus shares A positive sign. by J Victor on March 29th, 2011
WHAT ARE THEY? Bonus shares are issued in a certain proportion to the existing holders. A 2 for 1 bonus would mean you get two additional shares free of cost for the one share you hold in the company.If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you. WHO BEARS THE COST IF ITS FREE FOR ME? You are right. There is no free lunch.Bonus shares are issued by cashing in on the free reserves (accumulated profits) of the company.A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.So you do not pay; and the companys profits are not impacted. WHAT ARE THE EFFECTS OF A BONUS ISSUE? Bonus shares do not directly affect a companys performance. Bonus issue has following major effects. 1. Share capital gets increased according to the bonus issue ratio. 2. Liquidity in the stock increases. 3. Effective Earnings per share, Book Value and other per share values stand reduced. 4. Markets take the action usually as a favorable act. 5. Accumulated profits get reduced. 6. A bonus issue is taken as a sign of the good health of the company. WILL THE SHARE PRICE CHANGE AFTER BONUS ISSUE? A bonus issue adds to the total number of shares in the market.Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares.This is referred to as a dilution in equity.Now the earnings of the company will have to be divided by that many more shares.(Earnings Per Share = Net Profit/ Number of Shares)Since the profits remain the same but the number of shares has increased, the EPS will decline.Theoretically,When EPS declines, the stock price should also decrease proportionately. But, in reality, it may not happen. Thats because: i. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell. ii. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. THE RECORD DATE. When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus. After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex- bonus. HOW BONUS SHARES CREATES ENORMOUS WEALTH Bonus shares, in the long run would create enormous wealth for the investor. For example, a Rs 10,000 invested in Wipro in 1980 would have grown into several Crores as shown below:- In 1980 You buy 100 shares @ Rs 100 per share in your name . In 1981 company declared 1:1 bonus = you have 200 shares In 1985 company declared 1:1 bonus = you have 400 shares. In 1986 company split the share to Rs. 10 = you have 4,000 shares In 1987 company declared 1:1 bonus = you have 8,000 shares. In 1989 company declared 1:1 bonus = you have 16,000 shares In 1992 company declared 1:1 bonus = you have 32,000 shares In 1995 company declared 1:1 bonus = you have 64,000 shares In 1997 company declared 2:1 bonus = you have 1,92,000 shares. In 1999 company split the share to Rs. 2 = you have 9,60,000 shares In 2004 company declared 2:1 bonus = you have 28,80,000 shares. In 2005 company declared 1:1 bonus = you have 57,60,000 shares In 2010 company declared 2:3 bonus=you have 96,00,000 shares. Share price of Wipro is Rs 428.00 in July 2010 The value of 57,60,000 shares in 2010 406.60 Crores. CONCLUSION Declaring Bonus shares is a sign that companies are increasing their profitability. If you look back, many companies have announced issues of bonus shares to their shareholders by capitalizing their free reserves . Shareholders have benefited tremendously, even after accounting the inevitable reduction in share prices post-bonus, since the floating stock of shares increases. So keep an eye on bonus history when you decide to buy a stock-It may be a good indicator that the company is healthy. Using Beta to gauge volatility. by J Victor on March 31st, 2011
If your heart has a high beta level, invest in a stock that has low beta! Hi there , Beta is a measure of a stocks price volatility in relation to the rest of the market. In other words beta is a measure of risk. The rest of the market would be represented by any broad index that represents the market. Hence, in India, the broad based index could be the Sensex or the nifty. Understanding beta is simple. Stocks that have a beta greater than 1 have greater price volatility than the overall market and are more risky. Stocks with a beta of 1 fluctuate in price at the same rate as the market. Stocks with a beta of less than 1 have less price volatility than the market and are less risky.So, if the market goes up 20%,a stock with beta 1 goes up 20%. If the Market is down 10%, the stock comes down 10%. This is, of course, calculated over a period of months and does not necessarily hold true on a daily basis. NOT ONLY FOR INDIVIDUAL STOCKS.. Not only for individual stocks, beta measure can also be computed for the entire industry. That would compare the volatility that industry relative to the market. If you know the industry beta, it would be possible for you compare a stock relative to the industry and the market. For example, if you know that the beta for information technology stocks was 1.5 and you found a company in that industry with a beta of 0.7, this would tell you that the company is not only less volatile than the market as a whole, but extremely stable compared to its industry. Beta can be constructed for your individual portfolio also. Beta of a portfolio should be the weighted average betas of securities comprising the portfolio. Beta measures of a stock is useful in finding the cost of equity using the CAPM method. I ll explain more on that when we discuss about cost of equity in our valuation section. WHERE TO FIND ? All financial information web-sites like moneycontrol have information about a stocks beta. PROBLEMS WITH BETA. While the beta may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment. Beta is computed with historical data. Beta suggests a stocks price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a bull market, the stock that outperforms all will have beta thats greater than 1. HOW TO USE BETA. Beta is useful for short term decision making. In short term decisions, price volatility is important. Since beta measures exactly that, it useful for that class of investors. In a rising market, its good to have high beta stocks and in a falling market its better to stick to low beta shares. Later when I talk about risk premium, we will find more applications of beta. For the time being, remember beta as a simple and very valuable tool to gauge volatility. Bye for now .. Is a stock buyback scheme a good sign? by J Victor on April 6th, 2011
Hi there, Stock buy back offers or stock repurchase offers are generally understood to be a good sign. This is one indirect way for cash rich companies to maximise the wealth of its shareholders. LETS TAKE A CLOSER LOOK The idea behind share buy back is simple. The company uses its cash to repurchase its shares from the open market. Since the company cannot act as its own shareholder, the repurchases shares are absorbed by the company and the number of shares outstanding is reduced thereby increasing the EPS. So buy backs result in increase in shareholders value. Another reason why a company would resort to share buy backs is to improve its financial ratios For example, buybacks reduce the cash component on the balance sheet. Since cash is an asset, it effectively reduces the total assets of the company. Since ROA is calculated as return / total assets, any reduction in the total assets figure will improve the ROA figure. Similarly, re purchase results in a reduction in the number of shares outstanding. Since ROE is calculated as return / number of shares, any reduction in the number of shares will improve the ROE figure. So, if the company is buying back its shares with the sole intention of improving its rations like ROE and ROA, thats not a good sign. Another problem stock buybacks seek to cure is the dilution (too much stock on the open market) caused by stock option plans. When stock options are exercised the number of outstanding shares increase. This makes the companys ratios look weaker the opposite of what repurchasing does. The buyback offers however, reduces the book value of the company. ( see the example below)
Advantages to the Investor Buying back stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher earnings per share should command a higher stock price which is great! Improving EPS also means that the P/E of the company is reduced. A lower P/E, higher EPS, ROA and ROE are regarded as positive signals by investors. Buying back stock uses up excess cash which otherwise remain idle. Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend. Example: Lets take the financial figures of company xy ltd- Before buyback The total assets of the company are 5000 lakhs and the total liabilities are 3000 lakhs. Hence, book value would be (assets liabilities) = 2000 lakhs. Assuming that the company has 1o lakh shares outstanding, the book value per share would be (2000/10) = 200 per share. If the earnings of the company for the year was Rs 250 lakhs, the EPS of the company would be 25 ( 250 /10) ROE would be 25/200 = 12.50 % Let us assume that the shares of the company are trading at Rs 250 now and the company proposes to buy back 25% of its shares from the market. Post Buy back The company would need 625 lakhs to buy 25% shares @ Rs 250 The company takes cash worth 625 lakhs and buys back the shares.The assets of the company now get reduced by Rs 625 to Rs 4375 lakhs. The number of shares outstanding is reduced by 2.5 lakh shares to 7.5 lakhs New book value would be Rs 1375 lakhs (Rs 4375 lakhs 3000 lakhs ) therefore, book value per share = 183.33 per share EPS = improved from 25 to 33.33 (250 / 7.5) ROE increased from 12.50% to 18 % ( 33.33 / 183.33) As you can see, figures like price earnings ratio, earnings per share, return on assets, return on equity and others can be pumped up by a stock buyback program. So even if nothing has fundamentally changed about the company, the ratios will give a better picture after buyback. . All weaknesses in the business model before the stock buyback will still be there after the buyback. CONCLUSION Stock buy backs may not be a positive sign always.Do not buy a stock as soon as a stock buy back is announced, expecting a rise in prices. Always look behind the scenes and find out the real picture behind the buy back. Using Advance / Decline to spot market trends by J Victor on April 8th, 2011
ADVANCE/DECLINE NUMBERS Hi there, Stock exchanges around the world give out the number of shares that advanced or declined in a trading day from the last close. For example, the exchange may inform that out of the 7000 stocks, 4500 stocks advanced while 2000 stocks declined. The balance 500 stocks remained unchanged. A/D RATIO The advance/decline ratio is calculated by dividing the number of advancing stocks by the number of declining stocks. Values higher than 1 show that more issues are presently advancing than declining. Values between 0 and 1 indicate that more issues are currently declining in price. HOW DOES THIS HELP? Stock market indexes are very tricky. For example, it is possible for the Sensex to report a gain at the end of the day in spite of many stocks falling, if a couple of heavyweight stocks in the index do well. In such cases, stock indices may not give you that actual picture of whats happening. To get the real picture, you need the number of shares that advanced and declined out of the total number of shares listed. If too many stocks have advanced it gives us an indication that we are in a bull market. Another way you can use the advance/decline numbers is in watching trading during the day to spot trends or false trends. For example, if a major index is up significantly, but you find that there is no corresponding increase in advance numbers. So, that increase could be a bubble in a major stock thats going to burst. INDEX OR NUMBERS? If the broad based index conflict with the advance/decline numbers, you have to go with the numbers (and not with the index) to determine what the market really did in terms of direction. One of the major limitations of the advance/decline numbers is they dont tell you anything about the size of the advances or declines. It just tells the numbers. It doesnt tell whether advances were up a Rupee or a 100? CONCLUSION Advance/decline is a very simple and effective indicator. It gives you an indication of how the overall market is doing and can add a level of information to indexes for a better understanding of they mean. Keep an eye on the factors that cause volatility in stock markets by J Victor on April 15th, 2011
What moves the stock market? Hi there, That question has many answers. Economic factors like GDP and earnings reports, political factors like government policies and political unrest, commodity prices like price of crude oil and gold, social issues like war and terrorism, acts of God such as earth quakes and flood may cause the market to change direction or speed up or slow down its momentum. Most common of them are listed below. Inflation, Interest rates & Earnings High Speculative activity Demand and supply Oil/Energy Prices ,War/terrorism , Crime/fraud Serious domestic political unrest Uncertainty Inflation, interest rates & Earnings To put it in simple terms, Inflation is a sustained increase in the general level of prices for goods and services. There may be a lot of reasons for this. It is measured as an annual percentage increase. As inflation rises, every Rupee in your wallet buys a smaller percentage of a good or service. People living off a fixed-income, such as retirees and salaried class see a decline in their purchasing power and, consequently, their standard of living. Uncertainty about economic future makes corporations / consumers spend their money cautiously. This hurts economic output in the Long run As inflation increases, Reserve bank increases the interest rates to reduce the money supply and slow inflation down: When interest rates are high, people find it expensive to borrow, and therefore there is less money floating around. When interest rates are high; people require higher returns on stocks. Its not so easy to just increase earnings for a stock, so its price has to adjust downward. For example : Consider a stock that sells at Rs 100 with earnings of Rs 12, a 12% return. When Fixed deposits pay 8%, an investor may be willing to buy this stock for the extra 4% return. However, if interest rates were to rise, to say 12%, who would pay for this 12% return, when they could get 12% risk-free by Fixed deposits ? Therefore, the stock may drop to Rs 75. With earnings of Rs 12, this now generates a 16% return and is once again at a price where an investor might be willing to take the risk on this stock for the extra 4%. Mismatch between actual earnings and expected earnings of the corporates may cause the stock markets to fluctuate. Thats because, when the corporates report week results than expected, the investors react by selling of their holdings in that stock resulting in a huge drop in stock prices. The opposite is also true. If corporates come up with better than expected earnings results, more an more investors would invest in those stocks resulting in a surge in stock price. Speculators and investors Anyone who owns shares are generally referred to as investors. However, not everyone is an investor in share market. There is one category of buyers who do not follow the fundamentals Speculators. Excessive use derivative instruments like options and futures to speculate may drive stock prices to extreme levels defying all logic. Speculators are largely responsible in creating heavy volatility in the stock markets. Since they buy securities based on momentum, it leads to stocks becoming dramatically overvalued when everyone is interested and unjustifiably undervalued when the craze ends. Demand and supply The very basic economic theory of demand and supply holds good in stock markets too. When there are more shares available than demand, each of those shares is worth less. The opposite is true when there is more demand than shares available. Oil prices/fraud /scams and other factors affecting stock markets There are many other factor like hike in Oil prices (resulting in commodities and services getting dearer) war and terrorism (Example: The sept 11 attack and the uncertainty it created in stock markets around the world) Fraud / scams (Example :- Satyams case) serious political unrests which results in certain commodity prices moving up ( or revenues of a particular country decreases) which might result in stock prices crashing down. CONCLUSION If you have decided to become active in share markets, its important to know what moves the stock market. Events like those mentioned above create golden opportunities to buy shares of good companies at throw away prices. You may like these posts: Balancing your investments. by J Victor on April 22nd, 2011
Hi there, Remember the topic on market capitalization? Market capitalization is how we measure the total worth of a company. It is the way you categorize companies by size. A simple way of thinking of it is how much you would pay to buy all the shares of that company available in the market. The term cap is the short form of capitalization. General break down by size of companies are: LARGE CAPS There is no standard definition of Large Cap and it varies from institution to institution. But as a general rule, if a company has a market capitalization of more than Rs. 5000 Crores, it is considered as a Large Cap. A Large Cap company is normally a dominating player in its industry, and has a stable growth rate. It should be noted that almost all the Large Cap companies from India would be considered as Mid Cap or Small Cap companies in a global scenario, as globally, companies are usually classified as Large Cap if their market cap is more than $10 Billion (roughly Rs. 39,000 Crores). MID CAPS If a company has a market capitalization of between Rs. 1000 Crores and Rs. 5000 Crores, it is considered as a Mid Cap.A Mid Cap company is normally an emerging player in its industry. Such a company has a potential to grow fast and become a leader (a Large Cap) in the future. Mid -cap companies can show very high growth rates (in percentage terms), because they have a small base since their size is small, even a small incremental increase in revenue / profits can be a big figure when expressed in terms of percentage. SMALL CAPS If a company has a market capitalization of less than Rs. 1000 Crores, it is considered as a Small Cap. A Small Cap company is normally a company that is just starting out in its industry, and has moderate to very high growth rate. Such a company has a potential to grow fast and become a Mid Cap in the future. If you invest in the small cap markets expect volatility and failure. It is always risky to invest in these kinds of shares. But this doesnt mean that you should stay off from small caps. Small caps should form part of your portfolio in a limited manner. See the BSE list of Mid caps and small caps : Mid-caps click here Small caps - click here REMEMBER A companys survival is not guaranteed by size; however, it helps to be a fairly large fish if you are going to swim in the big pond. Small companies or small caps are risky investments, but can pay big rewards. You should not have too much exposure to small-caps if you are the risk-averse types. Mid-caps and small caps rise faster than large-caps in bull markets, but also fall as rapidly. Large-cap companies are typically more stable with larger, more diversified revenues and have steady predictable earnings. That is not to say that many a large cap has not melted down. Mid-caps tend to have some of the stability of the large caps but also some of the high-growth prospects of the small caps. Mid caps also have institutional ownership but to a lesser extent than large caps do. You should invest your money in a mix of large-caps, mid-caps and small-caps. Large caps would bring stability(steady growth) over long term, mid caps would bring in the acceleration (fast growth) and small caps would bring the excitement( risky investments, but may pay big rewards) A 60% exposure to large-caps , 30% in mid-caps and 10 % in small caps would be a balanced investment strategy, however, what is the right mix depends on an individuals risk tolerance capacity Investors may note that the total amount to be invested in equities would ideally be 90-your age. The balance should be invested in debt funds Shareholding pattern it tells you a lot. by J Victor on November 8th, 2011
Hi there, Reviewing the shareholding pattern and the change in shareholding pattern could be useful to the investors. It shows how shares of a company are split among the entities that make up its owners. The Shareholding structure is declared every quarter BASIC RULES. As a rule of thumb, higher promoters stake is perceived as positive and a lower equity stake could mean low confidence of promoters in their own company. Rise in promoter stake is considered positive because promoters will commit additional fund only when they are optimistic about future growth of their company. Similarly a higher FIIs stake is considered as positive and a lower FII participation could mean low confidence of FIIs in the company. Rise in FII stake is considered positive as they will commit funds only when they are totally optimistic and confident about the future prospects of the company. Too high or too low of promoters stake or FII holding is not favorable. WHO CAN HOLD SHARES IN A COMPANY? Share Holding can be done by any investor right from a person to a corporation to a FII. When an entity or a person buys a large chunk of share in another company, their intention may be to get control in:- The decision making power of the company Election of the Board of Directors of the company Controlling the management of the company PATTERN. Data regarding the share holding pattern is available in the stock exchanges website, all financial websites as well as in the companys website and annual reports. Share holding pattern of a company generally involves:- Promoters Holding Promoters may include domestic and foreign promoters. Promoters are the entities that floated the company, and to a large extent have seats on the Board of Directors or the management. Persons acting in concert with the Promoters. Relatives of the promoters who hold shares fall under this class and are termed as the promoter group. Holding of the Non-Promoters these include institutional investors like Banks, Financial Institutions, Insurance Companies, Mutual Funds , Foreign Institutional Investors and others like private Corporate bodies, Trusts, Foreign Companies , you and me .. PROMOTERS AND FIIs The two categories of shareholders to watch. While analysing the shareholding pattern of the company, the two important categories to be watched are the promoters stake and the FIIs stake in that company. An increase in promoter stake does not always constitute a sign of confidence. It is also necessary to see whether fresh funds have come in. If fresh fund have been invested, where will they be invested. Answers to these questions would help investors to determine whether jump in promoter stake is beneficial to the company. However, an increase in FIIs stake is a good sign It shows that they are bullish on the stock. At the same time, the flip side of huge FII holding is that the stock price will be subject to huge price volatility when they off load the stake. HOW TO ANALYSE Analysing the holdings of various categories of investors would give you insights into the pattern of control in the company. Heres a collection of tips for you Rise or fall in promoters holding is to be studied by looking at two aspects. First what is purpose of promoters in raising or reducing their equity stakes and second, the methods promoters have adopted to increase or reduce their ownership. If the promoters are increasing their stake to pay off debts and strengthen their balance sheet. This is certainly positive for the shareholders. Companies that have gone for share buy back also see rise in promoters stake. The core objective of a buyback is to create wealth, but it also increases promoters equity stake at no additional cost. A rise in promoters stake due to merges or buyback means little for investors in real terms. Promoters of companies that have opted for rights issue are forced to step in and bail out the unsubscribed portion just in case the rights are undersubscribed. Here, there will be an unintentional rise in promoters stake. Shareholders declining to subscribe to rights issue and promoters chipping to rescue the issue do not qualify to be positive development. A decline in promoter holding should also be analyzed in detail. Decline in promoter holding can be due to various factors such as issuing fresh share towards employee stock option, or it could be due to offloading/issuing of fresh shares to strategic/financial partners. These changes should be carefully studied. Promoters offloading their holdings in the open market are a warning signal. Some dubious companies announce positive development periodically; promoters keep on offloading equity stake at the same time. It is well laid-out trap for investors. If you see promoters increasing their stakes in successive quarters, you know that the financial performance is going to be good and the stock prices would possibly be higher. However, its unusual to see promoters holding increase on a regular basis. They usually step in to buy after a sharp market decline to shore up their holdings. A very high promoter holding is not a good sign. A diversified holding and a good presence of institutional investors indicates that promoters have little room to make and carry out random decisions that benefit them without gauging how it would affect earnings and other shareholders. Very low stake of promoters is perceived as diminishing confidence of promoters. This results in rampant sell off which results in loss for investors. FII holdings in stocks are used as indicators in stock selections; stocks with high FII holdings are largely favored. However, such stocks could take a hit should the FIIs decide to sell their stake. Retail investors may perceive such selling off to be a lack of faith in the stock by the FII. Holding by mutual funds and insurance companies is an indicator on how favored a stock is. Multiple funds holding the stock could be a sign of growth potential. Therefore, such high institutional holding may mean your investment is a tad safer since that company may then be more professionally run. While looking at the shareholding pattern, figures for a single period is also unlikely to tell you much. Compare holding patterns with those of the previous quarters to check how holdings have changed. Along with holding patterns, companies also disclose the entities other than the promoters that hold more than 1 per cent in the share capital. Companies are also required to declare the promoters shares that have been pledged as debt collateral. So next time you analyse a company, dont forget to have a look at the shareholding pattern for the present period and the previous quarter or two. It might just give you a surprise insight about the companys management. Is it possible to predict Markets accurately? by J Victor on December 6th, 2011
If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting whats going to happen to the stock market. Benjamin Graham Hi there, Recently I got a mail from a reader who wants me to predict accurately where the stock market is headed, instead of a broad market analysis. He wants a definite conclusion and a definite direction about what to do. First of all, in my opinion, its not possible to accurately predict Market movements. Making buy or sell decisions by predicting market movements is a strategy called Market timing. Its one of the most controversial topics in stock markets. The viability of the strategy is something thats debated for years now.
There are brokers and analysts who claim that they can predict exact market movements. Ive tested their services once and that was a disaster. Apart from that, there is no first hand experience to write about . But, I know many people who have availed paid services of these so called market forecasters. Nobody so far, has given me a 100% positive feed back. The second point I would like to mention here is that no two investors are alike. Risk bearing capacity, expected returns, investment horizon, investment objectives etc are different for every investor. Whats good for one may not be good for another. So theres no meaning in those calls to buy or to sell a particular stock which is not based on individual preferences. So, now, the first question is then, what do we see in these newspapers and websites about the future of the markets? Well, you have to take those comments in the right context. Chartists and analysts comment on the general trend of the market, they are never stock specific. At best, they may specify certain sectors that may be positively or negatively impacted by the economic events that are going around nationally and internationally. Its up to the investors to do some homework and try to find whether those factors need to be considered in their investment decisions. Secondly, what about those stock specific buy calls or sell calls that appear in newspapers and television channels? What they give out is their opinion based on historic data and future prospects. Whether that particular stock is suitable for you to invest is something you have to evaluate based on your investment objectives. There maybe big investment houses or big investors out there who have systems and experience to predict the market and make a killing. If they have, well, they are not going to disclose that to anyone. Even Mr. Warren buffet has never written a book on how he makes investment decisions. For the common investor, the option is to use publicly known information from their brokers or analysts or try some paid softwares or develop own systems, which yield excess returns. Market report generally combines technical as well as fundamental data. Common investors should have at least basic understanding about these. The Internet is the ultimate library, hosting hours and hours of reading materials in every subject imaginable. And, the subject of investments is no different. Several free resources offer beginners strategies for investing and basic definitions of the terminology used. Its important to prepare yourself by reading these materials before you try to read and understand a market analysis report. HAVE YOU DEFINED YOUR INVESTMENT OBJECTIVES? In one sentence, any investment objective would be In 20xx I need to create an income/wealth of Rs xx xx xx . The objective should be to get optimum returns and not maximum returns. Getting maximum returns would mean that you have to take maximum risk. So the basic objective, in my opinion , should be to optimize return on investment. How? The first step should be to do a SWOT analysis of your self and find out where you stand right now. Strengths would be a list of what you own Gold, property, parental wealth , cash , alternative sources of income, Knowledge, Support, money management skills, facilities and the platform available for investing. Weaknesses would be a list out what you lack Risk tolerance capacity, money management skills, lack of alternative income source, still living in a rented house Opportunities considering the investment capital you have, try to find suitable opportunities. For example if you think you can invest only a small sum, there no point in looking at real estate or solid gold. SIPs or gold ETFs could be a better way to start. Threats Inflation risk, interest rate risk, peer group pressures etc By listing out your strengths and weaknesses, you will be in a position to evaluate yourself first. Once you have done that, those market analysis and investment recommendations may make sense. 3 silly mistakes a beginner should avoid. by J Victor on February 2nd, 2012
Hi there, After interacting with some beginners, I found 3 very silly mistakes thats so common. So, i thought i should write about that in this article, with the help of an example. You buy shares in company x of IT sector. The shares move up and you get a decent profit. From that moment, you are tempted to look more deals like that., preferably from the IT sector- since you get a feeling the IT sector is a sure bet ! Not only that, in the process of trying to find such deals, you tend to overlook other investment opportunities that come your way a new mutual fund offer or a low rate in gold ETF or an opportunity to lock in a debt fund thats available at a higher rate of interest. This is the first point as long as your investment remains in a few stocks or markets, you may be missing on other opportunities. Its important to have an overall view of the economy and financial markets regularly- and not just stock market alone.Beginners tend to concentrate on stocks alone and in the process, they forget to take note of whats going around in the financial world. For example in 2010-11, it was gold that out performed all other asset classes. Those who had an overall knowledge about financial markets would have invested a part of their funds in gold. Continuing the above example let us assume that the buy price of that IT stock was Rs 150 and you sold it for Rs 225 in one month, thereby making a gross profit of Rs 75 per share. You made a killing on that stock. Every time that stock drops to Rs 150, even if its a year or two later, youll be tempted to buy that stock based on the previous experience. That Rs 150 remains in your memory as a sweet spot to buy. You tend to forget the fact that financial fundamentals of the company might have changed by then. So, thats my second point financial fundamentals of a company keep changing. Thats the reason why result announcements create such hype in the stock markets. Its important to keep track of the fundamentals of the company every quarter. Do not buy a share just because it came back to the previous levels. This time, may be, theres some problem with the fundamentals. Lets continue our story after valuating some IT companies including the stock you previously owned, you have now short listed 2 companies one trades at Rs 200 and the other trades at Rs 600. A common belief of beginners is that Rs 200 stock is 3 times cheaper than a Rs 600 stock. Thats wrong. For example, the company that trades at Rs 200 may have 6 million shares while the other one that trades at Rs 600 may have only 2 million shares. So the market capitalization of the two companies is the same. So the solution to this is in finding out the P/E of the stocks. The price of the stock is divided by the earnings per share and that tells you which company is more expensive. A stock that has a P/E of 20 is definitely priced lower than a stock that has a P/E of say, 65. That brings us to our 3 rd point price per share is not the criteria to decide whether a stock is cheap or expensive. You need the P/E of the stocks. From my interaction with freshers, these are 3 of the most common mistakes that they commit. Choosing a Broker and opening Demat Accounts What are Demat accounts? by J Victor on May 8th, 2011
WHAT IS A DEMAT ACCOUNT? Demat refers to a dematerialized account. Demat is very similar to your savings bank account. You have to open an account with a bank if you want to save your money, make cheque payments etc. Similarly, you open a demat account if you want to buy or sell stocks. So it is just like a bank account where actual money is replaced by shares. A dematerialised account holds shares in electronic form, saving you the bother of holding shares in paper form. Possessing a demat account is now a prerequisite for stock market investments. so, while your bank account keeps your money safe and transfers it from account to account according to your instructions without bothering you , your demat account keeps your shares safe and transfers it to the next owner when you sell it. WHO PROVIDES THE SERVICE? Demat services are provided by banks, financial institutions and stock broking houses. The broking houses in such cases also act as DPs (depository participants) intermediating between the depositories CDSL or NSDL and the investor. To open a demat account, you have to make an application to a DP and submit required documents. Once you have a demat account to your name, you can open a trading account with a broker of your choice. The shares bought and sold by you will be reflected in your demat account. Any previously held physical share can also be dematerialised and transferred to the account.The DP, at regular intervals, would provide you with an account statement showing the balance of shares in your demat account and transactions during a period. In short, to start trading in shares you have to open two accounts- 1. A trading account -with the broker and 2.A de-mat account Either you choose a bank/financial institution or a stock broker who could provide you the DP services. CHARGES The fees charged for DP services differ across the industry. Though the rates change, the charges normally go under the following heads: 1.Account opening fee 2.Annual maintenance fee 3.Transaction fee Besides the above, depository participants also charge service tax as applicable. DOCUMENTS REQUIRED For opening a demat account one needs to provide a set of documents to the agent. They are: 1.Duly completed account opening form and passport size photos; 2.A copy of PAN card as proof of identity; 3.Personalised cheque/Copy of the bank passbook 4.A copy of passport/voter ID/ ration card as a proof of address 5.Signing of the DP-investor agreement. On giving the above papers, the agent would complete the other formalities with the depository and facilitate opening of the account. You would then be given a unique account number (BO ID- Beneficiary Owner Identity), which would serve as a reference number for all further transactions. A set of delivery instruction (DI) slips will be give to you from the DP. This is almost similar to he cheque book you get when you open your bank account. A DI slip has to be filled and sent to the DP on every delivery (sale of shares) you make. DI slip is an instruction to the DP to debit your account and credit the brokers account with the specific stock. Take note that the DI instruction has to reach the DP the very next day after the sale, failing which the securities wont reach the broker and hence the exchange. This could result in auction of the security. When you open a demat account with your stockbroker, you also sign and deliver a standing instruction for delivery of stocks that you sell.Hence, the broker handles the delivery system and you need not worry about all this. CONCLUSION With that, we end our discussion about De-mat accounts.More about the topic in our next lesson. What is a trading account? by J Victor on May 9th, 2011
As said in the previous lesson, Your Demat account is merely an account which keeps track of which shares or equities you have bought and you currently hold in your portfolio. So there is not much to do as far as operating demat account is concerned. TRADING ACCOUNT Some of the beginners do not understand relationship between Share Trading account and Demat Account. This short lesson will explain the relationship between Demat account, trading Account and your Bank Account. We will also see how many trading or Demat account you can have in total. Trading account is an interface between your Bank account and your Demat account. To buy shares, the first step is to transfer money from your bank account to trading account. For example , if you want to buy 100 shares at Rs 50 , you have to transfer Rs 5000 from your bank account to the trading account. The shares that you buy will be stored in the demat account. When you sell, your trading account takes back the shares from your Demat account and Sells them in Stock Market and get back the money. If you want your money back into your bank account, you have to give a request online to the broker to transfer it to Bank account. The money gets credited in your bank account in 2 or 3 working days. Just as every person is allowed to open as many savings account as he likes, there are no restrictions of the number of Demat Accounts a person can have. You can have any number of demat accounts. SELECTING A DEMAT AND TRADING ACCOUNT The key criteria for selecting these accounts are: 1. Your purpose/usage. In short, how frequently are you going to buy/sell and is it intraday or delivery based. You may have to choose the Broker whose charges are lowest according to your transaction style. 2. Look at a complete solution and not just one individual product like a demat account. After all, the money in the savings account will be linked to your trading account for buying/selling shares and the trading account will be linked to your demat account for storing the shares. Suppose you have a Savings account with Bank A, and the trading account with Broker B and Broker B trading account does not have a partnering arrangement with Bank A, you will be forced to open a new savings account with a bank which has partnering arrangement with broker B. Usually, most non-bank brokerages have tie-ups with the popular banks for savings bank accounts and demat accounts, but brokerages in a banking group company may have only the same bank as its partner. 3. Think long term. In case you have got yourself a demat account and you have existing shares in it and you want to move to another demat account, transfer of shares is chargeable. Brokers may charge based on number of shares or amount worth or anything. Please find out what this amount is, in case you are ever tired of bad service and you want to change the demat account. These transfer rates are never mentioned anywhere. 4. Technology. Some online stock brokers do a great job in making sure that their clients can always access their accounts, and in turn buy and sell as quickly as possible. But on the other side of things, not all brokers run this smoothly. Due to excess demands on the system, some brokers have a slower load time than others. In fact, this can lead to the server becoming bogged down. This is not common as it once was, but still this can happen. 5. Service. With the demand increasing on discount stock brokers, it is common for errors to occur from time to time. Hopefully this never happens to you, but you never know what the future holds. If you notice a mistake on your account, it is important that you contact the customer support team right away. This will help to ensure that you get the issue worked out before it causes a snowball effect on your account. In most cases, the broker you are working with will be apologetic for the mistake, and will do whatever it takes to get the issue resolved within a matter of minutes. Also, Gauge the level of personal service that a stockbroker provides as a final step in the selection process. Every investor should be assigned a specific broker or representative to contact at any time. CONCLUSION Hope you are now clear about demat and trading accounts and about how to choose an account.Shopping around for your broker is a good idea. Who is a stock broker? by J Victor on May 10th, 2011
STOCK BROKER -EXPLAINED A stockbroker is an individual / organization who are specially given license to participate in the securities market on behalf of clients. The stockbroker has the role of an agent. When the Stockbroker acts as agent for the buyers and sellers of securities, a commission is charged for this service. As an agent the stock broker is merely performing a service for the investor. This means that the broker will buy for the buyer and sell for the seller, each time making sure that the best price is obtained for the client. An investor should regard the stockbroker as one who provides valuable service and information to assist in making the correct investment decision. They are adequately qualified to provide answers to a number of questions that the investor might need answers to and to assist in participating in the regional market. Are they governed by any Rules and Regulations? Of course, yes. Stock brokers are governed by SEBI Act, 1992, Securities Contracts (Regulation) Act, 1956, Securities and Exchange Board of India [SEBI (Stock brokers and Sub brokers) Rules and Regulations, 1992], Rules, Regulations and Bye laws of stock exchange of which he is a member as well as various directives of SEBI and stock exchange issued from time to time. Every stock broker is required to be a member of a stock exchange as well as registered with SEBI. Examine the SEBI registration number and other relevant details can be found out from the registration certificate issued by SEBI. How do I know whether a broker is registered or not? Every broker displays registration details on their website and on all the official documents. You can confirm the registration details on SEBI website. The SEBI website provides the details of all registered brokers. A brokers registration number begins with the letters INB and that of a sub broker with the letters INS. What are the documents to be signed with stock broker? Before start of trading with a stock broker, you are required to furnish your details such as name, address, proof of address, etc. and execute a broker client agreement. You are also entitled to a document called Risk Disclosure Document, which would give you a fair idea about the risks associated with securities market. You need to go through all these documents carefully. SUB BROKERS According to the BSE website Sub-broker means any person not being a member of a Stock Exchange who acts on behalf of a member-broker as an agent or otherwise for assisting the investors in buying, selling or dealing in securities through such member-brokers. All Sub-brokers are required to obtain a Certificate of Registration from SEBI without which they are not permitted to deal in securities. SEBI has directed that no broker shall deal with a person who is acting as a sub-broker unless he is registered with SEBI and it shall be the responsibility of the member-broker to ensure that his clients are not acting in the capacity of a sub-broker unless they are registered with SEBI as a sub-broker. It is mandatory for member-brokers to enter into an agreement with all the sub-brokers. The agreement lays down the rights and responsibilities of member-brokers as well as sub-brokers. STOCK BROKERS IN INDIA. There are a number of broking houses all over India. Many of them have International presence too. Following are some of the leading Stock Broking firms in India. IndiaInfoline ICICIdirect Share khan India bulls Geojit Securities HDFC Reliance Money Religare Angel Broking Investors have to check the brokers terms and conditions and decide about opening a trading account. Only Govt. tax rates like, security transaction tax, stamp duty and service tax are uniform other charges like brokerage for delivery trades, intraday trades, minimum transaction charge, statement charges, DP charges, annual maintenance charges etc., may vary from one broker to another. How to choose a Stock broker? by J Victor on May 11th, 2011
hi there, In this post, i would like to talk about some tips on choosing a broker. Stock Brokers are registered members of stock exchange. Nobody except the stock brokers can directly buy and sell shares in Stock Market. An investor must contact a stock broker to trade stocks.For availing the service, the broker charges a fee called brokerage. It is generally a percentage of the value traded. India has two big stock exchanges (Bombay Stock Exchange BSE and National Stock Exchange NSE) and few small exchanges like the Cochin Stock exchange. Investor can trade stocks in any of the stock exchange in India . The best and practical way to choose a broker is to get referrals. You can find out from other people about the broker they use and why they have selected them, it is better to choose someone whom you have heard good things about. Here are a few more tips from my experience:- THE BIGGEST MAY NOT BE THE RIGHT ONE. Some brokers are more geared for frequent traders and professionals. There are others that are geared more for beginners. For most novice investors, it is much better to go with beginner- friendly brokers. High professional stock brokers will have a long list of high flying investors. While theyll be busy attending their high profile investors, you a may not get the personal attention and advice that a newbie needs. BROKERAGE Most of them, Ive seen, select a broker who offers to charge fewer commissions on trade. But, thats not the criteria by which you select a broker. A broker should understand your preferences, your likes, your dislikes, your favored asset classes, your risk profile and they should be capable of giving you personalized tips based on that information. A stockbroker has to work with your goals in mind. Now, this doesnt mean that you should totally ignore the commission part. You should definitely negotiate. Commissions charged should be reasonable. DOES YOUR BROKER COMPEL YOU TO BUY STOCKS? Stockbrokers are service providers. They are in business to make you wealthy. Some stockbrokers feel that their business is to buy and sell stocks. For them, money making is just incidental. Whatever a stockbroker says to you, always remember you are the client. It is your money and you make the final decisions. If you feel uncomfortable about any investment proposition, tell your broker and they will respect your decision. If they go ahead and go against you, or compel you to buy shares of their choice, then you definitely have the wrong stockbroker. TEST YOUR BROKERS KNOWLEDGE Ask market tips to any broker and hell immediately give a list of 5 or 6 hot stocks. Whenever you get such tips ask yourself Why is this tip worthy of my hard earned money? A good stockbroker will make decisions based on your profile and then choose a stock. They should be able to explain to you in simple terms why they think that stock is a good choice for you. A broker will have to explain what the fundamentals are, about its market capitalization and PE, about its valuation and future prospects, about the degree of risk and the profit potential. The brokers product knowledge is critical. If they cannot explain their actions, drop them. BE WITH THE KING ! Check if the broker has any specialty or is a jack-of-all-trades. If a broker has special focus and strength and this agrees with your investment goals and aspiration, you will gain more working with him. RESEARCH REPORTS Some broking houses publish excellent research reports exclusively for its members.Ask your prospective broker to give copies of earlier research reports and see if the opinions expressed in those reports have some degree of accuracy. These research reports are useful guides to get useful insights. SERVICE Be sure to get opinion from investors about the quality of service that the broker provides. thats some tips from my side.. The Brokers role in investing. by J Victor on May 19th, 2011
Hi there, What should be the brokers role in your investing decisions? It would be better if you can limit your brokers role to executing your orders .This is not to undermine their importance. But, i feel thats where it should end. Because, your broker makes money through brokerage targets achieved through securities transactions. He does not make any money from setting up a long-term financial plan for you. Since a fee is charged whenever you buy or sell,the more you keep buying and selling the more he makes money. Knowingly or otherwise, the broker/relationship managers will be more interested in generating the target brokerage. This is the reality. Your broker may NOT be required to act in your best interest and you may be receiving dangerous advice that could cost you a fortune. Why? Because, brokers dont have fiduciary responsibility. Most people using stock recommendations from brokers expect the broker to recommend appropriate investments so that it improves their portfolios performance. Underlying these expectations is the understanding that they will act in the best interest. The legal term for acting in your best interest is called fiduciary responsibility. For instance, if you set up a trust for your child and name a trustee to oversee that trust, the trustee has a fiduciary responsibility to act in your childs best interest. If they dont, they can be taken to court and be held liable for their actions. A common misconception among investors is that their stockbroker has this fiduciary responsibility. They dont. Thats why following their advice can be dangerous. Want more proof? read the fine prints. How did you start your de-mat account? You just placed 32 odd signatures on that 60 page booklet. Isnt it? Did you read that whole thing? Most probably- No. If you go through those paragraphs, you will realise that You are solely responsible for all investment decisions and trades even if you have accepted the brokers call. Who gives you market tips? Your broker or analyst? Heres the reality- Most of the time, the guy who gives you market tips is the employer of the broker. They are given general market tips every morning by the main broker which they blindly tell to all their customers- without considering the risk tolerance capacity, age, equity or profile of the customer. Thats the exact reason why there are more losers in the market. This is not to say that researches done by brokers are not good, but those are general advices. Understand the difference between a broker and an analyst. At this point, it is also very important to understand the difference in role between a broker and a stock market analyst. An analyst literally analyzes the stock market, and predicts what it will or will not do, or how specific stocks will perform. A stock broker is only there to follow your instructions to either buy or sell stock and not to analyze stocks. Brokers target is to earn their money from commissions on sales. So when brokers themselves double up as investment advisors there is some danger in it. CONCLUSION Being with the right broker is critical. It can mean making money for yourself with your trades, or end up you making money for the broker. Ideally, brokerage should assume importance only when they threaten to eat up a significant chunk of your profits. This would be a problem more relevant to day traders than the long-term investors, who, in comparison, might trade occasionally. High-volume traders can consider negotiating their commissions with brokers. Alternately, such traders can also consider flat fee broking products, which charge fixed brokerage for a specified period, irrespective of the frequency or value of transactions. This ensures a limited trading cost even as traders enjoy the brokers services and advice. A good investor should be more concerned about the quality of tips and advices he takes, rather than negotiating on brokerages. So, If you are seeking advice on balancing your portfolio, then you need to look for an investment advisor (sometimes called a financial planner), who will charge a fee for drawing up a total financial plan for you. The financial planner may work out a strategy to manage your securities holdings in harmony with your total financial plan. Investment advisors- An introduction. by J Victor on May 20th, 2011
Hi there, As an investment professional, I can confirm that most members of the public have roughly zero investment skill. This is not meant to be derogatory, just realistic. However, most members of the public also seem to think that investment is or should be easy and as a skill has very little value added. If only it were so. The reality is that most people have limited financial skills because these things take effort, study and thought. In our time away from an occupation, we want to relax, not analyse annual reports. But to be successful, we need to see a lot of annual reports before we find the one we really like. This is a real chore. The ability to trade online through laptops and mobile phones has made share market even more available to investors and it has definitely expanded the number of trades being made, which brokers and stock exchanges around the world must be grateful for; but all of these facilities has not made us better investors. As long as the investor does not have the required skills to flourish, he needs an investment advisor that offers research and guidance. Should an investor with very limited funds be investing in the markets? If yes, what should his approach be? What should be the approach of an investor who has a huge chunk of money to invest? Should he hedge his investments in the derivatives market? If an investment is made that proves to be shockingly poor, and loses eighty or ninety percent of the money invested, it was a bad deal , right? If an advisor had pointed out just how risky the deal was, might the investment funds have been saved? Would that have been money better spent than saved? If an extra thirty or fifty rupees spent on advice from an investment advisor could have saved one thousand, might that not be an acceptable price to pay? The above thoughts clearly bring into focus the need of an investment advisor. More about investment advisors and portfolio management in our next lesson. What is a portfolio? Whats portfolio management? by J Victor on May 21st, 2011
PORTFOLIO Simply put- If you own more than one asset as investment, you have an investment portfolio.For example you may have 30% of your wealth invested in equities, 30% in debt funds, 20% in gold and the balance in cash- thats a portfolio of investments. In the context of shares, you have a portfolio of shares, when you own and manage a group of different shares.for example if you own stocks of Infosys , HLL , Cipla, Tata motors and DLF what you have is a portfolio of equity investments in diversified sectors. All investments carry risk. You cannot put all your money in one asset class . For example , you have 1 million with you and you decide to put the whole money into equities. What would be your fate if the stock crashes? or if you have invested in fixed income deposits that gives you 8% interest for a long term . The average inflation rate stays at 8% . Do you think youve made a penny ? So, putting all your money in one basket in not a good idea because it exposes you to great risks. The solution to reduce risk is to do the opposite- put all your money in different baskets- so that even if one fails , you get a return from other which may compensate the loss in other. The more you diversify, the less risky your portfolio becomes. This is one of the basic principles in investments. So, the main characteristic of a serious investment portfolio is diversity. It should show a spread of investments to minimize risk. WHO IS A PORTFOLIO MANAGER? A portfolio manager is that person who, with his skill and expertise, looks after your investments and manages them for you. PMs (Portfolio managers) make decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Are they known by any other names? Yes. They are also called money managers, investment advisors, financial advisors, financial consultants, investment consultants, financial planers etc.. after all, whats in a name? What matters is what something is, not what it is called. However, there are two types of portfolio managers- discretionary PM and non-discretionary PM. Whats the difference? The discretionary PM individually and independently manages the funds of each client in accordance with the needs of the client. So they make the buy-sell decisions without referring to the account owner (client) for every transaction. The manager, however, must operate within the agreed upon limits to achieve the clients stated investment objectives. Non discretionary PM manages the fund in accordance with the directions of the client. Is there an agreement between you and PM? Yes. The portfolio manager, before taking up an assignment of management of funds on behalf of the client, enters into an agreement in writing with the client clearly defining the relationship and setting out their mutual rights, obligations and liabilities relating to the management of funds containing details as specified in schedule IV of the SEBI (portfolio managers) Regulations, 1993. IS THERE A MINIMUM INVESTMENT? Yes. The PM is required to accept fund or securities having a minimum worth of 5 lakhs rupees from the client while opening the account for the purpose of rendering portfolio management services to the client. How much can a PM charge from you? The SEBI (portfolio managers) regulations, 1993, have not prescribed any scale of fee to be charged by the portfolio manager to his clients. However, the regulations provide that they can charge a fee as per the agreement wit the client for rendering their services. The fee so charged may be a fixed amount or a return based fee or a combination of both. The PM shall take specific permission from the client for charging such fees. Can a PM invest in derivatives (futures and options) for his client? Yes. However, leveraging of portfolio is not permitted in respect of investment in derivatives. The total exposure of the clients portfolio derivatives should not exceed his portfolio funds placed with the PM. What are the disclosure requirements of PM to their clients? The PM provides to the client the disclosure document at least 2 days prior to entering into an agreement with the client. The disclosure document contains the quantum and manner of payment of fees payable by the client for each activity for which service is rendered by the PM directly or indirectly, portfolio risks, complete disclosures in respect of transactions with related parties as per the standards issued by the ICAI in this regard, the performance of the PM and the audited financial statements for the last 3 years. Is premature withdrawal of Funds/securities by an investor allowed? The funds or securities can be withdrawn or taken back by the client before the maturity of the contract. However, the terms of the premature withdrawal would be as per the agreement between the client and the portfolio manager. Can a Portfolio Manager impose a lock-in on the investor? Portfolio managers cannot impose a lock-in on the investment of their clients. However, a portfolio manager can charge exit fees from the client for early exit, as laid down in the agreement. CAN A PM OFFER GUARANTEED RETURNS? Portfolio manager cannot offer/ promise indicative or guaranteed returns to clients. Where can an investor look out for information on portfolio managers? Investors can log on to the website of SEBI www.sebi.gov.in for information on SEBI regulations and circulars pertaining to portfolio managers. Addresses of the registered portfolio managers are also available on the website. How can the investors redress their complaints? Investors would find in the Disclosure Document the name, address and telephone number of the investor relation officer of the portfolio manager who attends to the investor queries and complaints. The grievance redressal and dispute mechanism is also mentioned in the Disclosure Document. Investors can approach SEBI for redressal of their complaints. On receipt of complaints, SEBI takes up the matter with the concerned portfolio manager and follows up with them. Investors may send their complaints to: Office of Investor Assistance and Education, Securities and Exchange Board of India, SEBI Bhavan Plot No. C4-A, G Block, Bandra-Kurla Complex, Bandra (E), Mumbai 400 05 That completes portfolio and portfolio managers. Our next lesson will detail about the qualities that you should look for in a PM and how to go about selecting a PM. How to select a Portfolio Manager? by J Victor on May 27th, 2011
Hi there, As said in the previous lesson,The portfolio manager manages the portfolio on behalf of the client by investing the money in shares and other securities. You can invest fresh money in Portfolio Management Scheme and the portfolio manager will build a portfolio by deploying that money. Also you can transfer your existing share portfolio to the Portfolio Management Scheme provider. In that case, the portfolio manager will revamp your share portfolio in sync with his investment philosophy and strategy. Once the Portfolio Management Scheme account is opened, you will be provided with an online access to your portfolio. You can look at where the portfolio manager is investing your money. Also you will be able to generate reports like Portfolio Transaction List, Investment Summary, Performance Analysis, Portfolio Statement and Quarterly capital gain report. As a result, Portfolio Management Scheme relieves you as an investor from all the administrative hassles of investments. Portfolio Management Scheme Vs Direct Stock Market investment: You can directly invest in stock market. Then what is the benefit of investing in the stock market through a Portfolio Management Scheme. Investing in share market demands time, knowledge, right mindset, and continuous periodical monitoring. It is really difficult for an individual investor to meet all these demands. But a Portfolio Management Scheme meets these demands at ease. The Portfolio Management Scheme will be managed by a professional expert. It saves a lot of time and effort of the individual investors like you. Hence it is advisable to outsource the stock market investment to a sound Portfolio Management Scheme operator instead of managing it on your own. Guidelines in choosing the right PM There are all kinds of money managers: good, bad, mediocre, and cheats. Clearly, its not worth paying for anything less than the best manager you can find. Look for PMs that are truly unbiased and independent. Advisory companies that have asset management companies as stakeholders may be biased towards their products. Choose an advisory company that offers a holistic approach to investments. There are companies that require their advisors to understand the clients needs through financial planning before recommending solutions. Regular communication in the form of newsletters, portfolio updates, investment alerts, etc, is a must and this indicates that the company hasnt forgotten you after youve given it business. Look for a company whose representatives are ready to explain product benefits in a jargon-free language, and help you decide what is best for you. Above all, do cross check to ensure that the company you choose to put your trust in has a clean record. The company should be established and should have a good reputation in the market. Disadvantages: The most obvious disadvantage of portfolio management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. The fees associated with portfolio management are also high. Its generally a percentage of the annual value of investments. Those who are considering investing in portfolio managers should evaluate carefully. Data from recent decades demonstrates that the majority of portfolio managers failed to perform to expectations. CONCLUSION Trusting a portfolio management advisor is difficult and risky . There are many known cases of churning, where the consultant shifts investment from one fund to another. Some investors restrict this practice by limiting the commission to the consultant depending on his performance; however, if there is a loss, it wouldnt matter much to them. How much should you pay for the right portfolio manager? by J Victor on May 28th, 2011
Hi there, The rationale for entrusting ones wealth and savings to a fund manager is simple - Majority of us have zero investment skills. The only safe investment that we all know is fixed deposits. so we nee someone who can create wealth for us- a professional- whos knows the investment game well. Now, lets assume that youve found one. Now, how much should you pay for the right fund manager? Are there any regulations for it? How can you make sure that he would perform? Imagine an electrician not doing the work for which he is paid and also causing damage to your electrical equipment.How would you feel? Here are some guidelines- Portfolio managers have been asked by SEBI that profits of their schemes be computed only on the high water-mark principle. This means the portfolio managers can only charge fee (or share profit) based on the highest value that the portfolio has reached over the life of the investment. For example, if a portfolio of Rs 10 lakh appreciates to Rs 12 lakh in the first year, a performance fee or profit sharing will be payable on Rs 2 lakh. In the next year if the portfolio value falls to Rs 11 lakh, no performance fee will accrue. If the portfolio value goes up to Rs 13 lakh in the third year, the fee can be charged only on Rs 1 lakh (Rs 13 lakh-Rs 12 lakh). For the fourth year, the high water-mark will become Rs 13 lakh. The regulator has thus ensured that portfolio managers do not charge for loss recovery. However, the high water-mark principle will apply only to discretionary and non-discretionary services and not for advisory services. The market regulator has also prescribed a standardized format of declaring fees and charge. Providers of portfolio management services are now expected to provide details of fees and charges under three scenarios 20 per cent profit, no profit/no loss and 20 per cent loss to all clients. This format enables a client to compute the indicative gain or loss on the funds he would be investing for a year. ASSOCIATED COSTS Annual management fees and profit sharing: PMS typically works on a 20/2 thumb rule. You pay 2 per cent annual management fees, on top of which you share 20 per cent of profits you make beyond a Hurdle Rate. The Hurdle rate is defined at the outset of your agreement terms and till such time this return is obtained by you, you dont have to share any profit with the service provider. Until then, you share profits on the basis of Watermark concept mentioned above. Brokerage Apart from these, you also incur the cost of brokerage for each transaction. Brokerage can vary from 0.25 per cent to 0.50 per cent of transaction value. Many PMS also take an upfront fee, which is typically about 2 per cent. Evaluate cost very carefully. Get a clear understanding of how often stocks will be churned in your portfolio as a high level of churn will mean significant cost on brokerage. This will reduce your overall returns. PMS providers have to mandatorily give at least a six-monthly statement but many of them report more frequently. Its better to get regular updates so that you can track your returns and take corrective actions if required. Some portfolio managers also provide online access to your portfolio. Exit clause And finally, look at the exit clauses. PMS may charge a fee if you exit a plan before a certain time period. This will be an important consideration if you think you may need the money in case of exigencies. PMS BY STOCK BROKING FIRMS Some of the leading brokerage firms in India are also offering PMS to clients without any lock in terms and conditions. They charge an annual fund management fee, payable quarterly . There is also a minimum investment of 5 or 10 lakhs depending on the brokers terms and conditions. Investing in Indian stock markets- A guide for NRIs by J Victor on May 29th, 2011
For most NRIs the difficult part about knowing how to go about investing in Indian stock markets is-finding one place where they can get all the required information. Theres isnt much complicated process involved in opening a share investment account in India. There are only 3 steps involved:- Step 1 : Get your PAN Card Step 2 : Open an NRE/NRO account. Step 3 : Open demat/trading account. Step 1: Pan Card PAN stands for Permanent Account Number and it is just an identification number like your Social Security Number in the United States or Social Insurance Number in Canada. The PAN card will have your photograph, date of birth and signature on it.PAN is mandatory for everyone who wishes to invest in Indian stock market. Step 2: NRE/NRO Account. NRE stands for Non Resident External Account and NRO stands for Non Resident Ordinary account. How to decide whether you need NRE or NRO account? Here are some pointers: Decide whether you want to repatriate (take back your profits/principal from share markets) to your country. If you want to take back the amount then, you should open NRE (Non Resident External) Account and if you do not want to repatriate, open NRO (Non Resident Ordinary) Account. Please remember that as an NRI you cant operate normal resident savings bank account i.e. all existing resident bank accounts should be converted to NRO accounts once a person becomes NRI. NRO accounts are generally opened by the NRIs to deposit previous or existing income earned in India in Rupees. So, if you have money flowing in from abroad alone, what you need is an NRE account. But, if you have some source of income in India too, you need to open an NRO account. Step 3- Open Demat/trading account. Final step would be to open a demat account- an account to maintain your online purchase and sale of shares. Demat and trading account can be opened with any registered broker. Thats it. Once your trading and demat accounts are open, you can invest in Indian share markets. The entire process of transferring funds and buying/ selling can be done online . General documents required to open a share investment account: Self attested Copy of Passport & Visa Self attested Copy of Indian Address proof & Overseas Address proof. Self attested Copy of Pan Card Passport size photos. Bank statement for 3 months A cancelled cheque and a cheque for initial investment. Other important informations: It is always better for an NRI to operate through a power of attorney holder in India. There are many investors who do this and its also a lot easier and faster. NRIs can invest in the Indian stock market under PIS (Portfolio Investment Scheme) which is regulated by RBI. Port folio Investment scheme is a Scheme is regulated by Reserve Bank of India (RBI). RBI monitors the investments made by non-residents so that it can keep a tab on money flowing into India from outside the country. NRIs are not allowed to trade in the stock market on day to day basis. i.e., you cannot buy and sell on the same day (Day trades or intra day trades as its usually called). Day trades are akin to speculation. NRIs are not allowed to speculate on a day-to-day basis in the markets. You can nominate only one bank account for your stock trading. NRIs can participate in the F & O segment (except currency derivatives) out of INR funds held in India on non-repatriable basis (NRO) subject to the limits prescribed by SEBI. An NRI, who wishes to trade on the F&O segment of the exchange, is required to apply for a custodial participant (CP) code. Thereafter he can open a trading account and start trading in derivatives. Position limits for NRIs shall be same as the client level position limits specified by SEBI from time to time.. Individually any NRI or a PIO cannot invest more than 5% stake in any Indian company. NRE bank account- explained NRE means Non Resident External rupee bank accounts. Balances held in NRE accounts can be repatriated abroad freely. This account is used for depositing money from abroad. An NRE account keeps the money in Indian Rupee. NRE account will let you convert your original foreign currency investment into Indian Rupees for investment in India and then convert it back to the foreign currency. These accounts cannot be held jointly with residents. But, Joint operation with other NRIs is permitted. A Power of attorney can be granted to residents for operation of accounts. Money once deposited in this account can only be withdrawn for local payments including investments. Interest on deposits in an NRE accounts is tax free in India. The balance lying on the account does not attract wealth tax. Any gifts given from the money lying in this account does not attract gift tax. Once you have the NRE account, you can invest funds to share market. Those who already have NRE bank accounts should check with their bankers to find out whether those are suitable for stock investments. Not all NRE/NRO bank accounts are suitable for investments. Investors should make sure you read all the fine prints regarding charges applicable. NRI vs PIO A Non-resident Indian (NRI) is a person who is a citizen of India or a person of Indian origin, currently residing outside India. To qualify for NRI status you must: (1) Reside outside India for more than 182 days per year, and; (2) Hold Indian citizenship, or; (3) Be a Person of Indian Origin (PIO) as defined in the Foreign Exchange Management Deposit Regulations of 2000 Condition no.1 is mandatory and condition 2 OR 3 should be satisfied A PIO (Person of Indian Origin) means a citizen of any country other than Bangladesh or Pakistan, if- 1. He at any time held Indian passport or 2. He or either of his parents or any of his grand- parents was a citizen of India or 3. The person is a spouse of an Indian citizen or a person referred to in 1 or 2 above. Conclusion Indias economy is sizzling and is one of the fastest growing in the world. Its definitely a financial mistake if you dont invest a part of your hard earned money in India. Going Online by J Victor on June 2nd, 2011
GOING ONLINE Traditionally stock trading was done through stock brokers, personally or through telephones. Busy phone lines, miss communication resulting in confusion and sometimes loss to the investors created lot of practical problems in trading. Information technology has helped stock brokers in solving these problems with Online Stock Trading. Online stock trading sites offer investors access to a variety of tools and research that just a few years ago were only available through full service brokerage accounts. Online stock trading is done through terminal installed in your personal computer. This online terminal is provided by the brokerage house .so, you can trade in shares from the comfort of your home.
A good online stock terminal would offer you the following : Fast trade execution with instant trade confirmation. Live streaming quotes and price watch on any number of stocks. Intra day charts, updated live, tick-by-tick. Live margin, position, marked to market profit & loss report. Set any number of price alerts on any number of scrips. Flexibility to customize screen layout and setting. Facility to customize any number of portfolios & watch lists. Facility to cancel all pending orders at one click. Facility to square off all transactions at one click. Top Gainers, Top Losers, Most Active, updated live. Index information; index chart, index stock information live. Market depth, i.e. Best 5 bids and offers, updated live for all stocks. Online access to both accounts and DP to check live updated Order and Trade Book. Facility to place after market orders. Online fund transfer facility from your Bank account. Online intra-day technical calls. Historical charts and technical analysis tools THINGS TO DO BEFORE OPENING A TRADING ACCOUNT Ask for Demo:Contact the broker who provide online trading service and ask him to give you a demo of product. Check if the broker trades in multiple stock exchanges. Usually most of the Online Trading Websites trade in NSE and BSE in India. Check the integration of Brokerage account, Demat account and Bank account. Compare brokerages with other peer companies. Standard document required to open an Online Trading Account 1. Proof of residence (Address proof-any one from the list) o Driving license o Voters ID o Passport o Photo credit card o Photo ration card o Utility Bill (Telephone, Electricity etc) o Bank Statement 2. Proof of identity(any one from the list ) o Driving license o Voters ID o Passport o Photo ration card o PAN Card 3. Two photographs 4. Bank statement and two cheques-one cancelled and the other for making initial investment. ADVANTAGES OF ONLINE TRADING Typically online trading requires the investors to pay lower brokerage. In case of online trading there is no middle man involved. In case of online trading there is no paper work involved. Trading on a real time. Investors can deal with different stock exchanges with single online trading account. Mutual funds and IPOs can be bought and sold on line. Understanding the online trading software by J Victor on June 2nd, 2011
Online trading is nothing but trading via the Internet with the help of trading software provided by the broker. The trading platform may be a source of great confusion to them. It is important that you get a firm grip on the trading platform since it provides all the necessary tools to do technical analysis. You can also transfer funds online from your bank account to your share trading account with the click of a button. The advantages of using online trading are: Fully automated trading process which is broker independent. Access to advanced trading tools to perform technical analysis Investors have direct control over their trading portfolio. Ability to trade multiple markets and/or products (you can trade in BSE/NSE) Real-time market data. Faster trade execution ( very crucial if you are a trader ) Easy to operate and manage account No geographical limits.(whether you stay in New Zealand or Dubai you can invest in Indian share market through online trading platforms) Our discussion is primarily based on the general features provided by a good online trading platform. Its important that you check the quality and speed of the trading software provided to you by the broker. LOGIN ID AND PASSWORD: Your online trading platform should be protected by a login id given to you by the broker and a password of your choice. Password should be changed frequently. Some software prompts you to change your password every 15 days. Further, the facility to lock the trading software to one computer would be an additional security measure. With this facility, you will be able to login only from one particular personal computer. THE MARKET SCREEN: For a beginner, the market screen might look like a jungle of numbers. Its nothing to be confused about. Market screen is the most important window that will help you get your trading done. This window gives a tabular representation of the current market position for selected shares. Each share makes up a row of data that contains the scrip name, its last traded price, last traded quantity, best bid rate, best offer rate, total volume etc. Market Watch window is highly configurable and you can decide which columns are to be viewed and which not, whether you require row or column separators, determine the size of all rows or each column, the color used to display data etc. There are a host of options available on a pop-up menu that can be accessed by right clicking on the Market Watch window. All these windows will be updated dynamically in real time and you need not pull or refresh any information. Its all real time updated. In fact you are in live market. It will take only one day to understand the market screen. Market Watch window is the prime controlling window from where you can launch your trading actions. You buy or sell a share by clicking on the specific share on the market screen. INDICES DISPLAY Trading screen should have indices displayed at a convenient location on the screen. It should display all popular Indices like Sensex and Nifty. The indices display should be capable of being customized to show other indices which you follow. An investor should keep track of the market indices so as to get an overall picture of the market sentiment. REPORTS Reports comprise of Order Book, Trade Book, Net Positions, Margin, Exercise Book and Holdings. In any trading terminal, all these reports are dynamically updated without the need to refresh or pull information. From the Reports window you can Modify, Cancel, Square Off or Exercise. The appropriate buttons will be enabled/ disabled depending on which action can be taken based on the currently selected row. You can save these reports to a file either in text or CSV format. CHARTS A Good trading software will provide the following facilities to chart: Streaming intraday tick-by-tick charts & historical data. Ability to chart multiple companies and open unlimited charts. Simultaneously. Unique draw tools including trend line customization and Fibonacci tools. Different chart type options such as Line, Bar and Candlestick. Lots of analysis options including indicators such as MACD, RSI, Williams % R etc for price and volume panels. There are at least 14 indicators that are useful to a trader. Facility to save chart as JPEG file. MARKET ANALYSER Market analyser feature would provide top traded, top gainers and top losers with % change, value and total quantity. It would also provide the list of shares that have touched their 52 week High or 52 week low. It would also help to analyse all quotes and extract those where quantity traded exceeds a given figure or transaction value exceeds a given value. This helps you identify large trades and can give you vital clues to where or in which scrip activity is currently happening. Online vs. Offline by J Victor on June 2nd, 2011
Typically, an online trading account is linked to a depository participant (DP) and bank account. Find out in which banks your broker has a tie-up with. If you do not have an account in one of those banks for trading, you may need to open one. Three-in-one account is offered by some brokers, wherein all the three accounts are opened with the same organization. This not only helps to transfer money but also to redeem the sale proceeds when you sell stocks from your portfolio. However, the two most important aspects that determine the effectiveness of e-broking platform are the trading software and customer service levels that the broker provides. If you are going to use internet to buy stocks- The first three steps would be to- Step 1. Understand how to place orders, modify and cancel them. Step 2.Learn how to verify your ledger balance, get details of transactions and, in general, learn to navigate through the software. Step3.Get a grip of the nuances of transferring money online both to and from the trading account. Demonstration of trading software. You get a good demonstration of the trading software from your relationship manager before you start trading. Customer service Since online trading reduces the human interaction you would otherwise have had in an offline account, the customer service team plays a key role in redressing any problem. Remember to enquire about the customer service to existing clients to get an idea of the competency of the team. Phone trading option Find out from your prospective brokers on how they usually handle a `market meltdown. This occurs when the market rises or falls rapidly and the broker gets loaded with orders five-10 times the size of normal orders. The internet is also not reliable all the time. Net connections can get disconnected or disturbed due to several reasons. In such cases, the broker should provide you with an alternate means of placing orders. Most brokers offer what is called phone trading to help their clients during such an untoward exigency. However, these phone trading options are sometimes charged. Pre market / after market orders. Find out if the broker will give you an option to place orders before the market opens for the next day. Commonly called the after market orders, you can use this option to place your order the previous day itself when you foresee a busy day ahead. Try to get details regarding the various trading products that are offered by the brokers and find the one that suits your profile. While some brokers offer a variety of trading products others offer only the basic trading product. Offline. An offline account is the traditional broking account, wherein you place orders with your dealer either by walking to the office or over the phone. Traders and high net worth individuals with a need for fast and professional execution of orders can consider such options. Since the dealer plays a key role in this model, find out if your dealer is good at execution of orders and is pro active in information sharing. Remember the dealers experience in the market is also a crucial factor. You might also want to negotiate on the trading exposure and the fee that is charged. Unlike the online model, offline brokers are more flexible with the exposure and the brokerage charged. Keep an eye on brokerage costs. by J Victor on November 11th, 2011
Hi there, The cost associated with buying and selling shares are very tricky. Ask any relationship manager of a broking house about the commission they charge and he would readily come up with this answer- .05% for intra day trades and .50% for delivery. If you try t0 walk away, hell come back with his second offer of .04% for intra day and .40% for delivery. This can go down even to .01 for intra day and .10% for delivery! Tip: Although you may finally select a broker, make sure that the brokerage applied on transactions is in line with the offer he made initially. You need to check the brokerage applied by your broker periodically. Brokers charge an amount called Annual maintenance charges from your account. Check those charges. If they are charging AMC every month, it eats into your invested fund. The best option is to pay a lumpsum amount while joining and get exempted from AMC being charged monthly. Generally, Borkers charge a lumpsum of around Rs 500 750 for a life time.
The effective rate of brokerage, however, is different from the above percentages. Apart from brokerage there are other related costs which these managers dont talk about. Before getting further into the topic we need to understand what the terms intra day and delivery mean. Lets see- Intra day - Intraday Trading, also known as Day Trading means you buy a stock and sell that position before the end of that days trading session thereby making a profit or loss for you. A buy position and a sell position of same number of shares of a company All in one days trading session. Thus, intraday means trading in a day. In intra day trading, brokerage is low in comparison to the delivery. Delivery- You do not square off your position in a day session. Instead, you decide to hold the shares till the next trading session or till 20 years or till your target is reached. Now lets talk about what those charges are. Since the topic is about brokerage , i have also mentioned about the brokerages on derivatives transaction. RATES OF BROKERAGE The net trading cost is computed as below: Trading cost = Brokerage + STT + Stamp duty + other charges Now lets try to separate all the cost components- Brokerage: It is calculated at the agreed percentage, on the total cost of shares bought or sold. If you are charged .03% for intraday and .30% on delivery, the basic brokerage figure would be as follows- Market price of the share x number of shares x .03% (intra day) Market price of the share x number of shares x .30% (delivery) Securities transaction tax- It is imposed on the sale/purchase of securities by investors and is charged on total turnover. It is charged as follows: Equity Delivery Transactions Purchase: 0.125% of Turnover i.e. (Number of Shares * Price) Sell: 0.125% of Turnover i.e. (Number of Shares * Price) Equity Intra-day Transactions Purchase: NIL Sell: 0.025% of Turnover i.e. (Number of Shares * Price) Future Transactions Purchase: NIL Sell: 0.017% of Turnover i.e. (Number of Lots * Lot Size * Price) Option Transactions Purchase: NIL at the time of purchase of option. However the purchaser has to pay 0.125% of the Settlement Price i.e. (Number of Lots * Lot Size * Strike Price), in case of option exercise Sell: 0.017% of Premium Transaction charges: There is a very slight difference in the rate of transaction charges for NSE and the BSE. Equity Delivery Transactions Purchase: 0.0035% of turnover in NSE and 0.0034% of Turnover in BSE Sell: 0.0035% of turnover in NSE and 0.0034% of Turnover in BSE Equity Intra-day Transactions Purchase: 0.0035% of Turnover in NSE and 0.0034% of Turnover in BSE Sell: 0.0035% of Turnover in NSE and 0.0034% of Turnover in BSE Future Transactions Purchase: 0.002% of Turnover i.e. (Number of Lots * Lot Size * Price) Sell: 0.002% of Turnover i.e. (Number of Lots * Lot Size * Price) Option Transactions Purchase: 0.05% of Premium Sell: 0.05% of Premium SEBI turnover charges: For equity transaction, this remains NIL but for derivative transactions, it is charged @ 0.0002% of total turnover. The calculation would be as follows. Equity Delivery Transactions Purchase: NIL Sell: NIL Equity Intra-day Transactions Purchase: NIL Sell: NIL Future Transactions Purchase: 0.0002% of Turnover i.e. (Number of Lots * Lot Size * Price) Sell: 0.0002% of Turnover i.e. (Number of Lots * Lot Size * Price) Option Transactions Purchase: 0.0002% of Premium Sell: 0.0002% of Notional Value in case of exercise or assignment Stamp Duty Equity Delivery Transactions Purchase: 0.01% of Turnover. Turnover usually taken in multiple of Rs 5000 Sell: 0.01% of Turnover. Turnover usually taken in multiple of Rs 5000 Equity Intra-day Transactions Purchase: 0.002% of Turnover. Turnover usually taken in multiple of Rs 5000 Sell: 0.002% of Turnover. Turnover usually taken in multiple of Rs 5000 Future Transactions Purchase: 0.002% of Turnover. Turnover usually taken in multiple of Rs 5000 Sell: 0.002% of Turnover. Turnover usually taken in multiple of Rs 5000 Option Transactions Purchase: 0.002% of Premium Sell: 0.002% of Notional Value in case of exercise or assignment Service Tax Service Tax, Surcharge and Education Cess are applicable only on Brokerage. No Service Tax, Surcharge and Education Cess are not applicable on Securities Transaction Tax (STT) etc..Service tax is levied at 10.30%. EXAMPLE: Now lets assume that you purchased 10 ICICI banks share at Rs 868.00 through NSE. Assuming that the brokerage charged is .05% for intra day and .50% for delivery, the total cost of the share (for delivery) would be calculated as follows: Basic brokerage: Rs 868 x .50% = Rs 4.34 Security transaction charge = 868 x 10 x 0.125% =Rs 11 Transaction charge = Rs 0.32 SEBI turnover charges = NIL Stamp duty = Rs 0.87 Service tax = 4.47 Total cost of 10 shares @ 868 = Rs 8740.06 When you buy shares, these figures will appear on your digital contract note sent to you via mail. Its important to keep a print out of those digital contract notes in a file. Brokerages are very important costs associated with stocks and you cannot afford to ignore it. You have to be vigilant on the amount you are paying. Periodic check of your ledger account is necessary. The brokerage affects investors in different ways. For infrequent traders, a higher brokerage would lengthen the amount of time required to break even. If you are a high volume trader, a large brokerage will eat into their overall return. Now, hope youve understood the cost structure involved with stock transactions in India. Make your debut !! The first step Paper trading. by J Victor on June 2nd, 2011
Hi there, The first step to test to stock picking skills is to do paper trading. Paper trading is nothing but following the progress of the company and share price without actually buying it. THIS IS HOW PAPER TRADING WORKS Lets assume that you intend to start investing in shares with Rs 100,000 Imagine that you have put that money in a particular stock you found out after studying the fundamentals. Now, follow up the progress over a period of time and see if it moved according to your expectations. If not, investigate where you went wrong- and youll start learning new things. But, how long? We advice a newbie to follow the market for at least six months. Too long? Never. I guarantee. Your friend who has not done his homework will take only six months to vanish from the stock market. Is this the process that you have taken? All the reading and theory should be accompanied some practical exposure- paper trading is where you start. Over time, youll observe a lot of co-relations between the stock price and various indices or commodity prices. The price might move in odd and unpredictable ways.Youll look for reasons to explain why it happened. All these will create the urge for more understanding and education. And, this desire for new knowledge is a core trait of successful investors. To succeed in stock exchange investments, it is vital to firstly keep up to date about business and economy around you. You may want to read economic journals, annual reports of companies, company reviews, sectoral studies, interviews, stock market opinions and discussions and much more.Its part of an ongoing education process that is very essential for success in stock markets. There are many weekly magazines that specifically cover money, finance, stocks and investment. These will look at the annual reports and news releases of all quoted companies in a way that a daily newspaper cannot. Moneylife, Dalal Street, Business and Economy, Outlook Money and our very on Dhanam magazine in Malayalam are examples of such magazines. Search and find out news, opinions and analysis about the company you selected to invest your money. The internet is full of information about any topic you want. CONCLUSION In the investment business, paper trading is the safest and the best way to start. Pick a couple of companies, make a note of their price, the date, the reason why you want to buy them and then start following the stock. As time passes, the assessment which made the stock such a great prospect will play out. Was it a good or bad decision? Would buying the stock for real have made a profit or a loss? If the result is loss, where was the mistake? keep on digging. Every attempt to find answers will open new insights for you. Happy investing! Initial wealth building strategies- 1 by J Victor on June 3rd, 2011
Hi there, By this time, I believe, you would have understood what investing is and the principles behind it. You would have also started paper trading. Any investing method (value or growth) suggests holding your investments for a long term. But, how long is long term? All those value picks may not create enormous wealth. Some may fail. So, how would you balance this? I would suggest the following method. First, spread out your initial capital into 4 or 5 lots. You are going to invest only 1/5th of your capital in a particular company. Secondly, Whenever you think theres an opportunity, put 40%from that 1/5th you allocated. The balance 60% should preferably be invested in 3 equal shots so that you can utilize all the dips in prices and you also bring down the cost. Invest with the intention of a 10-15% profit objective. Once you reach your profit objective, sell enough shares in the company to remove your initial investment and leave the profit there. This profit will remain invested for a long term. Repeat steps 1-3 as you search for another company to trade for a 10-15% profit and plant the Remainder for the long term. Keep repeating. By doing this, you Guard your investment principal at all costs and let your profits run .You will have a good portfolio of shares at the end. Initial wealth building strategies 2. by J Victor on June 4th, 2011
Hi there, That is an alternative approach for beginners to make safe investments. Now, it may not be possible for every one to keep analysing the stock market on a continued basis. . You might be working in an MNC or a professional lawyer who just cant afford to keep looking at stock market scores.So, how do people like you take advantage of share markets? How do you avoid making worst investment mistakes? All you need to do is bring in an element of discipline in investing by adopting a systematic investing approach. SYSTEMATIC INVESTMENT This involves investing in selected stocks through equal installments spread evenly over time. Such a style offers you some benefits. First, it is light on your wallet. You can get started by setting aside a mere Rs 2000 or Rs 5000 every month and keeping your investments going. I am sure that such a small sum set aside will not affect your family budget. You can increase the amount whenever you want. Second, it takes care of the principal problem related to timing of investments. It helps you stay in the market through its ups and downs, without making any conscious attempt to time your purchases. That is because when you invest the same sum of rupees, say Rs 5,000 every month in the stock market through the years, you automatically buy more shares when the market is low, and less when the market is buoyant. This is exactly as it should be. While you keep investing like this, you can also think of pumping in more money whenever theres a market downturn. For example , you invest Rs 10,000 every month systematically. In a particular month, the stock market has made a correction. You can think of utilizing those dips to buy a bit more than usual. May be an additional Rs 10,000. This is a more effective way of investing and building wealth in the initial years. As the saying goes, little drops of water make the mighty oceansuch is the impact of investing systematically. Initial wealth building strategies 3 by J Victor on June 5th, 2011
Hi there, Lets talk one more way to accumulate money. Lets assume that we are in a bull market. Stock prices are on the rise but you expect a correction sooner or later. You, as an investor, can take advantage of such situations in the market to build wealth. HERES AN EXAMPLE Lets assume that you own 500 shares that you bought at Rs 250 per share. The bull market, and nothing else, has pushed the price up to Rs 400 per share. You want to hold the stock, but are concerned that a market correction might drop the price below Rs 250 per share. You sell 250 shares at Rs 400 for a gross of Rs 100,000 which can be put in a short term fixed deposit. When the market correction comes, you buy back shares at a lower price. For example, say the stock fell to Rs 200 per share. Your Rs 100,000 profit will buy you 500 shares. You now own 750 shares of the stock and have reduced your average cost from Rs 250 per share to Rs 216 per share and you didnt take a penny out of your pocket. 250 shares @ Rs 250/share = Rs 62,500 500 shares @ Rs 200/share = Rs 100,000 Earlier you had 500 shares by investing Rs 125000. Now you hold 750 shares @ Rs 216.66 /share without taking a penny from your pocket. Of course in this example, for ease of explanation, I have not considered two things. One is the tax on income when you sell shares at a high price and the second is the brokerage for buying and selling shares. ALRIGHT..WHAT IF ITs A BEAR MARKET? If you have done your research properly, you will be able to judge whether the stocks price decline is simply a reflection of the markets general pessimism or a signal that something is fundamentally wrong with the company. If the price decline is due to general pessimism in the market, any smart investor would utilize that opportunity to grab more shares of that company at drop price, thus significantly bringing down the average cost per share invested. Buying & Selling shares by J Victor on June 24th, 2011
Buying and selling shares is an easy process with fast online terminals. There are different types of Buy & sell orders you can place in the market. Although its an easy process, carelessness in executing can result in financial loss. Heres a brief explanation of each type of order and its benefits. TYPES OF ORDERS LIMIT ORDERS Type of orders where you specify the price while entering the order into the system. You have to select the appropriate option to notify whether you are placing the order at Market or at Limit. If you select the Limit order option then you have to enter a price that is in multiple of regular tick size (multiples of 0.05). MARKET ORDERS when you place an order without a limit price with an intention to get it executed at the best price obtainable at the time of entering the order, its called a Market order. STOP LOSS ORDERS when you place an order with a trigger price its called a stop loss order.. Till the trigger price specified in the order is reached or surpassed such orders are kept dormant. The intention for placing a Stop Loss order is to restrict the maximum loss in a particular position to a predetermined amount. Stop Loss orders are always placed in pairs. The first order has to be a normal order either limit order or market order. The second order will be a stop loss order that will ensure that maximum loss is restricted. The benefit of stop loss orders: If you place a buy order at Rs100 and do not wish to take a loss of more than Rs2 then you will want to sell at Rs98, when the market starts sliding contrary to your expectations. You can obviously keep a watch on the market and sell when it slides and exit your position at Rs98. But this may not always be possible. By entering a Stop Loss order you achieve the same objective without a need to keep a watch on the market.If you place a sell order when the price is above Rs98, your order will get immediately executed. If you place a stop loss order for Rs98 then this order will remain dormant till market prices breach the trigger price. In the current example you will place a Stop Loss order for Rs98 with a trigger price of Rs98.10. You can also place a Stop loss order at Market with a trigger price of Rs98.10. In this case when stop loss is triggered the shares will be sold at market rate. Most users make a mistake of placing a stop loss order without the original order. Users typically mistake the limit price to be the main order and trigger price to be stop loss order. Thus in the above example many users intending to limit the loss to Rs2 will place only one order at a limit price of Rs100 and a trigger price of Rs98. You should have a clear understanding of how stop loss orders are to be placed before placing such orders. IOC ORDERS Here you place an order with an IOC instruction i.e. with an intention to get it executed immediately, failing which the order is cancelled. It is possible that the order gets partially traded, and in such cases the remaining portion of the order is cancelled immediately. Stop loss orders cannot be placed as IOC orders. You can place a normal order (at limit or market) as an IOC order. Take Note You must fill the Quantity text box correctly before placing the order. Quantity has to be in multiple of lot size. In cash market most of the shares have a lot size of 1. In Derivatives lot sizes vary from scrip to scrip. In most of the trading platforms, Quantity field cannot be directly entered in the Derivatives OE window. You have to click on the up/down control next to the Quantity text box and the quantity will increment/ decrement by lot size. Disclosed Quantity You can leave the Disclosed Quantity (DQ) text box blank. In case you fill it, it has to be at least 10% of the order quantity. An order with a DQ condition allows you to disclose only a part of the order quantity to the market. For example, an order of 1000 with a DQ condition of 200 will mean that 200 is displayed to the market at a time. After this is traded, another 200 is automatically released and so on till the order is executed fully. PLACING ORDERS TO BUY AND SELL Once you are sure you entered all the information correctly (quantity and the type of order) you can click on the Place button. This will create an Order packet and display it to you. You have to confirm that the packet is generated correctly by clicking on the Confirm button. After your confirmation, the order will be sent into the market. Each order packet that is created at your end is uniquely numbered (Local Order ID) and time-stamped before being sent to the broker. As soon as the order is received at the brokers server an acknowledgment is sent back. It is then given a unique Broker Order ID, time-stamped and sent for checking the limits. Once the broker confirms that the order is within your financial limits, it is put in queue for sending to Exchange and you will be notified of the same. When the order is sent to Exchange, another notification will be sent to you. When orders are received by Exchange they are numbered (Exchange Order ID) and time- stamped again. Exchange may either accept the order or may reject it due to errors in the order or due to price out of days price range or any other reason. It may also freeze your order and may release the freeze later. Whether the order is accepted, rejected or frozen by the Exchange will be notified to you. MODIFYING A BUY/SELL ORDER You can modify an online order to buy or sell a share once your original order it is accepted by the Exchange. You cannot modify or cancel an order after it has got executed. Obviously the application has in built safeguards and will not allow you to modify or cancel an order unless it can be done. However, there is a gap between the time when you picked an order to be modified/ cancelled and the time when it was received at the Exchange, and it is quite possible that the order changes status during that time. A pending order might get executed during that gap. You may therefore get a message saying Order does not exist. This means that the order that you tried to modify or cancel was not found by the Exchange in its Order Book at that time. CONFIRMATION OF A TRADE Confirmation messages for Order and Trade related actions will be displayed in the Messages Panel instantly. Generally, you will get confirmation messages for Orders sent to the broker Orders received by the broker Orders accepted or rejected by the broker Orders put in queue to Exchange Orders sent to Exchange Orders accepted, rejected or frozen by the Exchange Trade confirmations sent by the Exchange All these messages will display the time and associated order IDs Local Order ID, Broker Order ID and Exchange Order ID. Thats about buying and selling shares. How to practice buying/selling shares in live market. by J Victor on June 28th, 2011
If you are an online investor, you need to study how to buy and sell stocks from your remote terminal. Apart from that, your online trading platform is a powerful tool and has a lot to offer. You can customize your trading screen , do technical analysis, transfer funds from your bank account to your share trading account, know your exact cash position, check the profit or loss you made year wise or scrip wise etc. Further, there are shortcuts using mouse and shortcut keys. But how will you study all this unless you participate in a few trading sessions? PRACTICE WITH LOW PRICED SHARES The best way is open a share trading account with a nominal amount and start buying and selling low priced stocks. They are also called Penny stocks in the international market. These stocks which sell for, say, less than a rupee are a best way to start learning practical trading. It does not involve large amounts of money, and you can avoid very high risk at initial stages. Even if you lose, you lose a very small amount. ADVANTAGE You can master the method of using your online trading terminal and all its features. You also get first hand experience on live technical charts. This is no simple step to be ignored, especially beginners.For example shares of waterbase (code: BSE 523660) are available for less than Rs 5. Learn to buy and sell with 1 or 2 shares, it not going to cost you more than Rs 10 per transaction! The whole cost of mastering your trading screen should be less than Rs 200 ! Its worth and it works ! DO NOT TAKE IT AS A SERIOUS BUSINESS I recommend buying and selling low priced shares only for the purpose of practice. There is a certain section of investors who keep investing in such stocks seriously, trying to make huge returns from such small extremely risky investments. The disadvantage of investing in low priced shares is that in most of the cases, their fundamentals will be nothing much to talk about. Secondly, they can have a very thin margin of exchange. This means that when you are looking for a way to sell your stock; you might not be able to find a buyer at its current price. The reason for this stems from the fact that there are usually very low volumes of exchange for many such stocks. Hence, when you need your cash and thus when you try to exit these stocks; you might not be able to find a buyer who is willing to buy at the current price. You may have to lower your price considerably, so that you can sell your stocks and get your cash. Finally, you can be a victim of a biased recommendation as most of these low priced stock companies will try to influence the investors by using different channels of the media and especially the Internet. In the Internet, you can receive falsely constructed information about such stocks, but in reality you will be losing money since the information will not be true. Dont let emotions take control by J Victor on June 29th, 2011
The fear of losing money and the thought of somehow making a quick buck before the market closes or trying to square of days losses by trading again and again these are very common things people start doing once they start investing in shares .Ask any beginner hell admit of doing what i said above or ask any seasoned investor he would recall doing this mistake in his early days of investing. if you are doing any of these , emotions are taking control over your thoughts and you need some help Because ,these thoughts induces you to act illogically and prevents you from thinking clearly about how an action (buy or sell ) affects your financial position. Frankly, in the early part of my investing career, at least 15 years back, Ive gone through all these. I would buy a particular stock after doing some research, totally prepared to hold it for some time , but, as i see the price fluctuate , fear automatically steps in. I keep asking to my self- Did a make a mistake? Finally, unable to hold on to my nerves, i would end up exiting that position. Then, at the next moment, im in a race to somehow make a quick buck before the market closes- to bring back my capital position to where it started. So, whats the remedy? There are a couple of steps you can take to stop or limit the influence of emotions on your investing success. USE AN ADVISOR. A financial advisor can tell you no when your emotions want to chase a stock and remind you of your investing objectives. They can help you set your objectives so you have something to measure trades against. MAKE A PLAN Make a plan that focuses on your objectives. This is the do-it-yourself version of getting a financial advisor. The plan should address your objectives and any trades should be measured against the plan to see if they meet your objectives or not. Hold up any investment decision to the plan to see if it fits or not. If you are prone to fudging, you might have a spouse, partner or someone else hold the plan and make the call on whether the investment meets the plans objectives. COOL OFF Wait 24 hours before you make any investment decision that isnt part of your plan. Its amazing how different an investment can look after a good nights sleep and remember, there will always be another deal NEVER COMPARE Never compare your profits with what your friend has made . Your friend may be speculating or he may be experienced than you. Stay cool with the promise that youll also make it big one day and keep making fundamentally right moves. REMEMBER The stock market is always there and it keeps giving opportunities every time. If you miss the bus, dont worry. Wait patiently till the next. What is more important is that you should be there when the market calls. 4 simple Must follow rules for everyone. by J Victor on July 5th, 2011
Stock market would be a place full of surprises for beginners. Just when you thought youve done a good job buying a share, the prices can come down unexpectedly . Or on one fine day , just as you thought everythings normal, the stock prices may go frenzy recording gains after gains. Everything may seem to be totally illogical to you. Such dramatic moments are part of a stock investors life and it is in these situations that people lose control and forget all that theyve learnt . Lets go through 4 situations thats so common in every investors life. SITUATION 1 As you start investing, you start following economic news more carefully than before and get caught up in daily headlines and assume the stock market is facing a new and unprecedented crisis.Credit crunches, liquidity problems, crashes in particular stock sectors, and other major problems have all rolled through the market before. This doesnt mean that market wont react badly to severe problems. However, experienced investors know there is usually an end to any crisis and the market will be back on track.The recent stock market crash and the way market bounced back in two years is an example we all experienced. Many of them sold their positions when the market crashed. Remember this first Rule- Have patience !If you have bought a share at the right price, Hold it. A big fall will have an equally big rise. SITUATION 2 The reverse is also true.Imagine this situation- The stock market is soaring up like a rocket. Your broker expects the market to go beyond imaginary levels. The market sentiment appears to be so positive that youll find it hard to resist. Everyone whos investing keeps getting profits everyday. Naive investors watching a bull market run may go crazy looking at the way market moves. As a result, they may not choose their investments wisely and push the prices of hot stocks even higher. Because they are inexperienced, they buy stocks they hear about on television or from friends. Thats the time to be cautious. - So heres the second rule- A big rise will have an equally big fall .wait for the fall patiently. SITUATION 3 You have done your homework, including identifying the entry point for a promising stock. Now you are waiting with anticipation for the price to reach your entry point. Instead of pulling back the price lunges upward.You dont want to miss the bus. You panic, entering an order that is higher than your entry point. Now you have given away some of your potential profit and violated your risk reward of the trade. You even knew it was a mistake to make this trade, yet you let your emotions rule the day. Later it pulls back to your entry point. If only you had be more patient. Now you are faced with another decision: Do you buy more or do you wait to see what happens next? That brings us to the third rule- There are many fish in the lake and it isnt necessary to catch every fish that swims by in order to be successful. In fact, its only necessary to catch those few that bite. SITUATION 4 One of the stocks you have been following hits your entry point and you pull the trigger. You invest money in it. Now you wait for the expected to happen. It starts its move up and your positions are in profits.You feel confident and positive. However, according to your analysis it still has more room to run. Then it un-expectantly retreats and falls below your original entry point. You panic and end up selling it off with a small loss. Then the price moves up again and reaches your target, only you are not participating. Youre well thought plan was right, only you let your fear of a loss get in the way of the trade proceeding as expected. That brings us to our final Rule - Give time for your money to grow. CONCLUSION Do your home work , invest and just stick to your plan. keep learning, be disciplined and let the market do the work for you. Exhibiting patience when investing , having patience while your investment grows and keeping your nerves during market crash are integral parts to investing successfully. However, allowing patience to turn into stubbornness is something you must always guard against. Stop loss orders A way to protect your capital by J Victor on July 7th, 2011
It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop loss order works like this: You tell your broker you want a stop loss order at a certain price on the stock. When, and if, the stock hits that price, your stop loss order becomes a market order, which means your broker sells the stock at the best market price available immediately. The main advantage of a stop loss market order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. You can think of it as a free insurance policy. Most importantly, a stop loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, giving the stock yet another chance. In the meantime, the losses may mount wiping out a substantial figure. Here is an important point to remember: Be careful where you set your stop loss . If a stock normally fluctuates Rs 10-15, you shouldnt set your stop loss too close to that range or it will sell the stock on a normal downswing. TRAILING STOPS Another use of this tool is to lock in profits, in which case it is sometimes referred to as a trailing stop. A trailing stop loss is fixed at a certain percentage below the current market price of the stock you own. The trailing stop loss percentage depends on how volatile the stock is. If the stock begins to go down and the trailing stop loss gets triggered, you would be able to book your profits in the deal. However, if the stock goes up, you will be bringing the trailing stop loss up to maximize your profits. For example you bought shares in , say , Reliance for Rs 1000. The Current market price of the share is Rs 1100 .So you set the trailing stop at, say Rs 1070 so that in the event of stock price crash, your sell is at Rs 1070 booking a profit of Rs 70 per share . Now instead of stock prices coming down, suppose it went up to Rs 1200 .now, you may want to fix the trailing stop at 1160, locking a profit of Rs 160 per share. VERY USEFUL FOR DERIVATIVE TRADERS Big bucks are at stake when you enter futures and options. Stop loss orders are particularly useful for traders of derivatives. MARKET ORDERS AND LIMIT ORDERS The stop loss order can be stop loss market orders or stop loss limit orders. The difference is that A stop loss limit order is an order to buy a security at no more (or sell at no less) than a specified limit price. This gives the trader some control over the price at which the trade is executed. In a stop loss market order, the trader has no control over the price at which the transaction is executed. PROS AND CONS The other positive factor of stop loss orders is that you dont have to monitor on a daily basis how a stock is performing. This is especially in a situation that prevents you from watching your stocks for an extended period of time. The disadvantage is that the stop price could be activated by a short-term fluctuation in a stocks price. The key is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Cost Averaging- A strategy you should use carefully. by J Victor on July 22nd, 2011
AVERAGING-HOW IT WORKS You buy 500 shares at Rs 50 per share, but the stock drops to Rs 40 per share. You then buy another 1000 shares at Rs 40 per share, which lowers your average price to Rs 43.33 per share. The idea is to invest more at lower levels and try to bring down your purchase price almost near to the market price so that in the next minor upward movement, you can sell off the stock at a profit. But before doing that , we need to think about the angle from which you have invested money.Have you invested money in a business or is it just another sizzling hot stock in the block? The distinction is important. INVESTING IN A STOCK If you are investing in a Hot stock , you look for buy and sell signals based on a number of indicators. Your goal is to make money on the trade and you have no real interest in the underlying company other than how it might be affected by market, news or economic changes. Once the stock price reaches your expectations you sell it off and book profits. Averaging is not a good technique when investing in a stock (as opposed to a company) it is always better to cut your losses at 5%. When the stock drops that much, sell and move on to the next deal. In the above example you may sell off the shares at Rs 47.5 INVESTING IN A BUSINESS If you are investing in a business (as opposed to a stock), you have done your homework and know whats going on within the firm and its industry. You should know if a drop in the stocks price is temporary or sign of trouble. If you truly believe in the business,you should look out for opportunities to average down the cost of investments by buying more shares when ever there is a temporary fall in the price.That way, you can increase your holdings in the company and bring down the cost per share. Accumulating more stock at a lower price makes sense if you plan to hold it for a long period. This is not a strategy you should employ lightly. If there is a heavy volume of selling against the company, you may want to ask yourself if they know something you dont. The they in this case will almost certainly be mutual funds and institutional investors. THE RISK INVOLVED IN AVERAGING The risks associated with using cost averaging investment strategy is when the stock you purchased never goes up. You keep buying more shares at lower levels sinking more money into a stock that can never go up. So you have to do your home work before deciding upon a list of businesses youre going to invest in and employ the cost averaging strategy. For example- there are certain industries where India as a countrys competitive advantage is so strong that buying the shares of companies in that industry on declines is always a good strategy, examples being Pharmaceuticals & Technology. THE ADVANTAGE The advantage is that it helps to bring down the average cost substantially. The break even price is low and gains are made more easily. This remains true even if the initial entry price is not reached again. For example the investor initially opens with 100 shares at Rs 50. The price drops to Rs 40. Then a further 200 shares are bought at Rs 40. So the average cost comes down to Rs 43.33 I.e. the stock doesnt need to return to the original Rs 50 to breakeven. Consider then, if the uptrend takes off and the price breaks through to Rs 55. As then the risk pays off as the return is Rs 3,500 as opposed to the Rs 500 it would have been without averaging down. SOME PRACTICAL TIPS Try to average down on those blue chips. These stocks are comparatively safer than those mid-caps and small caps. Never use this technique on small caps. Before averaging down, always re-evaluate the fundamentals Try to understand why the stock price has come down. CONCLUSION If youre investing stocks, averaging down probably doesnt make any sense. Take a small loss before it becomes a big loss and move on to the next trade.In the above example you suffer a small loss of Rs 1250 /- and go into the next deal. If you invest in businesses, averaging down may make sense if you want to accumulate more shares and are convinced the company is fundamentally sound. Say no to day trading ! by J Victor on July 26th, 2011
Day trading (or intra-day trading) is the practice of buying and selling stocks during the same day. Ideally at the end of the day there has been no net change in your position. Your trading summary would show equal number of share bought and sold. A gain or loss is made on the difference between the purchase and sales price. Day trading is more risky than any other trading activity. It is very common to use margin with day trading (i.e. using borrowed funds), amplifying gains and also amplifying losses. The downside is that substantial losses can occur very quickly. Day trading was once the domain of financial firms and professionals along with experienced traders and speculators. It is now very common amongst everyday traders thanks to the internet. There is a common misconception among stock market participants that they can catch those fluctuations in price and make a regular income out of it everyday. Thats far from truth. A little gamblers instinct is there in all of us and it is this urge to react instinctively to any positive or negative market information that finally becomes an addiction. It goes on and on until the gambler himself is out of the game. (In fact, youll realise that youve been a gambler only when you look back at what youve done !) There are also some analysts around who gives out messages at the end of the trading day that their stock calls have made heavy intra day profits, everyday ! Claiming to have made 90% or more accurate stock calls every day, their purpose is to lure you to subscribe to their paid services. The genuineness of these kind of sure shot calls is questionable. Day trading is also promoted internally by most of the broking firms through their branch managers and relationship officers , since it helps to generate their target brokerage every month. Although these are the dark sides of day trading, i do admit that there are some very genuine day traders out there. STRATEGIES ADOPTED BY DAY TRADERS There are a number of strategies by which day traders attempt to make a profit. Following the trend: Trend following, a day trading strategy used in all trading time frames, assumes that prices that have been rising steadily will continue to rise, and the same for falling prices. The trend follower buys a share which has been rising or short-sells a falling share, in the expectation that the trend will continue. Fundamental analysis: Fundamental analysis is one of the biggest tools of the day trader. The basic strategy is to buy a share which has just announced good news, or short-sell a share on bad news.But to be honest, i havent seen many day traders who follow a stock fundamentally. Many ignore company fundamentals, focusing only on what might make the stock move in the very short term Technical analysis: Technical day trading uses mathematical formulae to decide when a share is going to rise or fall based on previous price action. Many day traders use technical indicators DANGERS OF DAY TRADING Many Day traders trade without a plan of any kind as to what to buy and sell and when. In many cases a day is simply not long enough to realize the profit of a share. Much of the fundamental analysis data day traders use is quite delayed and this will mean that by the time it is received and acted on, the rest of the market, especially the stock broking industry, has already taken action. Day trading in stock markets has the same lure to traders that Las Vegas has to gamblers. Typically, a new trader will come to the stock markets with a trading strategy of holding shares for a period of weeks or months. As they watch the markets move up and down every day, they believe they can catch many of these smaller moves by getting in and out every couple of days. Commissions are cheap, so it seems like an easy proposition. But, things are not easy as he thinks. Every other trade might end up in losses and at the end, he would realize that he would have done very well if he just stuck to his original plan and his life would likely have been much less stressful. The above scenario is a daily occurrence in most of the stock broking firms. Day traders often use leverage which can amplify losses as much as it can amplify gains. For the inexperienced it is a huge risk losing more than you have in your float. CONCLUSION Day trading may look like investing, but its far from it. Day trading can be very emotional and gut-instinct based. It might give opportunities to make profits. But we sincerely suggest not to do day trading in stock markets. Often, investors do this to make a quick buck. From our experience, 80%-90% of day traders lose money in the market. Resist articles you may see here or there profiling a successful day trader. Know that for every success, there are many more failures. Dont let yourself or those you care about get sucked into day trading. Never attempt short selling by J Victor on August 2nd, 2011
Investors go through all the number crunching to find one thing- the best stock to buy. Short sellers look for the opposite finding out the best stock to sell. Dint get the idea? Short sellers sell stock they dont own with the belief it will fall from the current market price. When the price drops, they can buy the stock at the lower price, pocket the profit and return the shares to the original owner. For example You expect the share price of A ltd to fall. You sell 500 shares in A ltd at Rs 50 per share and just after that , the price of A ltd begins to decline. Now the price has fallen to Rs 40 Per share. At this point you buy 500 shares @ Rs 40 and square up your position. The net effect is that you bought 500 shares @ Rs 40 and sold 500 shares @ Rs 50, pocketing a profit of Rs 5000 in the process. Good .well done! For being right, you pocket Rs 5,000 in a very short time. However, what happens if you are wrong? This is the dark side of short selling. WHAT ARE THE RISKS ? 1. If the price rises, you lose money. Since there is no theoretical upper limit to a stocks price, the investors loss is also without theoretical limits. 2. There is no way to accurately predict when a stock will fall (or rise for that matter). 3. Short selling is not for new investors.In fact ,you cant consider a short seller as an investor. He is basically a speculator. 4. When you short sell a stock, your maximum profit is the amount for which you sold the stock. When you buy a stock The potential is unlimited. There is no ceiling for a stocks price. By shorting, you are taking huge risk for a small profit. CONCLUSION Short selling is never recommended and its not a good idea to sell someones stock and make a profit out of it. In my experience, most of these short sellers end up in financial disaster. In short selling, the potential for loss is greater than the potential for profits. 3 basic questions you should answer before investing. by J Victor on August 3rd, 2011
Many people play in stock market and as a result, lose their money. Playing with stocks requires basic understanding about finance , economics and accounting. Without those fundamentals, the market can be a very dangerous place. Heres a set of 3 basic questions you should be answering before you pick a stock- DO YOU HAVE A VALID EXPLANATION FOR YOUR ACTIONS? In every case, you should be able to write out a short, simple explanation as to why you are purchasing a specific investment and they should be logical and reasonable. SHORT TERM MOVEMENT OR LONG TERM PERFORMANCE? If you ultimately expect to earn your profits in the market because a stock is going to go up as investors find it more fashionable, rather than an improvement in the long-term performance of the underlying business, you are not investing. A better word for your action would be gambling. IS YOUR INVESTMENTS LEVERAGED? Margin debt is dangerous because its so easy to access. If you approach a traditional bank, youre going to have to complete a myriad of paperwork, prove you have the cash flow to repay the loan, Give collateral security, go through a background check, and a whole lot more. With a brokerage firm, If you have Rs 100,000 in assets in an account, you can instantly borrow another Rs 100,000 to buy shares, effectively leveraging your funds on a 2-1 basis. The problem, of course, comes if stocks fall which they are often prone to do. You must invest in such a way that no matter what happens in the financial markets, you and your family should have enough money to survive and also invest and participate in the recovery when it comes. The point is, you shouldnt put all your money into markets in one go. And, you should not expose all your money into stock markets . If you are determined to put as much capital to work for you as possible, focus your energy on generating more cash in your professional life either by working more hours, starting a side business, cutting expenses, etc. It may take you a bit longer to get to your ultimate goal. But it will still be a much shorter journey than if you are completely or partially wiped out as a result of borrowing against your securities. Till my next article.. Most common stock market mistakes. by J Victor on August 3rd, 2011
1. TRADING TOO OFTEN Beginner traders often buy/sell their securities too much. Generally, the only person who gets rich off of this is the investors broker. For example, if you have Rs 100,000 to invest, making 50 trades in a year at 0.3% would eat up Rs 30,000 as commissions. Even if you get 30% return from the market, you make nothing. In fact, if you factor in inflation, you lose money. Trading frequently is also not tax inefficient, since these investors often end up paying short- term capital gains tax instead of tax free long-term capital gains. 2. INVESTING IN A SINGLE STOCK Never put all your money in the same basket. You should learn to diversify your investments. At anytime, your investment bag should contain different companies from different sectors. 3. COMMITTING ALL THE CAPITAL AT ONCE This is a really dumb thing to do; markets fluctuate up and down throughout the year, what if you end up buying the very top? Its much better to plan ahead, and spread your capital commitment over 3 or 4 steps. Whenever you think theres an opportunity, put 40% of your allocated money. The balance 60% should preferably be invested in 3 equal shots so that you can utilize all the dips in prices and you also bring down the cost. When you invest money in one shot and have no cash, you cant take advantage of the market when it has a bad day. You are also more prone to panic selling and making other fear-related decisions. 4. INVESTING IN THE COMPANY THAT YOU WORK FOR This is a dangerous thing to do; employees are often encouraged by their own employers to invest in the company they work for. Sometimes they even invest all their lifetime savings! The danger is that if the company goes bust, you will lose both your job AND your investment. 5. PANICKING One emotion thats detrimental to investors is fear. Yes, you should use caution and prudence when making investments. However, panicking whenever the stock market goes down never solves anything. Investors that are quick to panic often end-up buying high and selling low. 6.MAKING FINANCIAL DECISIONS BY TAKING ADVICE FROM FIRENDS: What works for one person may not work at all for another. Even beyond personal circumstances, the timing may just be wrong. For example, your friend might inform you about the latest hot stock in the market. He might have invested in it and his positions may already be in profits. By the time you enter, the prices may have peaked. 7. INVESTING IN TOO MANY STOCKS Investing in too many stocks would also lead to confusion .Youll find it difficult to follow-up with the companies.. If you want to diversify, its better to take the mutual fund route. If you end up investing in 50-100 individual stocks, effectively it becomes like your own mutual fund, but without the resources to adequately monitor the companies you are invested in. Diversification is necessary. But make sure youre not over-diversified. A good portfolio would contain 10 to 12 stocks from various sectors. 8. UNCONTROLLED ENTHUSIASM When we enter into something new, we will be over enthusiastic in the beginning and our enthusiasm level will drop as days go by. Especially so, in the case of stock markets. Beginners automatically get dragged into day trading before they gain enough exposure to the stock market. Over enthusiasm can work against you. Day trading requires a lot of experience to make profits. Even experienced traders tread very carefully when it comes to day trading. 9. INVESTING RISKY FUNDS Never invest money you cant afford to lose. There is no sure thing when it comes to making money with the stock market. You are allowing the risk to be too high if that loss of money is going to be a huge burden for your overall financial situation. I personally know people who have invested the money that they kept aside for their daughters wedding. 10. NOT HAVING A SOLID PLAN You plan to fail when you fail to plan. Be prepared about how you will invest by having a solid plan of action. It is not possible for anyone to study all the thousands of shares that are being traded in the market. Naturally, you will see your friends making investing plans quite contrary to your views. Never deviate from that plan for your investments. Of course this doesnt mean you are stuck with one method forever. Should you find that it isnt working to make you profits you definitely want to step in and re-evaluate it. 11. POSTPONING YOUR INVESTMENT PLAN Postponing the start of your investing until you have extra money is a crucial mistake. This can cost you a lot because the value of money invested compounds across time. You also miss good opportunities to make money. Opportunities do come again in stock markets it may be better than the previous one you missed or worse. But they are never the same. So its important to kick-start the investing process as early as possible. 12. CHASING PERFORMANCE
Many investors select shares based on recent strong performance. The feeling that Im missing out the opportunity has probably led to more bad investment decisions than any other single factor. If a particular share has done extremely well for the past three or four years, we know one thing with certainty: we should have invested three or four years ago. Now, however, the particular cycle that led to this great performance may be nearing its end. This is the point where smart money moves out and the dumb money is pours in. Dont be dump! 13. RELYING ON LUCK Luck factor is very less in stock markets. Investing is all about your own strategies, hectic analysis, patience and the knowledge you have about the company in which you are investing. I know people who still use the same computer keyboard they started off with. (So that their winning streak continues!) .There are some others who wear stones and rings to help them get profits. Some guys trade only by positioning themselves eastwards. If strategies like that makes money for you, dont look back. But I guarantee, its not going to work all the time. One day youll have throw those stones away. Do it now before its too late. 14.ENTRUSTING MONEY ON PROFIT SHARING BASIS This one is so common- unofficially !! You may come across experts who would offer to trade using your demat account on a profit sharing basis. Their terms are simple-Your money; his brain. Profit shared equally between . Do not get into such agreements with so called experts. You would ultimately end up losing all your money. Thats 14 of the common mistakes. Have the 15 th one? Send in. When to sell your stock by J Victor on August 4th, 2011
Since no one can time the market, knowing when to sell is one of the toughest decisions, especially since greed usually takes over and you always hope for a higher price. In theory, the perfect business is to buy a company so wonderful and at a price so attractive, that we never sell it. Of course, this rarely happens in reality. Wondering why? Because not all companies stay wonderful forever and The market at some point tends to grossly overvalue these companies, giving a sell opportunity. PRE-DETERMINED RETURN Its better for investors to take a conservative approach. Consider selling your stock once you achieve a 20% to 25 % return on investment. IS THERE A BETTER OPPORTUNITY? If you have found a better company, where the probability of growth and returns is higher and if that company is available at an attractive discount, consider selling of your earlier investment at the available profit and invest in the new one. SUDDEN CHANGES IN SCENARIO Uncertainty is a part of stock markets. If there has been a sudden change in circumstance or you have received new information, that changes your opinion about the company that you once believed was wonderful, consider selling the stock; even though its current price may not have reached your target. ACCEPTING LOSS When you value a stock and invest at discount, its hard to get into a trap. However, I need to talk about accepting losses here. One of the hardest challenges an investor faces is accepting ones loss and moving on before the situation worsens. It is much easier to sell and take profit than to sell and take a loss because it is emotionally far easier to leave a position with a win than with a loss. However, this very behavior puts investors at risk and can quickly lead to depletion of his position. Therefore, I argue that sometimes it is important to hold onto your stocks when they are going up beyond our target price, not because we are greedy, but because it is important to recognize a trend and take full advantage of the uptrend. On the other side, it is absolutely critical to recognize the trend down and cut losses early regardless of how hard it is to accept a loss. The Bottom line is dont hold onto your position too long or too short. Have a plan both ways and stick to it. What i said above is not an easy thing to do, specially for fresh investors. Holding the stock beyond the target price and getting out of a position before its too late are vital decisions. The ability to take such decisions needs to b developed with time. For that you need through understanding about the particular stock and of the industry and economy in general. Investor protection Message from the Bombay Stock Exchange by J Victor on August 4th, 2011
The Investor Protection Fund of the Bombay Stock Exchange Ltd has laid out certain Dos and Donts for investors to alert them to the attendant risks associated with trading in stocks. DOs Always deal with the market intermediaries registered with the Securities and Exchange Board of India (Sebi) / stock exchanges. Give clear and unambiguous instructions to your broker / agent / depository participant. Always insist on contract notes from your broker. In case of doubt of the transactions, verify the genuineness of the same on the exchange Web site (http://www.bseindia.com). Always settle the dues through the normal banking channels with the market intermediaries. Before placing an order with the market intermediaries please check about the credentials of the companies, its management, its fundamentals and recent announcements made by them and various other disclosures made under various regulations. The sources of information are the websites of exchanges and companies, databases of data vendor, business magazines, et cetera. Adopt trading / investment strategies commensurate with your risk-bearing capacity as all investments carry risk, the degree of which varies according to the investment strategy adopted. Please carry out due diligence before registering as client with any Intermediary. Further, investors are requested to carefully read and understand the contents stated in the Risk Disclosure Document, which forms part of investor registration requirement for dealing through brokers in the stock market. Be cautious about stocks, which show a sudden spurt in price or trading activity, especially low price stocks. Please be informed that there are no guaranteed returns on investment in stock markets. DONTs Dont deal with unregistered brokers / sub-brokers, intermediaries. Dont deal based on rumours generally called tips. Dont fall prey to promises of guaranteed returns. Dont get misled by companies showing approvals / registrations from Government agencies as the approvals could be for certain other purposes and not for the securities you are buying. Dont leave the custody of your demat transaction slip book in the hands of any intermediary. Dont get carried away with onslaught of advertisements about the financial performance of companies in print and electronic media. Dont blindly follow media reports on corporate developments, as they could be misleading. Dont blindly imitate investment decisions of others who may have profited from their investment decisions. For the benefit of investors, the exchange has installed a Toll Free line 1600 22 6663, wherein they can inform on any specific lead with regard to any type of undesirable trading practices in any scrip or any type of market aberration observed by them. Investors are hereby requested to get their messages recorded in English or Hindi. Identity of the investor will be kept confidential 10 Mistakes a beginner should avoid by J Victor on December 2nd, 2011
Hi there , Here is a list of faults that beginners in stock market usually commit. These are very common mistakes that eventually result in financial disaster. Investors who recognize and avoid these 10 common mistakes give themselves a great advantage in meeting their investment goals.
INVESTING IN LOW PRICED STOCKS I had said in an article about buying low priced stocks for the purpose of learning the trading screen. Thats where you should stop. There is a section of people who try to invest in those companies hoping to make serious profits. This is something you should avoid.At first glance, investing in these stocks may seem like a great idea. With as little as Rs 10,000 you can get a lot of shares in a small cap stock than a blue chip like Infosys which costs 2500 on an average. And, if the 4 Infosys shares you bought went up by Rs 25 youd only make Rs 100 whereas if 100 shares of Rs 100 went up Rs 10, you make Rs 1000. Small cap stocks can shoot up. It happens all the time but they can also crash in moments and may never peak again. PUTTING ALL IN ONE BASKET
Investing 100% of your money in stocks (or any other asset class for that matter) is never a good decision. You should always commit less capital into these markets in the beginning. Once you are familiar with them, you can afford to take more risk. INVESTING CASH RESERVES
Getting into investing doesnt mean you should invest to the point of illiquidity. Investing is a long-term business. So you must always have cash on the sidelines for emergencies and opportunities. Sure, cash on the sidelines doesnt earn any returns, but having all your cash in the market is a risk that even professional investors wont take. BORROWING MONEY TO INVEST.
Your broker will always encourage you to go ahead with margins, explaining its potential to make big money. His target is to squeeze out maximum brokerage from your account. At any cost, you must not fall to this trap. Worst still, I have heard of people pooling money , forming partnership firms or companies and getting into investing business. Their idea is to make it big at the first move itself. Such strategies never work out. All these are not recommended. TRYING TO CASH ON ROUMORS
Its natural for a beginner to be overenthusiastic about stocks, trying to find all sorts of information from brokers, internet, friends, investors, newspapers, magazines. Trying to guess the next Infosys or Microsoft is a terrible move for first time investors. Spotting winning stocks is an art thats practiced and perfected with lot of effort and time. Its not easy as you think. Ideally you should first invest in businesses that you can understand. JUMPING IN HEAD ON
The whole process of investing boils down to one simple theory- Buy low and sell high. World over, investors and experts still make mistakes in finding what is low and what is high in a market where everything hinges on different readings of a variety of ratios and metrics. What is high to the seller is considered low (enough) to the buyer in any transaction, so you can see how different conclusions can be drawn from the same market information. Because of the relative nature of the market, it is important to study up a bit before jumping in. The right price for you to enter would depend on the time frame you intend to invest, the rate of return you want and the amount and risk you are willing to commit. Its never the same for two investors. Its important to realize this. FOUNDATIONS FIRST
At the very least, you must know the basic measurements and its meaning such as book value, P/E , Market cap, support and resistance, all time highs , 52 week highs, 52 week lows , stock indices, volume, etc.. and understand what these figures mean. The more you learn, more youll find that the market is much more complex than a few ratios can express, but learning those and testing them on paper can help lead you to the next level of study. PATIENCE, PATIENCE. Lets assume that you decide to enter the market with a newly opened account, committing Rs 1 lakh to it. Its not necessary to start investing from day one. If you are in a bull market, may be youll have to wait 3 or 6 months until a correction unfolds. Its important to be patient. SHORT TERM AND LONG TERM. Short term is a really short period for most of the people. I have talked to many investors on this. To many of them, a short term is time frame of 3 to 6months and a long term is time frame of 1 to 2 years. If thats your idea about short term and long term, you need to correct yourself. A short term is generally referred to a time period less than 3 4 years and a long term is a time frame above 5 years. PROFIT CALCULATIONS If you buy a share for Rs 50 and sell it for Rs 65 , your profit from the transaction is not Rs 15, but an amount less than that. Thats because of the brokerage expenses involved in it. You must also consider the effect of income tax and inflation and calculate the actual profit you make, before taking a sell decision. More from stock markets The Diwali effect .. by J Victor on October 24th, 2011
For Indians world over, Diwali is the festival of lights and wealth. No doubt. Its a busy holiday shopping season. It also marks the beginning of the new fiscal year for many businesses in India. The whole nation celebrates the festival of lights with their families, with some flying off to distant lands on exotic vacations. But, there is one particular community that would still go to work in India Stock investors.They go and make token purchases to mark the beginning of their trading season. All brokers in India arrange special trading session called Muhurat trading. Muhurat Trading is a symbolic ritual which has been performed for years. The word muhurat essentially means auspicious. An auspicious time band is fixed and trading is carried out during this period. After worshipping Ganesha and Lakshmi, investors make token purchases during the session. Muhurat trading in the stock market happens for about an hour on Diwali day,usually, in the evening. . As Diwali marks the beginning of the New Year, it is believed that a positive start on this day brings in wealth and prosperity throughout the year.
Statistics show that the Indian stock market gets cracking during the Diwali festival. Though stock prices do not always move up before Diwali, the market has always recorded some gains on muharat trading session. Volumes on the Muhurat day have been rising every year over the last few years. The Muhurat session of 2008 saw NSE register a turnover of Rs 1,557 crore.This vaulted to Rs 3,806 crore in 2009. Last years Muhurat trade was a record with a turnover of Rs 4,200 crore and traded quantity of 2,390 lakh shares, with participation both by foreign investors and domestic institutions, though retail investors still traded the most volumes. Foreign institutional investors, believed to be absent in Muhurat sessions, actually did a turnover of around Rs 650 crore on the day. The Muhurat session of 2010 also saw the Sensex hit its all-time closing high of 21,004 points. The lesson: Use dips ahead of Diwali to buy stocks. The post-Diwali rally can be used to book some quick profits. However, in world stock markets, October and November are two of the most feared months. These two months have recorded the biggest upsets in world stock markets. It is the month in which the falls of Black Monday, Black Tuesday and Black Thursday occurred. Well, I dont want talk about great market falls now.
If you are a newbie who believes in Goddess Lakshmi,Get ready to welcome her. This is the right time . Diwali is dedicated to Goddess Lakhsmi, the Goddess of wisdom and wealth.Cascades of gold coins flowing from her hand suggests the wealth that may be in store for those who worship her. Gold embroidered red clothes suggests aggressiveness, boldness and prosperity. Jump start your investing season Positively. How does news affect stock prices? by J Victor on October 26th, 2011
News is something that affects stock prices. Whether youre a long-term investor or a short term investor, its important to review the news headlines periodically. There may be positive news, negative news or news to which market may not react at all. One has to be smart enough to decode the news and quickly grasp whether it will affect his stocks in anyway and if yes, the degree to which the news can have an impact. POSITIVE AND NEGATIVE NEWS.
News which is considered as positive tends to have a positive effect on stock markets and one can see share prices rising soon after the news come out in the open. Positive news such as a joint venture agreement, securing of new orders, healthy sales numbers, , discovery of huge oil reserves in a country, excellent financial results of a company etc should send a stock up. Stock prices react slowly but steadily to positive news. A curious fact that I have noted in some cases is that good news doesnt always translate to a jump in stock price; in fact, often the good news will produce a slight drop in a stock price. Why? Because unofficial news, also known as rumors, can have as much impact on stock prices as official news announcements. The stock market often anticipates these news stories and prices in its expectations accordingly. When those expectations are confirmed with actual investment news, the price may temporarily drop. Of course, the reverse applies, too: if rumors swirling around a stock arent proven true, investors may respond in surprising ways. If the surprise is a good one, stock prices can be driven upward as a result. Thats why its key to watch the investment news online and see how headlines influence stock quotes. Another point observed is that good news at home and bad news abroad can adversely push stock prices down. The international market is intertwined within the home market. Sometimes, all it takes is a bit of bad news from overseas to have a down market day. Negative news has more far reaching effect on stock prices and investor sentiment than positive news. Stock prices react very heavily to negative news that it may seriously stop average people from wanting to buy stocks. The sentiment of the market is also an important factor. In a largely negative atmosphere, the slightest bit of worrisome news is enough to send a stock tumbling. GOOD BAD NEWS.. There are some news which might seem negative at first but it isnt actually negative. For example, firing of CEO or top officials. This may sound very negative at first, but it does show that the companys board of directors was bold enough to take drastic actions to help the company in the long run. Another example is lay-offs in a company. This is usually good for the company and its stock price because expenses will be reduced significantly and quickly. This should help increase earnings right away. It is not always a major warning sign; it could just be a reaction to a slower economy. It is one of the quickest ways a company can cut expenses if sales have not been meeting expectations. STOCK BLOGS: Apart from news that comes in Medias like television channels and news papers which brings out the actual news , Blog is another category that influences stock market investors. The difference between a blog and other Medias is that a Blog is usually maintained by an individual with regular entries of commentary. Most of them contain opinions on a particular event along with the actual news. So just in case you are confused about whats going to happen in stock markets after RBI hikes interest rate or whats in store for apple after Steve jobs era, these are sources to know what the people think about it.Following some good blogs on stock markets would help you to understand economic events better. CONCLUSION The news has a direct impact on the market. It can change a bad day into a good one or a good day into a bad one. The relationship between the news and the market can be highly unpredictable by the best analysts. The next headline can turn out to be a boon or a bust. Good news will have a positive impact on stock prices Stock prices reacts to negative news quickly than it would react to a positive news. The good news locally can be overshadowed by the negative news across the globe. In a negative atmosphere, the slightest bit of worrisome news is enough to send a stock tumbling. The opposite is also true. To an extend, news effects largely depend on the reigning sentiment rather than the actual significance of the news. Just because the news is bad doesnt mean the stock market will have a bad day. News about the following affects stock markets: Crude Oil prices, IIP, Inflation, Unemployment, government policies, political unrest, draught or monsoon, company results, Global cues, FII activities, mergers and acquisitions , insider trading, bonus dividends and stock buy backs, stock splits, rights issue, inclusion or exclusion from indexes, change or death of top officials, loss of customers or break through deals, changes in demand and supply, fluctuations in prices of raw materials, war, terrorist attacks, joint ventures, rumors , new interventions etc.. How is a bonus issue different from a stock split? by J Victor on October 27th, 2011
Hi there , Most readers seem to have some confusion about whether bonus issue and stock splits are the same or not. They may appear to be the same especially in the eyes of a person not well-versed in finance. But they are, in fact, two different things. This article will help you to get a clear picture of the difference between the two. WHATS THE DIFFERENCE? Simply put- A bonus is a free additional share. A stock split is the same share split into two. Usually companies accumulate its earnings in reserve funds instead of paying it to share-holders in form of dividend. This accumulated reserve fund is then converted into share-capital and allotted to share-holders as bonus shares in proportion to their existing holding. So, Share-capital of the company increases with a concomitant decrease in its Reserve profits. Share-holders get bonus shares in compensation of dividend. But when a share is split, say, from Rs 10 denomination to Re 1 denomination, there would neither be an increase in the share capital nor a concomitant decrease in the reserves of the company. This is because while in a bonus issue a person having one share of Rs 10 face value would get another share of the same face value should the company go for a 1:1 bonus what would happen in a stock split is his one Rs 10 share would now be converted into ten Re 1 shares. WHY DOES A COMPANY ISSUE BONUS SHARES? One of the major reasons why companies declare bonus issues is that a higher number of shares improves float and liquidity and thereby traded volumes of the stock. A lower price also makes the stock seem more affordable to small retail investors, who might otherwise give it a miss at high price levels. Another aspect of a bonus issue is that it reflects the confidence of the company in its ability to service a larger equity base. Thus, bonus issues are said to be a good signaling mechanism on the companys capacity to deliver future benefits to shareholders in terms of increased dividend. Not all is positive with a bonus issue. In some cases, a bonus share ploy is used by companies to mask flagging performance and to perk up sentiment. For example, a company has an authorized share capital of Rs. 1,00,000. It has issued 10,000 shares with a face value of Rs. 10 each. Thus, its issued share capital is also Rs. 1,00,000.It has an accumulated reserve of Rs. 10,00,000. It decides to issue bonus shares in the ratio of 1:1 or 1 for 1 that is, 1 bonus share for each share held. In this case, it transfers Rs. 1,00,000 from its reserves to its authorized share capital. Thus, its reserves come down to Rs. 9,00,000, and its authorized share capital increases to Rs. 2,00,000.Using this new share capital of Rs. 1,00,000, the company issues 10,000 new shares, each having a face value of Rs. 10, and gives a new share the bonus share for each share held. Its issued share capital also goes up to Rs. 2,00,000. HOW DOES BONUS SHARE AFFECT INVESTORS? Immediately, It doesnt affect your investments anyway. Post the bonus, the share price should fall in proportion to the bonus issue, thereby making no difference to the personal wealth of the share holder. However, more often than not, a bonus is perceived to be a strong signal given out by the company and the consequent demand push for the shares causes the price to move up.So, when stock prices move up in the long run, there will be dramatic increase in the wealth youre holding. WHY DOES A COMPANY SPLIT ITS STOCK? The primary reason is to infuse additional liquidity into the shares by making them more affordable. It needs to be reiterated here that the shares only appear to be cheaper, though it makes no difference whether you buy one share for Rs 3,000 or two for Rs1,500 each. HOW DOES IT AFFECT YOU? It is like cutting an eight-inch pizza into 12 slices from four slices before. But if you want to buy the shares of a company which are frightfully expensive, you can now buy them for less. Except for that , in a stock split, fundamentals about the company does not change, the issued share capital remains the same, the revenue remains the same, and the profit remain the same too! But, since the number of shares issued increases, the profit per share (or the Earnings Per Share EPS) decreases by the same factor. So, if EPS is Rs. 15 per share for a share having a face value of Rs. 10, after a 10:1 stock split, the EPS would come down to Rs. 1.5. But since you would be holding 10 shares now, your share of EPS remains the same: Rs. 1.5 * 10 shares = Rs. 15, which is as before! So, if the PE of the stock is 20 in our example, the price would go down from Rs. 300 (EPS of Rs. 15 * PE 20 = Rs. 300 per share) to Rs. 30 (EPS of Rs. 1.5 * PE 20 = Rs. 30 per share). But again, since you would be holding 10 shares now, your actual holding remains the same: Rs. 30 * 10 shares = Rs. 300, which is as before! So, there is absolutely no change anywhere, except for the number of shares traded! WHY DOES MARKET CHEER STOCK SPLITS? Stock market interprets a stock split as a statement of confidence by the company it interprets a split as a signal from the company that it is confident about its future growth. Also, a stock split increases the number of shares traded in the market, which increases liquidity.These factors are considered positive, and therefore the market reacts positively! TAX IMPLICATIONS Bonus shares- As far as tax is concerned, since no money is paid to acquire bonus shares, these have to be valued at nil cost while calculating capital gains. The originally acquired shares will continue to be valued at the price paid at the time of acquisition. An incidental tax planning benefit is that since the market price of the original shares falls on account of the bonus, there may arise an opportunity to book a notional loss on the original shares. This is known as bonus stripping. The Indian Income-Tax Act has introduced measures to curb bonus stripping. Stock splits As far as the tax implications for stock splits are concerned, well, there arent any. A stock split, like a bonus issue, is tax neutral. However, when the shares are sold, the capital gains tax implications are different that what is applicable for bonus issues. Here, the original cost of the shares also has to be reduced. For instance, if the cost of the 100 shares at Rs 1,500 per share was Rs 1, 50,000, after the split the cost of 500 shares would be reduced to Rs 300 per share, thereby keeping the total cost constant at Rs 1, 50,000. CONCLUSION So, if you are an investor in the company, you have reason to celebrate when you get a bonus. But dont celebrate when your company splits stock. Its is just a technical change in the face value of the stock. But if you want to buy more shares, it is good news because now, you will be able to afford them or at least get them cheaper! Dividends vs Bonus by J Victor on October 28th, 2011
WHAT ARE DIVIDENDS ON STOCKS? When you buy a companys shares you expect that company to make a profit. The profit that company makes is then divided among the shareholders on a ratio proportional to the number of stocks one has. Dividend on stocks is therefore the proportion of a companys profit that it pays to its shareholders. This is usually declared as a dividend per share. Although a company makes profit, they are in no way obligated to pay dividends. Its the managing boards decision whether to pay or not. For example - If a company whose share price is Rs. 400, declares a healthy dividend of 60% (face value Rs. 10), the dividend paid would be Rs. 6 per share.( Rs 10 * 60%) and not Rs 240 (400 * 60%). The dividend yield in this case would be 6/400 = 1.5% Dividends are looked upon by the market at large as an important signaling mechanism determining the health of the corporate. Dividends are paid out of reserves and by paying dividend the company is distributing a part of its reserves amongst shareholders. However, there is a school of thought that considers dividend payouts as a waste of money. Fast growing companies are perceived to be much better off ploughing their profits back.. Equity dividends in India are tax-free in the hands of shareholders. WHAT ARE DIVIDEND PAYING STOCKS? Dividend paying stocks are shares of a company that pays regular dividend payments to its shareholders. These are good companies to invest in because even if the stock price was to go down, you still get a worthwhile return in your investment from dividends. Investors who follow the income investing strategy may have a portion of their investments in regular dividend paying companies. Some stock owners reinvest dividends, which allow them to buy more stock. That can lead to a great long-term strategy of dividends leading to you owning more stock, which leads to better profits over time. If you hold good quality, dividend paying stocks for decades and reinvest the dividend received yearly, that would finally accumulate into a lot of wealth than you could imagine. MAKING SENSE OF DIVIDENDS. When you hear a company announce its annual results and reward its shareholders with a 1000 per cent dividend , doesnt that look attractive? But dont get carried away. Companies declare dividends as a percentage of the face value of their shares, which may range from Re 1 to Rs 10. So a 100 per cent dividend on a Re 1 share is only worth Re 1 a share.Not all companies give away a chunk of their hard-earned profits to its investors.Some plough it back into business, to generate greater returns from business in the future. But even after having attained scale capabilities, some capex intensive companies are not known to reward shareholders. For instance, telecom major Bharti Airtel, inspite of operating several years in business, declared its first dividend to its shareholders only in 2009. What is face value?A companys capital is subdivided into shares.So if a companys capital is Rs 10 crore (Rs 100 million), that could be divided into 1 crore shares of Rs 10 each.If the company has divided its capital into shares of Rs 10 each, then Rs 10 is called the face value of the share. When the share is traded in the stock market, however, this value may go up or down depending on demand and supply for the stock. The value of a share in the market at any point of time is called the price of the share or the market value of the share. So the share with a face value of Rs 10, may be quoted at Rs 55 (market value higher than the face value), or even Rs 9 (market valuelower than the face value). Dividends are always declared on face value. WHEN IS IT PAID? Dividends are paid after the board recommendation is accepted by shareholders. So dividend payouts have direct effect on the cash balance of the company.While it is not mandated by the law to sustain dividend payouts, many companies make it a regular process to retain their value among the investor community.Dividends are seen as a harbinger of corporate prosperity, as it is the most popular route taken to reward investors.However, this does not imply that all companies that declare dividends may be on a sound business footing. You may need to run a few litmus tests to find out whether such dividends stand to gloss up your portfolio returns. Test 1. Dividend Yield. DY is calculated as the ratio of the annual dividend amount announced and the prevailing market price of the companys share. The dividend yield ratio shows what investors stand to earn on their shares. For example, lets assume that information technology majors Infosys Technologies and Wipro (whose face value is Rs 5 and Rs 2 respectively) declare their annual dividends, of 270 per cent and 200 per cent respectively. On the face of it, you might think that Infosys is better. But do not go by the mere percentage of dividend announcement since dividends are paid at face value of the stock. That is, for Infosys (face value of Rs 5) the dividend per share is Rs 13.50, whereas for Wipro (face value Rs 2) it is Rs 4.However, the dividend yield will be higher for Wipro (1.2 per cent) as its current market price is lower than that of Infosys (0.8 per cent). While analysing through high dividend stocks, you will also notice that the companies with high promoter holding declare dividends periodically. Apart from public sector companies, others such as Tata Consultancy Services, Sterlite Industries, Reliance Industries, Wipro and HCL, where promoter holdings are 45-75 per cent, declare dividends regularly. Test 2- Dividend coverage. This ratio measures the extent to which a companys earnings support its dividend payments.The dividend cover ratio tells us how easily a business can pay its dividend from profits. A high dividend cover means that the company can easily afford to pay the dividend and a low value means that the business might have difficulty paying a dividend. Heres the formula followed by an example. Dividend cover = Net profit available to equity shareholders Dividends paid to equity shareholders BONUS SHARES Bonus shares have been already dealt in the previous articles.Bonus shares issued by capitalizing a part of the companys reserves. Following a bonus issue, though the number of total shares increase, the proportional ownership of shareholders does not change. Also, post the bonus the cum bonus share price should fall in proportion to the bonus issue, thereby making no difference to the personal wealth of the share holder. However, a bonus is perceived to be a strong signal given out by the company and the consequent demand push for the shares causes the price to move up. As far as tax is concerned, since no money is paid to acquire bonus shares, these have to be valued at nil cost while making calculations for capital gains. WHY DO COMPANIES ISSUE BONUS SHARES? The issue shares allows the company to declare a dividend without using up the cash that may be used to finance the profitable investment opportunities within the company and thus company can maintain its liquidity position When a company faces stringent cash difficulty and is not in a position to distribute dividend in cash, or where certain restrictions to pay dividend in cash are put under loan agreement, the only way to satisfy the shareholders or to maintain the confidence of the shareholders is the issue of bonus shares. I By issuing bonus shares, the rate of dividend is lowered down and consequently share price in the market is also brought down to a desired range of activity and thus trading activity would increase in the share market. Now small investors may get an opportunity to invest their funds in low priced shares. The cost of issue of bonus shares is the minimum because no underwriting commission, brokerage etc. is to be paid on this type of issue. Existing shareholders are allotted bonus shares in proportion to their present holdings. Dividends and relevant dates by J Victor on November 1st, 2011
Hi there, We covered dividends in our last article Dividends vs bonus. The purpose of this article is to make you aware of the process of dividend payment and its effect on stock prices. There are five major dates in the process of a company paying dividends. These are: 1. Dividend declaration date, 2. Last Cum-dividend date 3. Ex-date, 4. Date of record or record date and 5. Date of Dividend payment.
EXPLANATION The first one, declaration date is the day on which the company announces to shareholders and to the market that the company will pay a dividend. The company communicates this decision to shareholders through notices to the stock exchanges and to the public and market participants through newspaper advertisements. Stock are bought and sold on daily basis. So who is eligible to get dividends? That question brings us to the second ,third and fourth dates. The date up-to which the shares can be bought in the stock market and be eligible to receive dividend is called the Last cum-dividend date. This date is fixed by the exchange. To determine which shareholders will be entitled to dividend payment a record date is set. The record date is the day on which the company looks at its records to see who its shareholders are. A person must be listed as a holder of shares in its records to have the right to receive a dividend from the company. If you do not own shares of, say, Infosys, but would like to buy the stock and be entitled to the dividend amount, you need to know when the last cum-dividend date and ex-date is. The ex-date usually precedes the record date by about two days. On or after this date, the shares of Infosys will trade without its dividend. That means, if you buy Infosys even one day before the ex-dividend date, you will still get the dividend. But if you buy on the ex-dividend date, you wont get the dividend. For example check the dividend declared link of moneycontrol.com at http://www.moneycontrol.com/stocks/marketinfo/dividends_declared/index.php .You can see the record date and ex-dividend date of various companies that have declared dividends. Thats also a huge archive to study the dividend history of companies. What happens if you actually buy on the ex-date? Whenever a company announces a book closure or a record date, the exchange sets up a No Delivery period for that security.During this period, trading is permitted in the security, but these trades are settled only after the no-delivery period is over.Therefore, although you may have bought shares before the record date, you will not be a shareholder on the records, as the shares would have still not been delivered to your account.Therefore, the buyer of the shares on or after the ex-date will not be eligible for the benefits. However, if you sell shares on the ex- date, you will still be eligible for dividends.The last one, the date of payment is the date the company sends out the dividend to the entitled shareholders. CALCULATING DIVIDENDS. Always remember that dividends are paid on the face value of the share and NOT on the market price of the shares. Thats one common mistake people make. Whats the difference between face value and market price of a share? This topic was also discussed in the last article.Face Value of a share is the value which is decided by the company issuing it, at the time of initial offering. Face value has nothing to do with market value of a share. Market value of shares changes depending on several conditions. Face value changes only when splitting takes place. EFFECTS OF DIVIDENDS ON STOCK PRICES From the dividend announcement date till the record date, the share prices keep moving up since investors buy into such shares to get dividends. But, Share prices fall on the ex-date. Why? Lets discuss with an example. Lets assume that Infosys is currently trading in the market for Rs 2500 per share. And lets further assume that the company decides to declare a dividend of 60 per cent with a record date of Monday, September 17. The face value of the stock of Infosys is Rs 5. This means the dividend works out to Rs 3 per share. Investors buy into the share to be entitled to the dividend. This could explain the spike in share price when a stock is cum-dividend (trading with dividend before the ex-date). However, the stock market sees the actual payout of dividends as the company giving up a part of its profits, thereby reducing its cash reserves. Also, since buyers on or after the ex-date are not entitled to the dividend, share prices drop by the amount equivalent to the dividend per share as a way of compensation.This is why Infosyss s hare price will probably fall by Rs 3 when the stock goes ex-dividend (without dividend). DIVIDEND INVESTING. Falling markets give little room for capital appreciation. However, this doesnt imply that investors cannot benefit during such a period. They can look at investing in companies that hold promise of rewarding them through dividends. In such a case, choosing the right company, with a good track record of growth, sound financials and history of dividend payment, becomes critical. The beginning of the new fiscal will usher in the annual dividend season. Beginning from the middle of April, companies will start announcing the annual dividends to the shareholders. So the period of March -April is the right time to look for some dividend stocks. It makes sense to focus on dividends which are also incidentally tax-free in the hands of the investor. In fact, a dividend yield of 6.5% is equivalent to 10% interest earned over a period of one year, which is a taxable income. Dividends are also more stable than corporate profitability. Most companies raise their dividend payout ratios during times of low profitability instead of cutting the dividends in tune with a decline in profitability. if we look back in history, a number of companies had a consistent dividend-paying record over the past 10-15 years regardless of the ups and downs in the business cycle. We also need to appreciate the fact that even the promoters of these companies depend on dividends as a source of their income.A company that has never missed a dividend pay-out in the past 10 years, have healthy operating cash-flows, comfortable debt-to-equity ratio and havent performed too badly in the first 9 months of the year is a good candidate for dividend investing. However, readers should note that the payment of dividend is at discretion of the company management and shareholders should not treat it as their right. Hope you are clear about dividends dates and its relevance. The two ratios that deal with dividends are dividend pay out ratio and dividend yield ratios. All these have already been explained in previous lessons. Understanding Rights Issue by J Victor on November 2nd, 2011
WHAT IS IT? A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing holdings. A rights issue is, therefore, a way of raising new cash from shareholders this is an important source of new equity funding for publicly quoted companies.
Legally a rights issue must be made before a new issue to the public. This is because existing shareholders have the right of first refusal (otherwise known as a preemption right) on the new shares. By taking these preemption rights up, existing shareholders can maintain their existing percentage holding in the company. However, shareholders can, and often do, waive these rights, by selling them to others. Shareholders can also vote to rescind their preemption rights. WHATS NOT GREAT ABOUT A RIGHTS ISSUE The shares do not come free of cost. A rights issue will need you to buy the shares. They do not come free. For shareholders the earnings per share will reduce since there are now more shares for the same earnings, and so will the dividends. Whenever a company comes out with a rights issue you have to evaluate it to see whether it makes sense for you to subscribe to it. Subscribe to a rights issue only if you really trust in the companys performance. Dont just buy it because you are getting it cheaper that market price. Try to find out why the company is coming out with a rights issue. If the company needs this to raise money for a sound business plan that will eventually increase the profits and share price, then it is good. You can choose to subscribe to all of the shares you are eligible for, or a part of them. WHATS GREAT ABOUT A RIGHTS ISSUE.. The good news is that the shares will be cheaper than the current market rate. When a company offers new shares via a rights issue, it is usually at a discount to the current market rate. What this means is that if the market price of the share is Rs 500, the company may offer the shares for Rs 450. So you get more shares at a cheaper rate than what you would get if you buy it from the market. Generally, when a rights issue is announced, the price will go up because investors now want to buy the shares so that they can avail of the rights issue. WHAT HAPPENS TO SHARE PRICES AFTER RIGHTS ISSUE? After the right issue is offered price of that particular stock falls in the stock market. It happens because the number of stock of that company increases in the market. Especially if the number of the right issue is relatively higher than the paid-up capital the price falls. Moreover the dividend yield and the PE ratio of that particular stock also falls after the right issue is offered. Theoretically the right issue does not give significant profit to the shareholders in spite of the fact that they get the stock in lower price. But in practice the shareholders always find the right issue an attractive option to buy the shares of the company. This is because the presume that the company is going to utilize the additional fund from the right issue for further development and expansion of the company that will eventually strengthen the financial standing of the company. To sum up - A rights issue has the following effects on the price of a stock. 1. Share capital gets increased according to the rights issue ratio. 2. Liquidity in the stock increases. 3. Effective Earnings per share, Book Value and other per share values stand reduced. 4. Markets take the action usually as a favorable act. 5. Market price gets adjusted on issue of rights shares. 6. Company gets better cash flow which may be used to improve the business and may help increase effective Earnings per share. 7. Usually a shareholder may not back out from applying for the rights issue unless the offer is almost same as the prevailing market price. This is because if a stock is trading at 100 and a rights issue in the ratio 1:1 at a price of 40 will make the stock trade at 70 soon after the ex-rights date. THE RECORD DATE. The company will make an announcement that it is offering the rights issue to all shareholders (those who own the shares of the company) on a particular date. This date is called the record date. After the rights announcement but before the record date, the shares are known as cum-rights. Even if you do not currently own the shares but if you buy them at that time, you will get the rights issue. On the record date, they become ex-rights. If you buy them after this day, you do not get the rights issue. The dates follow the same logic as discussed in our article on bonus shares. CONCLUSION Choose to subscribe for a rights issue only if its right for you Do not subscribe just because it comes at a lower price. You can exercise your right partially also How does interest rate affect stock markets? by J Victor on November 3rd, 2011
WHY SHOULD YOU KNOW ABOUT INTEREST RATES? Interest Rate in simple words means the cost of borrowing funds. It is the payment we make to the lender for the facility of using his money for our own purpose. Many times our spending decisions are also guided by the interest burden that we would be bearing.
But, more than the returns we should be concentrating on real returns on our savings (real return = interest rate- inflation). The real returns concept has been already discussed in our previous article titled Inflation. Even as consumers, interest rate is an integral part of our spending habit as we borrow from the bank for buying house, cars, house old items etc. For the business community interest rate is also very important as they borrow money from bank for investment activities like capacity expansion, setting up of plants, acquisitions, modernization etc. So interest rates play a critical role in a businesss profitability and hence, on stock prices. INTEREST RATES DECIDE WHERE WE INVEST. How many of us would invest in stock markets if our bank would pay 12% interest in fixed deposits? Many of us will prefer to deposit money in that bank than invest in stocks (as well as mutual funds). Why? Because, we have the opportunity to earn higher returns at very low risk. As a result, funds move out of stock market affecting the stock markets adversely. THE IMPACT OF HIGHER INTEREST RATES. After reading the above paragraph, some of you might have thought that it would be great to get a 12% risk free return annually. Unfortunately, thats not the case. If the bank is paying you 12% interest, it would have to charge its customers anywhere between 15% to 18% on their loans. (Customers here would mean anyone who borrows money from bank including big corporates, small and medium enterprises, farmers and individuals). This, inturn, will result in higher borrowing costs for them and thereby disturbs the overall profitability. A drop in profits would result in stock prices coming down.If interest rate continues to rise for a longer duration then it will have an all round negative impact on the economy, leading it into a recessionary mode. For example farmers who borrow money at higher interest rates to buy land, fertilizers, seeds, tractors etc would find it difficult to improve agricultural productivity to match up with the rising costs. Since agriculture is the backbone of Indian economy, high interest rate would act as a road block to the entire growth process. SHORT TERM AND LONG TERM IMPACT. In the short term: The immediate impact of rise in interest rate is on companies with high debt in their balance sheet .The interest payment made by them rises which reduces their EPS. Thus there would be negative sentiments for such stock; resulting into depleted stock price. In the long term- high interest rate would have more sector specific impact. The sectors which are most impacted by high interest rate is the real estate, automobile and all the capital intensive industries. So, any investment by you in these sectors must be taken with a lot of caution during the situation of high interest rates. So, definitely High interest rate is not the way to go about for the country. SO, WHAT ABOUT LOW INTEREST RATES? DOES THAT WORK? When the interest rate is very low, you would be obviously saving less and consuming more. The fixed deposits are no longer attractive. This would leave the banks with much lower money to lend out to the borrowers, and their profit margins would also be affected by lower interest rate. Thus there would be fall in consumption & investment activities in the economy. The government in this situation would resort to printing of currency to infuse more money in the economy. This would lead to inflationary situation in the country. Also,FIIs pace their decision on the basis of difference in interest rates between economies among other things. At very low interest rate the inflows are likely to be reduced. So, what a country like ours needs is a balance between high and low interest rates. Interest rates cant go high and it cannot be very low. A moderate inflation & interest rate over a period of time will keep the banks, business community and the consumers happy. REPO RATE AND REVERSE REPO RATES. Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money is in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to attractive interest rates. It can cause the money to be drawn out of the banking system. RBI, using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man. BASIS POINTS. A basis point is one hundredth of a percentage point (0.01%). Basis points are often used to measure changes and differentials in interest rates rates of return, and other percentage-based performance metrics that can occur as fractions of a percent.. Basis points are used to mention changes in interest rates because percentage changes are often small. When changes in interest rates are quoted in basis points, it is always understood this indicates an absolute change in the rate. This avoids the ambiguity that arises when changes in interest rates are quoted as percentages. To illustrate, if an interest rate were 5%, and we were told the rate rose one percent, it wouldnt be clear whether the change were absolute, rendering a new rate of 5% + 1% = 6% OR relative, rendering a new rate of 5%(1 + .01) = 5.05% If instead we were told the rates are up 100 basis points, we would know the change was absolute and that the new rate must be 6%. So, One basis point is one-hundredth of a percentage point. 25 basis points is 0.25%. INTEREST RATES AND STOCK MARKETS. Having explained so far, I know you would have already guessed about the relation between interest rates and stock markets. They are inversely related. As the interest rates go up, stock market activities tend to come down. The following points are also worth taking note- Capital intensive industries would be most affected by high interest rates but when the interest rates are lower they would be gaining the most. It is better to avoid investments in sectors such as real estate, automobiles etc when the interest rates are rising. Companies with a high amount of loans in their balance sheets would be affected very seriously. Interest cost on existing debt would go up affecting their EPS and ultimately the stock prices. But during low interest rate these companies would stand to gain. Sectors like Pharma and IT are less affected by interest rates. The IT sector is more influenced by factors such as currency rate fluctuations, rising attrition level, visa restrictions, competition from the large global players and margin pressures. Certainly, IT sectors are not interest rate- sensitive. Pharma is considered as the defensive sector and investors can invest here during uncertain and volatile market conditions. In a high interest rate scenario, companies with zero or near zero debts in their balance sheets would be kings. FMCG or fast moving consumer goods is one sector thats considered as a defensive sector due to its low debt nature. Banking sector is likely to benefit most due to high interest rates. The Net Interest Margins (It is the difference between the interest they earn on the money they lend and the interest they pay to the depositors) for banks is likely to increase leading to growth in profits & the stock prices. So thats about interest rates and stock prices.. How do FI investors affect stock markets? by J Victor on November 4th, 2011
WHO ARE THEY? FIIs are Foreign Institutional Investors. A term that is commonly found whenever theres a discussion on stock markets. FIIs are entities (banks, insurance companies, mutual funds etc) registered in a country other than in which they are investing. For e.g. a US Mutual Fund which invests in the Indian Stock Market. FIIs usually pool large sums of money and invest those in securities, real property and other investment assets. As bulks of their investments are in the stock market, the inflow or outflow of money by FIIs affect the stock market movement significantly. If you follow financial dailies, you are bound to see headlines such as FIIs remained net buyers. Net buyers implies that foreign investors poured more money into the stock market than they took out, which is generally seen as a positive development as far as our economy is concerned.
In India, Foreign Institutional Investors are not permitted to invest in equity issued by an Asset Reconstruction Company. They are also not allowed to invest in any company which is engaged or proposes to engage in the following activities:- Business of chit fund, Nidhi Company, Agricultural or plantation activities, Real estate business or construction of farm houses (real estate business does not include development of townships, construction of residential/commercial premises, roads or bridges).Trading in Transferable Development Rights (TDRs). FIIs VS FDIs. FDI is defined as investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. Examples of FDI would include POSCO setting up a steel plant in Orissa (in-bound FDI), Tata buying Arcelor (out-bound FDI) and so on. ARE FI INVESTORS BENEFICIAL FOR OUR ECONOMY? The presence of institutional investors has its own plus and minus points. On the brighter side FIIs always purchase stocks on the basis of fundamentals. And this means that it is essential to have information to evaluate, so research becomes important and this leads to increasing demands on companies to become more transparent and more disclosures. This will lead to reduction in information asymmetries. The increasing presence of this class of investors leads to reform of securities trading and transaction systems, nurturing of securities brokers, and liquid markets. FII inflow increasing every year will bring the very welcome inflow of foreign capital. Attracting foreign capital is the main reason for opening up of the stock markets for FIIs. If FIIs are investing huge amounts in the Indian stock exchanges then it reflects their high confidence and a healthy investor sentiment for our markets. They have improved the breadth and depth of Indian markets. FII inflows help in financial innovation and development of hedging instruments. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals. FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets On the Flipside- There are always some dangers if certain limits are exceeded. Firstly, the foreign capital is free and unpredictable and is always on the look out of profits.FIIs frequently move investments, and those swings can be expected to bring severe price fluctuations resulting in increasing volatility.Infact the FIIs are greatly responsible for causing volatility in Indian market. Increased investment from overseas may shift control of domestic firms to foreign hands. The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the countrys stock markets and thus have great influence on the way the stock markets behaves, going up or down. The FII buying pushes the stocks up and their selling shows the stock market the downward path. This creates problems for the small retail investor, whose fortunes get driven by the actions of the large FIIs. FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive. FIIs EFFECT ON STOCK MARKETS. While analysing a stock, the percentage of FII holding is an important factor to be noted. When % holdings of FIIs increases in a stock its stocks price goes up and when it drops, its share price comes down. However, readers should not take that as a negative remark. If an FII invests in a company, it also means that they see growth potential in that company. If the number is too large then its easier for the individual entities to move out of a stock which would make stock price of the company very volatile and risky. So, investing in a company which has smaller number of FIIs could be a safer investment option. A fundamentally sound company which has a consistent and stable FII shareholding would be an ideal candidate for investment. When some FIIs exit from a good stock, its price actually falls thus giving a good chance to invest in it. However be sure to check the reason for the FIIs exiting the stock. If it is due to change in the fundamentals of the company, it is a negative sign. How does IIP data affect stock markets? by J Victor on November 6th, 2011
WHAT ARE IIP NUMBERS? IIP- index of industrial production is a measurement which represents the status of production in the industrial sector for a given period of time compared to a reference period of time. IIP number is one of the best statistical data, which helps us to measure the level of industrial activity in Indian economy. It is a short term indicator. It is useful to guage the rate of industrial growth until the actual results from the annual survey of industries are published. IIP data is broadly divided into three segments manufacturing (79.36%), mining & quarrying (10.47%) and electricity (10.17%). Another way of categorizing the items used in the calculation of IIP is a Use based classification with categories like Basic Goods, Capital goods, Intermediate goods, Consumer durables and Non-consumer durables. The IIP index reflects the growth in Indias industrial activity and excludes all kinds of services ( for example banking sector). The base year for the index over the period of the analysis is 1993-94 and it includes items whose gross value of output is at least Rs 80 crores and Rs 20 crores at gross value added level. The products included are the ones used on consistent basis and can comprise of small scale sector as well as unorganized production sector. WHEN IS IT PUBLISHED? Usually IIP number of a particular month would be published after two months. The date of publishing IIP numbers are usually between 11 to 14 th of a month. As IIP shows the status of industrial activity, you can find out if the industrial activity has increased, decreased or remained same. IIP AND STOCK MARKETS. The reduced consumer spending leads to lower demand situation. The producers respond by cutting down on the production. Low industrial production results in lower corporate sales and profits, which directly affects stock prices. So a direct impact of weak IIP data is a sudden fall in stock prices. A continuous fall in overall IIP data may lead to many fundamentally strong stocks being undervalued. This gives you the perfect opportunity to invest in fundamentally strong companies at discount price. Growth in IIP numbers are good signs for cement and steel industries. Mining Sector contributes approx 10% to the IIP. Growth figures can tell us in advance about how mining and steel companies are going to fare in coming quarters. The IIP data is purely industrial data. Banking sector is not included in it. But, increase in production & investment activity is usually financed through borrowings from banks. So, if industrial production & capital spending is increasing then it is likely to have a positive impact on the banking sector. A lower IIP data can affect banking industry adversely. You need to check the reason behind the increase/decrease in IIP figures before investing. Though IIP does indicate the condition of the countrys economy, it should not be taken as the sole basis for investment. This is because some sectors may show higher performance as compared to others. This was evident in the recent past when realty sector showed higher performance, pharma sector lagged behind. PROBLEMS WITH IIP NUMBERS. A major problem with the IIP data is its outdated base year 1993-94. Its product basket of 543 items is no longer representative considering the dramatic transformation of the economy and the consumption behavior of the people in the post-reform period. Some of the old products have gone out of use and many new products have come into the market over the past decade and a half. There is very little representation of the products manufactured by the micro, small and medium enterprises which account for about 45 per cent of the total industrial output in the country and 40 per cent of exports. Hence the IIP numbers fail to capture the actual trends in this sector. Another drawback is that the data are revised, reclassified, challenged by industry associations and found not in tune with the Annual Survey of Industries. However, IIP data is something that investors need to keep track. Indian stock markets are very sensitive to IIP Numbers. A better IIP number would show a positive growth on our Industrial production and share markets would possibly cheer. Pledging of shares -A must check. by J Victor on November 9th, 2011
Hi there, In our last article we talked about analysing the shareholding pattern of the company and its significance. In this article, we look at one more aspect connected to it-Pledging of shares by promoters. For example, the promoters of the company may hold 60% of the shares, but what if all those shares are pledged with a financier as collateral for getting additional loan funds? Thats a dangerous situation. WHY ? Promoters, in order to raise funds for either personal or company needs, pledge their holding shares to any financial institution. Non-banking financial institutions are more active than banks in providing such loans. Sometimes, promoters collateralize their shares for converting warrants into shares. Also, they might find share prices in the secondary market quite lucrative for fresh purchase and adopt this route for garnering funds for the consideration to be paid for open market purchase. So there are lots of reasons why promoters pledge their shares. Generally, pledging shares is not a good sign.
As a general rule, if promoters raise the money for the betterment of the business, investors should take it positively but if the money is raised for any personal needs, it imparts negative signal. Even if the funds are raised for improving the business it indicates a liquidity problem. WHAT DOES PLEDGING INDICATE? Low credit-worthiness of the company Businesses need money to grow and invest in resources. The most preferred ways to do this is to go for debt or equities. Going for equities is not a frequent event and hence most of the companies need debt to finance their business expenses. However, some companies do not have enough credit worthiness to secure required debt for their needs. Hence pledging shares is the only way to get loan. High debt in the company Companies do not get further debt if they already have high debt in their balance sheet. This could be a reason for companies to pledge the share against loan. A high debt in the balance sheet will increase the interest expenses of the company. Hence major part of the profit will go towards paying the debt holders, leaving very little for shareholders. This will hurt investors in two ways. First, it may eliminate the option of dividends completely. Second, because of low earnings per share, the stock price appreciation is also less. Its even more dangerous in a falling market. Bankers or financiers give loan taking the shares as collateral. When the market is in bull phase, pledging doesnt create issue because promoters can count on rising value of their stake. Banks too do not mind lending against shares because of rising value of shares as collateral. The problem occurs when the market enters in a bear phase. whenever the prices of shares come down to a certain level in the secondary market, the promoter is required to either make some payment or pledge more shares. If the promoter cannot do either, the lender keeps the right to sell pledged shares in the market. Apart from this, promoters always have the risk of a hostile takeover. NBFC`s -The preferred lenders: Under Section 19(2) of the Banking Regulation Act 1949, it is provided that no banking company shall hold shares in any company whether as pledgee, mortgagee or absolute owner of an amount exceeding 30% of the paid-up capital of that company or 30% of its own paid-up capital and reserves, whichever is less.So, NBFC`s or other lenders are preferred by promoters as lenders as such loans will give them greater flexibility. WHERE TO GET THE INFORMATION? Before the Satyam debacle, there were no disclosure norms made by SEBI (Securities and Exchange Board of India) for promoters to disclose their pledged shares. But post satyam, disclosure regarding Pledging of shares by their promoters has been made mandatory by the Securities exchange board of India. Sebi has asked promoters to disclose details of pledged shares if the same exceeds 25,000 shares in a quarter or 1 per cent of the total shareholding or voting rights of the company, whichever is lower. WAYS TO HIDE THE INFORMATION. Many promoters are uncomfortable with their share-pledge details put in the public domain due to the stigma attached to such information and the attention it draws from short sellers. In order to keep such borrowings away from the market glare, a promoter often parks a slice of his holding which is to be used to borrow into a separate demat account and creates a negative lien on it. Its a mechanism to ensure the shares cannot be pledged or sold to anyone else. Non-banking finance companies (NBFCs) and finance arms of brokerages lend against such an arrangement. Another transaction to circumvent the rule is to transfer some of the shares to a special purpose vehicle (SPV) controlled by the promoters or members of the promoter group, and raise money by pledging shares of the SPV. Its also common to give lenders power of attorney that can be exercised to sell shares if borrowers default or certain triggers are breached. Often these are arrangements entered into between the borrower, the brokerage and the NBFC arm of the same brokerage. CONCLUSION Pledging shares by promoters is generally not good for investors. However, investors should be careful about the rumours. There could be vested interests in the market that spread rumours about companies and their promoters pledging shares. This happens when the market is already beating down a company because of this. Investors should use the sources available to know about companies and promoters pledging their shares. NSE website is good source of information. Important dates for Indian stock investors. by J Victor on December 1st, 2011
Hi there, This article takes you through the list of dates that are relevant for indian stock market investors.For Indian markets, the most important dates are : 1. FIRST MONTH OF EVERY QUARTER April, July, October and January. Its the time when the quarterly results of companies come out. Companies that are expected to come out with strong financial results see a bounce in their share prices. Short-term investors can take advantage of this trend by buying into shares in the last month of the quarter such as December or March. If you are wondering how to pick up those shares, the figures given by various companies during the last quarter, the expectations of the management for the next quarter, news that circulates around about the company and the mood of industry in general all these factors, if closely followed up, can give you clues. 2. LAST WEEK OF FEBRUARY - Thats when the union budget presentation happens. Companies expected to benefit from the provisions of the Budget see their stock prices moving up ahead of the Budget-Day. Investors can buy into such stocks for short term profits. A general follow up of the pre budget discussions that goes around in channels and new papers should serve as a quick guide to get clues. 3.DIWALI
Muharat trading, as we all know, has always recorded gains for investors. Read more about muhurat trading here 4. INDUSTRY SPECIFIC DATA-
Some industries release sales report at the end of every month. These reports cause variation in the stock prices. Notable among the industry reports released at the beginning of every month are automobile industrys monthly sales reports and cement industrys dispatch numbers. These numbers would give guidance on the growth trajectory of these industries o 5. RBIs REVIEW DATES- Banking stocks are affected by the Reserve Bank of Indias Credit Policy. Moves by the RBI to tweak interest rates or liquidity always affect banking stocks. The RBIs Annual Credit Policy is announced in April. The Mid-Term Review of the Policy is announced in July, October and January. o 6. GDP DATA Published quarterly . Generally there is a 1 to 1.5 months lag . So data for the 1st quarter will be available by the mid part of the second quarter and so on . o 7.INFLATION and IIP data. Both these figures are published by the government for every month. The relevance of Inflation and IIP data have been already discussed in previous articles. o 8.WPI OR WHOLESALE PRICE INDEX. The Indian WPI figure is released for every week with least time lag. It gives an idea of the week-to-week fluctuations in the prices of all the traded commodities in the country as a whole.The Wholesale Price Index focuses on the price of goods traded between corporations, rather than goods bought by consumers, which is measured by the Consumer Price Index. o 9. LAST THURSDAY OF EVERY MONTH Thats the time when the derivative contracts expire in Indian markets. Generally stock markets witness heavy volatility on derivatives expiry. Depending on the situation, market may move up or down.The reason for such volatility is due to the cash settlement mechanism of futures contracts and position adjustments by market makers. o 10. DIVIDEND DATES Although no particular date is fixed for dividends, the dividend declaration date and record date are important dates to be watched. More on dividend dates here. o 11. U.S ECONOMIC DATA RELEASE DATES The economic and statistics administration of US releases 12 monthly reports. Global business community rely heavily on these indicators to take business decisions. Since the Indian markets are influenced by the economic conditions in the west, these dates are also important. Main among them are US GDP data published every quarter, Manufacturers shipments , inventory and orders data published every month, Inflation data and employment data released by the US department of labour. So apart from financial analysis and stuff, Keep track of these dates. It might just give you a chance to pick up a wining stock. Circuit breakers by J Victor on December 17th, 2011
Hi there.. As you would have observed , stock prices can move up or down due to a number of reasons. For example earnings results, government policies, trends in the industry etc. Such prices movements are reasonable and logical. But in some cases, stock prices may move up or down drastically, accelerated mostly due to fear or greed by speculators and manipulators. Such movements are harmful for the stock markets. In order to control such heavy price fluctuations, stock exchanges have a system called circuit breakers, something that works similar to the electricity circuit breakers that we have at home.
Circuit breakers were first introduced in the trading system of Indian stock exchanges back in 1992 at the BSE. There are separate circuit breakers for the indices and individual stocks. These control systems ensure sanity of the stock market and protects investors. These are also called circuit limits or price bands. HOW DOES IT WORK? When the volatility of a stock breaks a certain limit as decided by the exchange, trading in that stock is stopped for some time. The limit is fixed as a percentage of the stocks price by the stock exchange. The rules for circuit breaking are decided by the Securities exchange Board. For example if the regulators decide that the circuit limit for a stock is 15%, then, trading in that stock will be halted for the day, if the stock price moves up or down 15% in one day. CIRCUIT LIMITS FOR SENSEX AND NIFTY There are 3 circuit limits for indices 10%, 15% and 20%.Circuit filter is applied to Sensex or Nifty whichever is breached first. The trigger of circuit limits also depends on the time at which it occurs. 10% movement in either direction If the movement is before 1 pm 1 hour halt If the movement is after 1 but before 2:30 pm half an hour halt If the movement is after 2.30 pm no halt 15% movement in either direction After the above mentioned halts, trading starts again. If the market hits 10% again, there will not be any halts, but if it breaches 15%, circuit limits comes to play again. If the movement is before 1 pm 2 hours halt If the movement is after 1 pm but before 2 pm- 1 hour halt I the movement is after 2 pm no further halt. 20% movement in either direction On resumption, if the market hits 20%, trading will be halted for the day. The above percentage is calculated on the closing value of the Sensex or the Nifty on the last day of the immediate preceding quarter. So, for deciding the circuit limit for the Jan-march 2011 period, the closing value of the bellwether indices on December 31, 2010 would be used. WHAT HAPPENS TO ORDERS DURING CIRCUIT LIMITS? If the market hits the upper or lower circuits, trading is halted and you cannot place orders until the market re-opens If you have pending orders with the broker at the time of circuit break, such orders can be modified or cancelled only once the trading re-opens. CIRCUIT LIMITS FOR INDIVIDUAL STOCKS. Stock specific circuit filters are applied in both BSE and NSE index; the percentage for circuit filter limit is 2%, 5%, 10%, 20%. Not all stocks fall in the circuit limit category. There are stocks to which circuit limits are not applicable. For newly listed companies, there is a circuit limit of 20% from the issue price. Thats about circuit limits.. Insider trading by J Victor on February 21st, 2012
INSIDER. Any person in power He could be a director or an officer or anyone connected to the company Who has access to sensitive information relating to the company PERSONS CONNECTED WITH THE COMPANY These includes directors, officers, employees who have access to such sensitive information, other professionals like Merchant banker, share transfer agent, registrar to an issue, debenture trustee, broker, portfolio manager, Investment Advisor, sub-broker, , employees of the Board of Trustees of the Mutual Fund etc who are people connected with the company. It also includes temporary insiders like lawyers and auditors. Relatives of these connected persons are also considered in the same category. INSIDER TRADING When an insider, using his position and power in the company, collects price sensitive unpublished information and passes it out to his friends, relatives or known persons for the purpose of making money from price changes, such an act is generally called insider trading.
price sensitive information includes proposed expansion plans of the company or major disposal of a part of business, main contracts that are negotiated, proposed changes in share holding pattern, senior management, dividend policy, financial results, amalgamations , potential litigations etc LEGAL OR ILLEGAL? Generally the term is used in a negative sense. But not everythings negative with insider trading. When corporate insiders buy and sell stock in their own companies and informs the same to the securities exchange board of India, the same becomes a legal transaction. Information on legal insider trading can be found on the websites of BSE and NSE. It perfectly legal for a companys insider to sell or buy shares. To an extent, such published information on insider trading may provide us with some hints on price movements. For example If the management is increasing its stake in the business, it could mean that the management is bullish about the future prospects of the business. It becomes illegal when the motive behind the insiders is to make money from secret informations thats passed on to them by the insiders .For example The CEO of a company knows that the company is not going to report high profits as expected in the year and passes this tip to his friends who, in turn, sells off their investments in the company. Thats an illegal transaction all together. But how to find if a transaction is illegal insider trading is a very tough one. The line that separates between a legal and an illegal insider trade is quite thin. WHO CONTROLS? In India, The SEBI. The Securities Exchange Board of India has framed strict rules The SEBI (Prohibition of Insider Trading) Regulations, 1992 amended from time to time sets stringent norms regarding illegal insider trading. It prohibits insiders who buy or sell any number of shares of the company from entering into an opposite transaction, i.e. sell or buy any number of shares during the next six months following the prior transaction. For example if an insider has bought 1 lakh shares in company x, he shall not sell the same before 6 months. If a connected person subscribes to an IPO, he cannot sell his holdings for 3 months. All insiders are also prohibited from taking positions in derivative transactions in the shares of the company at any time. Through the SEBI (Prohibition of Insider Trading) Regulations, 1992 the SEBI tries to ensure that the innocent investors are protected. Heres the link to information regarding insider trading on the BSE site. What is Rajiv Gandhi equity savings scheme (RGESS)? by J Victor on January 27th, 2013
The union budget 2012-13 introduced this equity savings scheme with a view to promote equity investments among people and to promote the scheme, will allow a deduction of 50% of the amount invested subject to a maximum of Rs 25,000. The deduction is claimed through a new section introduced in chapter VI A of the income tax Act, called the 80CCG. The investments can be made in installments throughout the year or in a lumpsum and it should be made after 23 rd
November 2012- the date on which the scheme came into force. Schemes similar to RGESS were earlier introduced in Belgium and France which had positive results. In France, the implementation of a similar scheme resulted in public participation in retail trade which increased from 7% to 17%.The scheme is introduced in India with the same objective to promote equity investment among freshers. That means, only first time investors will get the twin benefit of equity investing and tax exemption. One more condition that has been attached to this is that the new investor should not have an income before tax deductions that exceed 10 lakhs in a year.
From the governments side, the benefit of this scheme is that it would improve the depth and liquidity of our equity markets. More savings would be channelized into the market which will improve common peoples perception about the stock market as something very dangerous. So its a win-win scheme. Both the government and the investor has benefits from it. Concerns: An investment of Rs 50,000 results in a deduction of Rs 25,000 from the taxable income. This in effect, means that the investor will get a maximum tax saving of Rs 5,000 in a year, assuming that he falls in the tax bracket of 20% under the Income Tax Act. Now, the big question is equties are inherently risky investments. Its a field where only expert investors can make money. However, the exemption is for new investors who may not know the basics of investing. Would it be worth for such a new investor to open a demat account and make such a high investment even before knowing what to buy? Even if someone manages to quickly learn all the basics and make an attempt to invest, would it be worth to take a risk of Rs 50,000 for getting a tax benefit of Rs 5000? The answer would depend from person to person , we guess.May be those who have already exhausted 80C limits may prefer this scheme. Equity investments. For the purpose of the scheme, equity investments do not have the broad meaning as understood by all of us. Here equity investments means: Investments in shares of companies that are included in the BSE-100 or CNX 100 or equity investment in the PSUs which are categorized as the Maharatnas, Navratnas orMiniratna by the central government. Investments could be done right now by purchasing shares or ETFs / mutual fund schemes which invests in stocks approved by the RGESS scheme. Equity shares can be purchased from the secondary market or it could be done on a follow on public offer or an IPO of eligible PSUs. An investor can also opt to invest in new fund offers of eligible mutual fund schemes. The Stock exchanges are directed by the SEBI to furnish list of RGESS eligible stocks / ETFs / MF schemes on their websites. The details of qualified equity investments are now available on the BSE and NSE websites. So basically, equity investments are allowed only in a certain category of stocks / mutual funds and not in all types of small caps and speculative stocks. The reason is that top corporates and PSUs are relatively safe when compared to others. Relatively safe in the sense that for such stocks, the volatility is lower, the liquidity is high and adequate information is available for research. Such a condition is introduced for protecting the interest of the new investors. Eligible Equity investor. The scheme offers tax soaps only to new equity investors. A new equity investor is someone who has not done any trades in the equity or derivative markets on or before 23 rd November 2012. The logic is that, 23 rd November was the date on which the scheme came into force. So, that date has been fixed as the cutoff date. The scheme says that no investments / trades should have been entered into by a first holder on or before 23 rd November 2012, but does not mention the date on which the trading and demat account should be opened. So , that means- Even if you have an old demat account in which you have not bought even a single stock or derivatives before 23 rd November 2012, you are still eligible to be counted as a new equity investor and, Even if you are the second holder of an existing demat account in which trades have been made, you can still avail the benefit by becoming the first holder of a fresh demat account opened in your name. Any other conditions? Yes. There is a lock in period. The investment should be held of for a minimum period of 1 year. You cannot sell / pledge the shares/ mutual funds for 1 year. This 1 year period is also called a fixed lock in period. After the completion of 1 year fixed lock in period, the lock-in extends to 2 more years, which is known as the flexible lock-in period. During the flexible lock in period, the investor can trade in the RGESS eligible securities, subject to certain conditions. The conditions is that , the investor should maintain the value of investments at the amount for which they have claimed income tax benefit or at the value of the portfolio before initiating a sale transaction, whichever is less, for at least 270 days in a year. This process of maintaining the value of the portfolio may be a bit complicated for new investors. Summary of the scheme: Its Only for new investors in equity markets Annual income should be less than 10 lakhs Maximum exemption is Rs 5000 Fixed lock-in period of 1 year and flexible loch in period of 2 years. Valuation of shares Finding shares to invest. by J Victor on January 4th, 2012
Hi there, In this series of posts, Im starting the topic of valuing shares, a very subjective topic. There are many procedures commonly used by investment analysts to estimate the price at which a stock can be purchased. Values can be ascertained based on assets that the company holds or the cash flow its expected to generate. Values can also be ascertained by comparing certain ratios like P/E to similar shares in the market. Some methods are not for all- they are complicated and require expert knowledge in finance and accounts. Some are relatively easy, within the reach of everyone.
The absolute value obtained by different methods would be different but all results will fall within a price range. So, whats more important is to stick to any one valuation method you are comfortable with, and keep trying on it until you really become an expert in it. All valuation methods have its plus and minus. No one valuation method is perfect in all aspects. Whats important is to get to that price range which informed investors would prefer. In any case, the first step is to short list a set of companies worthy for analysis. You cannot value all the 7000 plus stocks listed in the stock exchange and then decide which stock to buy and at what price. So, from practical point of view, some smart moves are required to spot a stock worthy for further analysis. How can you use the resources around you to find companies worth investigating further? Thats the first question Ill try to answer. The second question is- whats the general nature of the stock selected? Does it exhibit growth every year? Is it a consistently dividend paying company? Or is it a company that pays increasing dividends? Or is it a company that pays no dividends at all? You should get the clues from historical data. The final question to be answered is Whats the reasonable price at which you can buy that particular stock? The answer is- there are no hard and fast rules or formulas for finding the correct price to buy stocks. In fact, there is no correct price at all. What these methods would reveal is a price range which you can consider. Whether you enter at the high or low end of the price range is a matter of holding on to your nerves. Different tools and indicators exist which can be used to form your own opinion about the quality of the stock, the reasonable price at which it can be bought, the risk of buying at that level and the expected returns for taking the risk. In the articles to follow, what I would attempt is to bring together some scattered ideas some practical tips, some theories and principles which you can use to spot good stocks, make investing decisions and thereby increase your odds of success. GETTING THINGS RIGHT. In my opinion, the key to successful investing is to buy a great stock, at a reasonable price, at the right time from the right sector- not by relying on a single factor like P/E, but by considering all the available factors. These include Historical performance Fundamental analysis Qualitative aspects, future prospects Reasonable future estimates. Expected risk & Risk premium (is there anything left? ) Yeah, its solid research Im talking about. Its your hard earned money. You just have to do all the hard work before investing that money. More you work, more you are likely to end up making money. The more reckless you go, more money-less you become. After stitching together all the factors, you should be able to fix a price range for the stock. Once the price range is fixed, investment decisions are made by comparing it with the market price of the stock. till my next post .. Bye.. End note: some readers have confusion between valuation of shares and value investing. Valuation of shares is an attempt to find what the stock is worth. Value investing is a strategy of investing below the book value. The process of Valuation may result in finding value shares, growth shares etc.. Qualities of a good investor by J Victor on January 5th, 2012
Having given an introduction about valuation, and before I discuss more on the topic , I would like to talk about the qualities you may have to develop before embarking on a mission to value stocks. I know, most of you would be of the opinion that this is a very silly post. Id put it this way whats easy and silly is easy to miss ! What many beginners miss are those very simple basics.Since im primarily writing this for beginners, I think I have to say these points. so heres a list of traits you got to have : First and foremost Patience. Valuation is not an easy process. It may take a day or it may take months to analyse a stock. Academic interest in the subject- You must do real research. You have to study a lot before investing. Memory If you can remember a time when the business conditions were similar to this one, then you can go back and determine what happened to stock prices. For instance When recessions hit, what happened to IT companies? Faith- Have faith in your decisions. When you buy or sell or hold a stock, you must be confident that youve done your homework and must be lest affected by the rumors that are going around. Courage The stock markets may sometimes seem illogical. After all the research, the stock you invested in may defy all your analysis and crash in a way that may result in wiping off half of your portfolio. An investor should have the courage to survive such market gyrations. Business-mindedness value of a business should be decided according to how it is performing and not from what someone else is willing to pay them for it. Some investors justify high prices of shares and argue that there will be a bigger fool to whom they can be sold. Investing with such expectations is akin to gambling. Positive mind- Mistakes are inevitable in every investors life. But, all that hard work will pay off at the end. To earn a return, they need to think positively and must take calculated risks. Perseverance Understanding the basics of company valuation may take several months. Mastering valuation takes decades. It depends from person to person. Youll will make many mistakes in your early attempts but persistence will lead to fewer and fewer errors. Independent thought investors who are influenced by short-term price movements, or what others are doing, usually find it difficult to value shares independently. Sources to pick stocks for valuation. by J Victor on January 10th, 2012
The most practical issue for a beginner is to find out potential companies that are worth investigating. There are more than 7000 listed companies in the Indian stock exchange and its definitely a daunting task. Although, later, you may be a totally independent stock picker- free of all biased views- in the initial stages, one has to make some smart moves to find sources from where he can pick stocks for analysis. Thats my opinion. SOURCES TO PICK STOCKS. 1.Indices: One method to find companies is to locate them from the indices. These include General indices like Sensex, and nifty, Capitalization wise indices such as mid cap index and small cap index, Sector wise indices like Bankex , auto, reality etc.. A stock is included in the index only if it meets many quality criteria set by the stock exchange. For example, if you are trying to spot a blue chip stock, better select a company that has been included in the index. This gives you a reasonable assurance that the company is worth in a particular sector and that it is a company that complies with all the legal requirement set by the SEBI and the stock exchange.
This is a smart way to start. Its not fool proof-for example satyam computers was a Sensex stock at the time when the scam broke out. Those can be considered as exceptional cases. 2. 52 week lows: A second source is to locate those companies from the 52 week lows list. But, here you have to be a little more careful since the list is prepared from all the companies listed and traded, regardless of its market capitalization and category. Unlike index stocks, quality aspect of the stocks selected from 52 week lows need further validation. 3. Stocks below 200 day DMA This is another source to hunt for good stocks. The 200 day moving average is supposed to be a major support point for stocks technically. Financial websites provide data about stocks that break this major support. Needless to say, you must check why the stock is in a down trend. 4. Analysts comments You can hear about stock experts saying their opinion in various Tv shows, financial magazines and websites. They are experts in their own field and their comments and views are not something to be ignored totally. This doesnt mean going after each and every piece of information from all sources. Try to follow one or two reputed experts. They might just give you some hints to start off. 5. Spurt in volumes traded. Did you notice a sudden increase in volumes traded in a particular stock? One thing is sure- there is something going around that stock. Investigate the reasons for increase in investors interest and you could spot a winner there. 6. 52 week highs Stock that break their previous 52 week high is another category. Since the list is prepared from all the companies listed and traded, regardless of its market capitalization and category, you have exercise extra caution on such shares. Sudden rise in prices of sleepers could be due to smart speculation by some smart fellows out there.Yet, those companies are worth looking at. 7. Lifetime highs Thats the last specific category I would like to mention. Stocks that break lifetime highs should be always noted. A companys share would keep hitting life time highs as it continues to grow and post excellent earnings year after year. 8. Own research: The above mentioned sources are short cuts for people who need some sort of a kick-start. It has its limitations too. But, if you are going to become a full time investor, then the prudent way is to go out and look for ideas. And, that means, you need to do your own research and keep up with the stock market and current trends. Reading business papers and magazines will help you decide. SUMMARY OF PERFORMANCE. After short listing the companies, the next step would be to collect the summary of financial performance of the company for the last 5 or 10 years. Thats not a big job since the datas are available in finance websites like Google finance in summarized form. 2 hours of browsing through any financial web site would get you the historical information. The art of investment is to narrow your search down to a few companies that you can study and follow, and, based on the information you discover about them, you can then make better informed investment decisions Three main obstacles. I consider it appropriate to advise the investor at this stage itself, that there are three main obstacles in the way of successful analysis Inadequate and/or incorrect financial data pertaining to the stock under study. I dont think I need to explain further on that. If invalid data is used, the results will also be invalid!! Future uncertainties: Uncertainty is a fact. It is not quantifiable like risk. Irrational stock market behavior: The market is ultimately ruled by the aggregate psychology of market participants, and as a result, bubbles will form or the market will crash, bringing prices to levels that extremely deviate from what fundamental analysis would predict. Nobody can time or predict all these. CONCLUSION. With these realities in mind, we proceed further; the next step would be to collect quantitative data about the company. This includes a 10 year history scan and available information about the companys future plans. More about that in our next lessons.. History Scan An introduction. by J Victor on January 12th, 2012
Past is a fact. Future is just an opinion, estimate or a hopeful thought. The financial history of a company, however great, is not a guarantee of any sort that it will continue to perform so in the future. However, History is the only factual material we have and studying the past data provides insights into lot of factors qualitative and quantitative that may help to form an opinion about the company. SOURCES TO COLLECT HISTORY. The data to be collected includes dividend payment history, stock splits, bonus, historical highs and lows, volume of shares traded history about management and so onYou have to collect at least 5-10 years historical data of a particular company. The first source would be the documents and updates that companies themselves put out. Take the annual report. These are usually treasure troves of information on financials, material developments through the year, management strategies and outlook.
The Internet is one powerful tool where you can get all the past information about a company. The BSE and NSE websites give broad market information such historic stock prices, volumes, shareholding patterns, financials and corporate actions, annual reports , important ratios and much more. Moneycontrol, Yahoo finance, Google finance and Reuters are other websites from where you can dig out a wealth of information about a company. Financial informations for the past years like balance sheet, profit and Loss, cash flow, all ratios including book value and P/E , experts comments, audit report, competitors , news about the company, charts , trendseverything is available in separate tabs. There are other websites such as myiris.com where research reports put out by brokerage houses are available. All main ratios and analysis are also available. There are a few indicators that signal poor liquidity in a stock. For instance, if you find $ tag in a BSE (Bombay Stock Exchange) stock, be careful. These are stocks from the Indonext segment which denotes that it falls under the small and medium enterprises group. Stocks from this segment do not see good market demand. Based on certain qualitative and quantitative parameters, BSE has categorized stocks into different groups. A group stocks, the most liquid in the lot, are the ones that have reported trading in 98 per cent of trading days in the preceding three months and have been checked by the exchange for adherence to compliance norms. T group stocks come in trade-to-trade category where only delivery trades are allowed due to surveillance reasons. Z category companies are ones that have not complied with listing requirements of the exchange and have pending investor complaints. CONCLUSION. If you are valuing a company, a 5-10 year scan of its history is a must. The assumption is that , if there is a great business thats driven by a team of dedicated people and if they have shown that they are capable of generating more and more revenues in the past -they will continue to do so in the near future also. Without this assumption, you cannot enter into any stock. We have mentioned some websites that contains this information. But these websites would contain a large collection of data, all of which may not be required for analysis. Our next lesson The Eight point check list- deals with whats required and whats not. Eight point checklist for history scan by J Victor on January 15th, 2012
In the last article I gave broad guidelines about where to find the data. Collecting the historical figures of a number of companies is a definitely a time consuming task. The internet is full of information that leaves most of us confused! Now; let me give out a specific list of data to be collected. A powerful Eight point check list through which we can identify companies with an Excellent Financial Track record. The Eight point check list.
1. Revenues- A company can grow only by increasing its sales. Hence, revenues over that last 10 years is the first number to be collected. A promising company should have a minimum growth of 15% every year. 2. EPS-Earnings per share- Profit, of course, is next in the check list. The profits and Earnings per share should be in proportion to revenues. 3. Book value Book value is simply the value of the company right now, as per the balance sheet. That is, the companys assets minus its liabilities. This figure shows how much would be left for ordinary shareholders after all the outstanding obligations of the company are paid off and the company is closed. Divide this figure by the number of shares and you get the book value per share. This book value per share should show a minimum consistent growth of 15% year on year. 4. ROIC- Return on capital invested ROIC measures a companys profitability by revealing how much profit a company generates with the total money it has invested. Total money invested in business includes long-term debt, and common and preferred shares. Invested capital can be in buildings, projects, machinery, shares in other companies etc. Check whether the company is recording a consistent growth in its ROIC. 5. ROE Return on Equity. Return on equity measures a companys profitability by revealing how much profit a company generates with the money shareholders have invested. A consistent growth in ROI is a must. 6. Debt /Equity ratio- Indicates what proportion of equity and debt that the company is using to finance its assets. An ideal debt equity ratio would be less than 1. A debt/equity of .60 or less is excellent. A higher ratio would demonstrate a heavy reliance on loans. 7. Debt to net profit ratio- As said earlier, borrowed money forms the debt of the business. Its common for business to borrow money from banks. This ratio answers one important question: Does the business generate enough earnings to repay its financial commitments? If yes, the probable time frame within which it would be able to pay back its commitments. 8. Historical share price- You should also have an idea about how the stock price has moved in the past. How it has reacted when major events unfolded like the 9/11 attacks and how it bounced back. While analysing historical share prices, you may have to watch for stock splits and bonus issues, which reduces the stock price. It is an automatic adjustment. CONCLUSION Only fundamentally strong and well managed companies will pass this 8 point check comfortably. This will give a clear idea about the companys financial history. Thats not all. You also need to collect some qualitative factors about the company. More about those non- financial datas in our next lesson Gathering Qualitative information. Qualitative data analysis by J Victor on January 18th, 2012
If historical data collection was all about collecting financial figures of the past years, qualitative analysis is about using subjective judgment based on nonquantifiable information, such as management expertise, industry cycles, strength of research and development, labour relations etc.. The difficult part in qualitative data analysis is to analyse and arrange the data collected into meaningful information. This is the most important part in analysing stocks, since you are trying to form an opinion about the future prospects using scattered information available from different sources, some of which may be biased. Quality analysis should be done in two levels. One, at the company level and two, at the industry level.
Qualitative analysis of the company The first challenge will be to get familiar with companys business what they do and how they make money. Unless you get a grip on their business, you wont understand what the companys prospects are. The easiest way to get the information about companys products or services is to check their website. A main point to be noted while going through the companys business model is whether the company enjoys economic moats. Economic moat refers to a business ability to maintain its competitive advantage. Competitive advantage is any factor that allows a company to provide the same goods or services that is similar to those offered by its competitors and, at the same time, outperforms those competitors in terms of quality, customer satisfaction, cost or profits. Two major questions to be answered in this regard are whether the company enjoys economic moats? Whether the company is doing similar activities in a better and different way than its rivals? Quality of the management team is another area to analyse. You may have to view their interviews in channels how they answer the questions, forthright or do they avoid clear answers like politicians do? You can also check if past plans declared by the management have been carried out on time or not. Also, research the ownership and insider trading of company executives. If you can find managers among shareholders and if they were increasing their share lately, that may be a very positive sign. Qualitative Data Analysis of the Industry Apart from analysing the company, you should also get familiar with how the industry you intend to invest in, works. Areas to be researched include industry growth, competition and industry regulations. CONCLUSION. Qualitative analysis may be difficult. It may be subjective. It may be hard to lay down specific formulas for qualitative assessment. But, honest analysis when combined with other techniques, will give clues into the quality and health of a company. In my next post, I will detail about where to find qualitative information and how. How to gather qualitative information? by J Victor on January 19th, 2012
There is a lot of information that you can gather to check the qualitative aspects of a particular stock. This includes a lot of information including- Sectoral Performance Is the company doing business in a Sunshine sector? For example in the 1990s IT Sector was at its best and anyone who invested in those shares would have accumulated a lot of wealth by end of the decade. Quality of the Products Great companies have products and services that people want year after year because of their universal appeal or because the company keeps the products fresh with shifting consumer concerns. Leadership /Monopoly Market leadership is a very important factor. Market leaders can set benchmarks for their industry. Market leaders set the pace for the industry and use their size to protect their position. They are able to hire top talent and have the resources to keep pushing their advantage. Quality of Management A consistent performing management is important for organizational well-being. Investing in companies with reliable management is a safe bet since they have the ability to overcome unfavorable situations. A good management builds trust and confidence in investors mind. Customer Satisfaction Are the customers of the company satisfied? The answer to this question decides the fate of the company in the long run. Customer satisfaction has direct impact on a companys business and hence its stock value. As long as customers are happy, you investment is a safe bet. This is especially true in highly competitive markets. For example, markets for food and beverages are very sensitive to customer satisfaction and consumer tastes and preferences. Business news Business news about the company can also impact its share prices. The news of a new product launch, labor dispute or a significant trade agreement affects stock prices. This is because these factors affect the investors conception and confidence about the company. The Reliance Industries share prices went up drastically when the news of its Lyondell bid being rejected hit the market. This is because the investors had feared that Reliance would overpay for this international deal. - Insider information or leaking of confidential information about the company can also create a stir in its stock prices. To give an example, the stock prices of Reliance Communications took a dip (almost 26%) in the month of October of 2009 when information given in the government commissioned audit report that the company had understated revenue to the government, was revealed. Media reports Keep a track of news about companies in which you are interested. Positive news will most likely cause stock prices to rise. The opposite is also true. Here you need to understand the nature of the news and also try to estimate the possible duration of such effect on investor sentiments. This is important when you make decisions about selling or keeping a stock. Follow the Big Players Institutional investors such as mutual funds, pension funds or hedge funds have access to a greater amount of information than retail investors. Therefore, when such institutions invest in a particular stock, it sends a positive signal. Because of the sheer volume of their transactions, stock prices can rise when they buy and tumble when they sell off these shares. Presence of institutional investors increases the chances of price volatility in a stock. So, you may have to keep a close watch on the moves of these big investors. It is easy to figure out whether a stock has attracted institutional interest. Both BSE and NSE provide the bulk deals data, shareholding patterns of companies, FII holding and other major shareholders. Check the promoters share. Promoters are the entities that floated the company, and to a large extent have seats on the Board of Directors or the management. Relatives of the promoters who hold shares also fall under this class and are termed the promoter group. It shows the extent of control promoters have over running of the business a very high promoter holding is not a good sign. Companies are also required to declare the promoters shares that have been pledged as debt collateral. Such pledging of shares is a sign of risk as it indicates that a company is extremely strapped for cash and has no alternative route to fund raising. Such pledges are risky- If the company falter in making payments, the lender may sell the shares. Also, prices of pledged shares fall below a certain limit the promoters may be required to make up the difference. So a balanced share holding pattern is what you should be looking for. A good presence of institutional shareholders would mean that it wont be easy for the management to carry out decisions according to their whims. CONCLUSION Before you start analyzing a company, its important to collect the above mentioned factors. Before going into financial analysis, these non-financial factors will give you first hand information about the company and to where its headed in future. This is not a complete list. I hope this helps to get an idea about how to go about collecting data about the qualitative aspects. 5 Investment concepts by J Victor on January 20th, 2012
The whole purpose of valuation is to find out the approximate price at which you can buy a stock. And, if you do that, the return you deserve for taking that risk . For this, there are some concepts that you should be aware of. They are Concept 1. Intrinsic value A notional value of the stock based on certain calculations. A price at which you feel the share is worth buying. Read More Concept 2. Book value what a company is worth recordically. Its computed from the balance sheet by adding up all the assets and deducting from it the total liabilities of the company.Read More Concept 3. Margin of safety A general theory of safety applicable in all walks of life-not only in finance. For example- If you are driving a car at 100 mph, would you drive it so close to the vehicle in front? No. Youll leave a distance. Why? Because, you need a margin or a space to break your car to safety just in case the driver in front commits an error. Faster you drive, more distance or margin of safety you need. Similar is the case with shares. Unforeseen events can ruin a company or errors are possible in your calculations and assumptions. So youd try to buy a share only at a rate thats 30 or 40% below your intrinsic value calculations- just in case. The more risk averse you are, more Margin you need. Iconic investor Warren buffet recommends a margin of more than 2/3rds or 66% from intrinsic value. Concept 4. Risk premium The minimum amount of return that an investor expects to park his cash in risky assets like stocks instead of risk free deposits. This is the difference between the average return of stock markets and return from risk free investments. Concept 5. Cost of equity A company gets money to do business in two ways loans and capital contribution from shareholders. Loans carry interest. So, the cost of availing loan is known. Equity capital contributors have to be compensated by the company by giving them returns.What is the rate of return to be given to equity investors? There is no specific rate of return. The returns given by the company should be sufficient to compensate the risk that the investors have taken in giving money to the company. This rate of return is called the cost of equity. The cost of equity is directly related to risk. If the shares of a company are considered risky, investors would demand more return to park their funds in that company instead of a safer one. We take up all these concepts in our next posts Concept 1: Intrinsic Value. by J Victor on January 24th, 2012
As said in my last post, there are 5 concepts to be discussed in detail. The first concept I will discuss is the notion of intrinsic value. Intrinsic value is one term thats on every website that talks about stock market investing. Lets try to crack down what its all about. Intrinsic value is basically finding answer to one question at what price do YOU think that a stock is available at a bargain and why? It is basically an estimate. There is no correct intrinsic value. Two investors can be given the exact same information and both of them may come out with a different value on a company. The intrinsic value of a stock may be very different from its market price.
Why is it impossible to compute intrinsic value precisely? Because, intrinsic value is the value an investor places after considering the business growth potential, market forces, products, management, earnings, ROE, shareholders value creation, competition, economic changes, political changes, etc. Hence, it is subjective. There is definitely no way you could measure them all in terms of numbers and figures. Famous investors have devised their own formulas for deriving the intrinsic value of a company. Benjamin Graham, the father of value investing and the person who popularised the concept of intrinsic value has given the following formula to calculate intrinsic value of a company. Intrinsic Value = Current Earnings x (8.5 + 2 x Expected Annual Growth Rate) You cannot apply this formula directly to any market conditions. That doesnt make sense. This formula was created in the 1940s by Graham to find value stocks traded in US. So, an investor may have to find the intrinsic value based on his research and study. INTRINSIC VALUE VS. BOOK VALUE Some people confuse book value with intrinsic value. Both are different. Book value is basically an accounting measure. Book value is the difference between what a company owns and what it owes as recorded in the balance sheet. However, a company may have valuable patents, brands, softwares, manpower, ideas, expertise, positive customer relations and licenses that cannot be measured in terms of money and such internally generated assets are not recorded in the balance sheet. These assets are strengths of the company which increases its value and are excluded while calculating book value. The only case where such a figure is recorded is in the case of goodwill/patent rights when its acquired from another company by paying cash. Hence, a software company may have more of such intangible (cannot be seen or touched) assets, and their book value as per the balance sheet may be meaningless since it does not show the actual worth of the company. An investor, who has considered the value of such intangibles, may be willing to pay more than their actual book value. That value- The price at which he thinks that a stock is available at a bargain is called intrinsic value. That brings us back to what we said in the beginning. Intrinsic value is an estimate. There is no correct intrinsic value. Many websites like Moneycontrol publish the book values of business. So there is no need to compute these figures. Intrinsic value, however is not published since its an estimated figure that varies from investor to investor. CONCLUSION Understanding intrinsic value is crucial if you are adopting value investing strategy. Intrinsic value may differ from book value because of brand names, customer base, patents and other intangibles that are difficult for investors to quantify. It may also be different from the market value The current quoted price of the share which is driven by investor sentiments. It is not possible to find accurately, intrinsic value of a stock. There are various approaches but no standard formula for calculating the intrinsic value. Investors should develop their own strategies and models for this purpose, according to availability of information and analysis tools he has. Many traders use different indicators like book value, P/E ratio, asset to liability ratio etc to find the intrinsic value of the stock. Value investing is all about buying a stock below its intrinsic value. Concept 2: Book value by J Victor on January 26th, 2012
BOOK VALUE Book value is basically an accounting measure. It can be computed by looking at the balance sheet of a company. Book value is the net of what the company owns and owes recordically Total of land, buildings, machinery etc Reduced by the total of what it owes liabilities like loans. How to find book value? The simple way to find book value is Book value = Equity share capital + Retained earnings Both these figures are available in the companys balance sheet. You can add the above said numbers to get the book value. The other option is to rely on financial websites where this information is available straight.
For example The Balance sheet of Reliance communications is given in the following link. What you see is the last 5 years figures.(2007-2011) As you can see under the sources of funds for march 2011, the Equity capital is Rs 1032.01 Crores and the retained earnings (Also called reserves) is Rs 47,112.47 Crores. Book value = 1032.01 + 47112.47 = Rs 48144.48 Crores Total number of equity shares = 2,064,026,881 Nos. ..ll Check ll Book value per share = 48144.48 Crores/ 206.40 = Rs 233.26 per share. ll Confirm it here ll Book value is what the company would realise should they stop the business and sell off all the assets they have. PROBLEMS WITH BOOK VALUE. Most investors think that all they have to do is to spot a company thats trading below the book value and invest in that stock. But, things are not so easy. The book value as reflected from the balance sheet has some problems. First, a company may have self generated assets like patents, trademarks, customer base etc which do not find Place in the balance sheet. Book value excludes such intangible items. So, book value is not much useful when it comes to valuing companies with huge intangible assets. For Example software companies like Microsoft. Second, the assets as shown in the balance sheet may not be properly valued. For example, if the company bought land worth 5 Crores in 1992, even 20 years later in 2012, the land will be shown at 5 Crores only. But in reality the asset value might be much more than that. Book value does not reflect such increase in value. Third, Plant, machinery etc are shown at cost less depreciation. In reality, such plant may have depreciated much more. For example- Machinery worth lakhs in the balance sheet may be totally worthless because of technological changes. Hence it may not fetch the value as shown in the balance sheet. Fourth, the value at which current assets like debtors and closing stock appear in the balance sheet has to be taken with a pinch of salt. Most retail firms carry their inventories at high cost. Debtors may default in their payments. So the value that appears as current assets is always questionable. Finally, the part that most of us forget to look- the liabilities side. A company may have pending litigations which may be unfavorable resulting in additional burden. Adequacy of provisions is another questionable area. Such potential liabilities are not reflected in the balance sheet figures. Hence, book value may not be the right measure in all cases. PRICE/BV RATIO The price to book ratio or P/B ratio reflects the value the market places on the book value of the company. The price to book ratio is calculated as: P/B ratio = market price per share / book value per share The market price divided by book value shows the market value of every rupee of asset that the company has. For example if the P/B ratio is 4 it means that for every Rs 1 in books, the price paid by the market is Rs 4. Investors generally would like to have a P/B of less than 1 so that each rupee they pay is backed by more assets. Price to book ratio varies between industries. Asset based companies like infra structure, banks and financial institutions may have high book values. For investors, P/B is a tried and tested method for finding low-priced stocks. The thumb rule is that Book values are useful to measure companies with huge tangible assets in their books like banks. If a company is trading for less than its book value it tells investors that the stock is priced low. Difficult to find a good stock thats below book value? Thats exactly how it is. Investors will be always willing to pay more than the book value for companies with strong profits and solid growth prospects. It would be very difficult to catch such companies at less than their book value. For example Microsoft, the software giant, has rarely traded below 10 times it book value. So, if you find companies that trade below its book value, do not jump in and invest. May be somethings wrong with the fundamentals. You have to be very cautious in such cases. Book value thumb rules are valid if and only if the companys balance sheet is strong and its business is not in troubled waters. Otherwise, an undervalued share might mean that one of two things: Either the market believes that the asset value is overstated or The company is earning a very poor (even negative) return on its assets. Thats the concept of book value for you.. Next one is Margin of safety. Concept 3: Margin of Safety by J Victor on January 28th, 2012
As humans, we need to acknowledge the fact that all of us are flawed. In one of the previous article, I discussed about intrinsic value, an estimated figure which varies according to the investors perception about a company. Margin of safety is a concept that accompanies the intrinsic value concept. For example An investor may find that stock x is currently trading at Rs 130. The intrinsic value of stock x is Rs 100 according to his calculations. The margin of safety he would like to maintain is 30%. So, if the price gradually drops to Rs 70, and if he finds nothing suspicious about it, he buys the stock. This allows him to make investments with moderate downside risk. Margin of safety according to Benjamin graham. Benjamin graham in his book The intelligent investor describes margin of safety: Any investor, bearing in mind the objective of capital preservation, should seek, in all its investments, a reasonable difference between the value it assigns to the business (intrinsic value) and the price it can be bought in order to protect himself in case some unfavorable event happens and to maximize the investment return if the analysis is confirmed. Why is margin of safety so important ? First, Being wrong is part of the investing process. Intrinsic value estimate calculated by you would be different from the value I calculate. Errors may creep in our calculations. So, its more like an insurance policy that helps prevent us from overpayingit mitigates the damage caused by over-optimistic estimates. Second, any estimates, at best, are imprecise; at worst, they are completely wrong. Lets assume that your intrinsic value calculations were 100% right. Still, what about future uncertainties? The future is uncertain. Its a fact. You need to provide a margin for this uncertainty you face. Nobody is an exception to this. All the analysts and experts in this world make mistakes and they face uncertainty. Hence margin of safety is important. Whats the ideal margin of safety? There is nothing called ideal Margin of safety. The percentage you would like to maintain depends on how accurate and confident you are with your intrinsic value estimation. If you are confident that your calculations are 100% correct, your margin of safety is 0%. If you are less confident about your forecasts, youll need a larger margin of safety before buying the shares. Because, theres simply a greater chance that something might go wrong and that your forecasts are too optimistic. The percentage of margin is your call. I would suggest 25 percent margin of safety for very stable firms with strong competitive advantage to 65 percent for high-risk stocks with no competitive advantages. On average, I suggest a 30 percent to 40 percent margin of safety for most businesses. Price , quality and Margin of safety. The margin of safety concept makes sure that the price you pay for a stock is closely tied to the quality of the company. Great businesses are worth buying at smaller discounts to fair value. Because, high-quality businessesthose that have wide economic moatsare more likely to increase in value over time. As warren buffet has said, its better to pay a fair price for a great business than a great price for a fair business. CONCLUSION Having a margin of safety is critical to being a disciplined investor. Investing in the stock market requires some degree of optimism about the future. But that optimism cannot be too much. That results in buying shares at high levels. The margin of safety concept corrects this over- optimism that investors are generally prone to. Next in line is a concept called risk premium. Concept 4: Risk premium by J Victor on February 1st, 2012
We know that risk is the other side of return. When we invest money, our decision to invest in that asset is partly based on our estimate of the return it generates and the relative risk it carries. Its a trade off. If you want more returns, you have to take more risks. Risk may have different meanings. To investors, risk is the likelihood that the outcome of an investment is different from what was calculated. One point to note here is that the term risk is a combination of two parts- systemic risk and unsytemic risk. Systemic risk is the risk beyond the control of any investor. For example recession, war, inflation etc. Its also called non diversifiable risk. Once the investor is in the market, he has to face it. Unsytemic risk is otherwise called specific risk it is the risk specifically associated with company or an industry and is due to factors specific to a company/industry. For example- labour strike, Product failure etc. Unsystematic risk can be mitigated through investing in diversified assets. In short, only a part of the risk can be mitigated. The other part is uncontrollable. RISK FREE RETURN Risk free return is the returns generated by investing in risk free assets. Investments where both the capital and the interest are guaranteed are called risk free assets. Generally, government bonds are considered to be risk free and the rate of return on such bonds are considered as the risk free rate of return. So risk free return is something anybody can earn by simply investing in that risk free assets. Lets assume that government bonds promise 6% return. Now, let us further assume that the stock market index like Sensex has given a return of 16%. Anyone who has invested in stocks that constitute the index will be able to earn that 16% . This excess return earned over and above the risk free rerun is called the risk premium. In our example, the risk premium would be 16-6 = 10%. So we can split the total return from stock market investment as: 10% risk premium + 6% risk free rate = 16% from stock market. So, from the above example it follows that if an investment is risky just like the stock market index, the risk premium to be earned is 10%. We forgot to consider volatility!! Recall the topic on beta. Lets assume that the beta of a particular stock Axl ltd is 1.5. That means, the stocks volatility is 1.5 times than the overall market. The overall market risk premium is computed as 10%. Hence the risk premium to be earned from investing in that particular stock would be 10% x 1.5 = 15%. Thats only risk premium! add to it the risk free return of 6% and you get 21% as the target retrun for taking the risk of investing in that stock. This theoretically is the default model for measuring investment risk called the Capital Asset Pricing Model or the CAPM formula. In other words, the CAPM approach helps you to decide whether or not the current price of a stock is consistent with its likely return that is, whether or not the investment is a bargain or too expensive. Formula for CAPM The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.
Or to put it i simple terms- Expected Return = risk-free rate + Beta x (Market return risk-free rate) Risk free rate in Indian context. For Indian investors, the risk free rate is 8% now. Risk free rate of India can also be measured in comparison with The US treasury bonds which is supposed to be the safest of all bonds. The default spread of investing in India when compared to US treasury bonds according to international rating agencies like Moodys or standard and Poors. And, the standard deviation in returns from equity and bonds. Such an exercise may not be required in this ever changing global scenario. Moreover, average Indian investors have limited opportunities to invest overseas. Hence, the risk free return for Indian investors can be safely assumed to be the Return from Government of India bonds. To conclude Risk free return rate becomes the primary base from which other valuations are derived. CAPM approach helps to calculate what return on investment we should expect. This rate of return expected by investors is called cost of equity from the companys point of view. That is, the compensation an investor demands in exchange for parking his funds in stocks and bearing the risk of ownership. There are other models to calculate risk premiums and cost of equity. Three factors determine the risk premium: (a) the systemic risk of the investment; (b) the average expected return for the market relative to an index and (c) the return expected from a risk-free investment. Hope you are clear about risk premium. Concept 5: Cost of equity. by J Victor on February 8th, 2012
In concept 4, towards the end, I gave a hint on what cost of equity is all about. It is the rate of returns expected by an investor. A decision to invest is made only if the current market price of a share is consistent with its likely return. What is it? Cost of equity is the rate of return that an investor expects when he invests in a company. This rate of return has two components- Dividends expected from the investment and Capital appreciation. For example lets assume that an investor expects 15 % return from a stock that pays 3 % dividend yield. That means, the capital appreciation expected by him is 12%. The total return from that stock will be 12 % + 3% = 15%. Getting closer Lets take a closer look at the above mentioned return of 15%. If the investor has targeted a 15% return, it simply means that 15% returns is enough for him to compensate for The risk he takes for investing in stock market The risk he takes for investing in this particular stock and The return he forgoes on a risk free investment alternative. Why cost of equity matters An investor would expect his equity investments to grow by at least the cost of equity; Cost of equity can be used as the discount rate to be used in stock valuation models like discounted cash flow or DCF. In general, Cost of equity can be calculated in two ways. First method is called the dividend growth method or Gordons method and the second one is called the CAPM (discussed in concept 4 while discussing risk premium) Gordons method The traditional method to calculate cost of equity is the dividend capitalization model which is as follows: (also called Dividend growth model) Expected Dividend Per Share / Market Price + Expected Growth rate of dividends The only way to find the expected dividend rate is by relying the past dividend history and also by listening to what the management of the company hints about the future dividend payment. It worth noting here that One, past history is no guarantee that future results will follow the trend and, Two, the management is often very optimistic about the future prospects of their business. So the expected dividend should be calculated on a conservative mode. The Gordons model assumes that the company has an infinite life, a constant dividend growth rate and a constant rate of return. It also assumes that the company has only equity and retained earnings to finance its business.For example , if the current stock price of a company is Rs 1000, the expected dividend yield for the next period is 3% and the expected growth rate in earnings and dividends in the long term is 10% then cost of equity would be calculated as follows: Cost of equity = Expected Dividend Per Share / Market Price + Expected Growth rate of dividends Cost of equity = 3% + 10% = 13% If the risk free rate is 7%, the equity risk premium would be 6%. The method is simple and straight forward but it does not apply to companies that do not pay dividends. From Cost of equity to Cost of Capital In fact this cost of equity is just one part of a concept called cost of capital. Equity is one part of the capital that the company uses; the other part is called debt. When you add up the cost of equity and debt, you get the cost of capital. Whats worth to note is that the proportion of equity and debt content in the capital structure of a company would not be equal. Secondly, the debt portion may carry a cost which is already fixed and the equity portion may carry a cost which depends on the risk-return trade off. So to bring everything to balance, we compute the overall cost of capital called the weighted average cost of capital. (WACC) WACC. Weighted average cost of capital is not an easy measure to compute. Its the total of- Cost of equity and cost of debt. Cost of equity may have to be calculated using CAPM or any other approach. The cost of debt is pretty straight- its the cost that the company is paying for its debt funds. Since the company can deduct the cost of debt from its revenues (interest is an expense) the resultant tax benefit too, has to be taken into account. so the actual cost of debt would be interest paid less the tax savings resulting from the tax-deductible interest payment. Falling interest rates results in a reduction of the WACC while frauds, scams , market speculation and volatility results in investors demanding more to park their funds in equities and therefore would increase the WACC. WACC as an Investment Tool WACC is a valuable tool to make investment decisions. The WACC is the minimum rate of return at which a company produces value for its investors. For example, lets say a company generates a return of 15% and has a WACC of 7%. That means that the company generates a value of 8% (15-7) for investors in that company. WACC can also be used as the discount rate in discounted cash flow valuation method for valuation purposes. Even small changes in WACC may cause significant change in DCF. Ill discuss more about DCF method of valuation in later stages Thats about cost of equity and capital concept. In our next post , we discuss an important topic on valuation- estimating the EPS growth rate. Estimating EPS-Growth rate by J Victor on February 12th, 2012
You know what EPS is. Its earnings per share. EPS-GR stands for Earnings per share growth rate. This estimated growth rate is an important figure for valuing a company. When you compare the EPS history with the stock price history, it helps you determine the most likely future direction of the stock price. Take note: In calculating a companys earnings growth rate, you need to decide whether growth should continue at that same rate. Studying the firm, its products, and its competitive environment will help guide your decision to adjust the growth rate up or down. Why is EPS-GR important?
Let me clarify with an example. Lets compare two stocks stock of AB Ltd with an EPS of 5 and stock CD ltd with an EPS of 7. At once glance, you may think that stock CD Ltd is better since it has an EPS of 7 A year later, AB Ltd has EPS of 5.50 per share while CD Ltd has an EPS of 7.50 per share. This means, AB Ltd has grown 10% whereas, CD ltd has grown only 7.14% Naturally, the price of AB Ltd will increase higher than stock CD. The stock price has direct relationship with the EPS and hence you will be getting more profit from a stock that has higher EPS-Growth rate. Stock with the highest EPSGR rises fastest in that year as compared to its competitors in the same industry. If a company maintains a 10% or more EPS growth rate, that company may be a good target. However, such growth rates in EPS are more reliable in the case of matured companies which has experienced a complete economic cycle of expansion and contraction, through a bear market phase and a bull run. New and fast growing companies may not have such a financial history to rely upon and may exhibit greater volatility in earnings history. Earnings history of such new and fast growing companies is less reliable in projecting growth rates than large matured companies with a consistent earnings history of 10 years or more. So, the chances of accuracy in predicting EPS growth increases for companies with greater financial history. Calculation. To calculate the growth rate in earnings of a company, lets take an example. Lets assume that the earnings per share (EPS) of a company is as follows: Year EPS 2011: 4.50 2010: 4.20 2009: 3.90 2008: 3.45 2007: 2.80 2006: 2.10 In the five years from 2006 to 2011 the earnings per share increased from 2.10 to 4.50 and the growth has been consistent. In such cases, the first step is to calculate the growth multiple. Growth multiple = 4.50/2.10 = 2.14 Next we raise the growth multiple of 2.14 to the 1/5 th power: (2.14) 1/5 = 1.164 1/5 th power has been used because we are calculating for 5 years. If the time period was three years, we use the 1/3 rd power. Next we take the 1.164 figure and subtract 1: 1.164 1 = 0.164 As a final step, we multiply .164 by 100 to get the average annual growth rate. 0.164 x 100 = 16.40% is the average annual growth rate. From the historical and qualitative analysis, you have to take a decision as to what would be the rate of growth for the company in future. Its your call. You can assume it as 16.40% or you can play safe by assuming a lower growth rate of 12% or 10%. Its your decision. Ideal growth rate. If you are looking to invest in a company thats consistent, you have to make sure that the company in question has a consistent earnings growth history of at least 10%. Most of the start up companies may not have such a consistent history of earnings. Some times, you may come across companies with strong fundamentals but with low annualized EPS of less than 4 or 5 % but analysts may talk about a huge turnaround in the earnings due to heavy order book. Keep watch on such companies. Research and find out if theres some fact in it. You could be near to spotting a high growth company. Estimating the P/E by J Victor on February 14th, 2012
One of the main figures that an investor should estimate in the process of valuation is the PE of the company. The details regarding a companys past P/E ratio is available on many financial web sites. All these are real, past data.The question is how to arrive at the future P/E ratio of the company. For that, the simplest method is historical analysis Given below- in a two step format. Step 1. The historical P/E ratio of the company is taken and a reasonable present day price-earning ratio is computed. For example lets say the price-earning ratio for A Ltd for the past 3 years was 9.00, 7.80 and 8.56. Then, the average price-earning ratio for the company would be (9.00+ 7.80 + 8.56) / 3 = 8.45. We may safely assume that the average price-earning ratio for the past three years is applicable in the immediate future also. In the example I have used 3 but, its safe to take 5 or even 10 year average P/E of the company. By taking a long-term average, you smooth out the noise and bumps.
Instead of averaging the ten, you may also drop the low and the high number of the sample and average the balance eight. The logic is Companies sometimes have one-time events that can affect net earnings either positively or negatively.. This will distort the P/E. Thats why a removal of the highest and the lowest PE is recommended. Also take note that during market bubbles, P/Es can be inflated for extended periods of time. Similarly, caution should be used while taking PE figures during market crashes. P/E ratios are also generally higher in a low-interest-rate environment because a companys cost of capital is lower, and also because investors are more likely to take on the risk of owning equities when bond yields and fixed income rates are low. Step 2. Cross section analysis- With the average P/E in hand, the next step is to look at price earning (P/E) ratios of similar competing companies in the industry; and then take a view on whether the average P/E ratio is a reasonable for the company under study. Remember to compare apples to-apples. Future PE will be lower than current PE if earnings are expected to grow in the future. Future PE will be higher than current PE if earnings are expected to slow in the future. CONCLUSION The above said is an easy and practical method to calculate estimated P/E. There are other methods to calculate expectedP/E which are more complicated and require expert knowledge in accounting, finance and the industry under analysis. The above method works for everyone. Since high quality stocks are commonly favored by stock investor, they are normally high in its P/E Ratio. Stock investors have to pay premium investing in high quality stocks as the demand for it is relatively high. Since the future P/E also depends on the companys specific projected growth in earnings per share and its specific risk factors, which are very difficult to project, the best approach is probably to forecast growth rates and then to calculate a target P/E at various potential levels of growth and risk. This may give quite a wide a wide range of target P/E ratios. Simple Valuation Method- I by J Victor on February 15th, 2012
In this article I am suggesting a very simple method to find intrinsic value. Any novice can do this valuation. Its not a fool proof method and may have downsides, but this method does give a reasonable down target to buy stocks. Step 0 Do the ground work. You have to pick a target based on historical analysis, future potential, qualitative aspects etc.. Step 1 The first step is to find the EPS-GR. Based on the EPS growth rate, calculate the expected EPS. Step 2 Estimate the future P/E Calculate the estimated future price by : EPS x P/E Step 3 From the future price, calculate the present vale of the stock. Use the concept of margin of safety to compensate all the errors in valuation. Compare the stock price with the current market price Step 4 Invest, if you find the stock price less than what you got in step 3 Else, wait for the stock to fall. EXAMPLE
Lets take the case of ICICI bank which has an EPS and PE as follows: (Source: Moneycontrol.com) 2007 -Rs 34.50, PE 26 2008 -Rs 37.37 , PE 21.40 2009 Rs 33.76 , PE 10.27 2010 -Rs 36.10 , PE 27.51 2011 Rs 44.73 , PE 25.90 STEPS Step 1: The EPS CAGR would be 6.7% The estimate for 5 years hence at 6.7% growth rate would give a target EPS of 61.86. Step 2: The average P/E for the last 5 years would be 22.21So, expected share price in 2016 = 61.86 x 22.21 = Rs 1373. Step 3 Rs 1373 is what we expect in 2016. The next step is to calculate the present value of the stock, that is, what is the comfortable price now. For this, we need to know what the average inflation rate is. Lets assume that it is 8% on an average. So, the present value of Rs 1373 discounted at 8% inflation rate would be Rs 934.00 Step 4 Applying the margin of safety: Warren buffet recommends buying shares at 2/3rds of the intrinsic value. Thats a 66% down target. Lets put a margin of safety of 35%. Rs 934 x 65% = Rs 607 We get Rs 607 as the intrinsic value . Instead of a correct price, we may set a target range between 30-40% of the intrinsic value as our entry point. Recommended Buy range The recommended range would be between - Rs 560-653. The beta value of ICICI bank according to the BSE is 1.41. Its a volatile stock. So, a small drop in stock markets may give better chances to accumulate the stock at our target rates. ICICI bank hit Rs 641 on Dec 19th, 2011. Anybody who patiently waited for this catch in 2011 would have easily picked up the stock at Rs 650 + levels. Today when Im publishing this, the stock has opened at Rs 952. Thats an average of 45% jump in just 2 months. If we follow Buffets method: We would target 66% down The book value of ICICI bank as on march 31st is 478.31. Rs 934 x 34% = Rs 317 is the buy target which is below the book value. Lets check the results- August 2011- Bank of America-Merrill Lynch has recommended to buy ICICI at Rs 873 with a target of Rs 1200 in future. November 2011- Dalal street investment journal has recommended to buy the shares in a staggered manner August 02, 2011- India Infoline research desk had recommended to buy at Rs 1021 August 02, 2011- Gaurav Doshi, VP Equity Specialist, Morgan Stanley PWM, had commented in economic times Aug 2 2011 issue that he is bullish on the stock and he would accumulate the stock at reasonable levels. Nov 03, 2011 way to wealth in its research report recommended buy with a target of Rs 1153 Oct 25 2011- A C choksi in its research report recommends buy at Rs 892. Oct 24 2011- Emkay securities in its Diwali special recommendation rated accumulate for Icici bank at Rs 852 or below. Feb 8 2012- India Infoline recommends ICICI at Rs 906-908 Feb 8th 2012- Motilal Oswal recommends ICICI with a target of Rs 1100 Thats one value method for you. Simple and effective. It doesnt require much knowledge in finance or accounting and anybody from any stream can do this with a bit of effort. A word of caution This valuation method is effective only in fundamentally good stocks, especially large caps. You might need a higher margin of safety while applying this technique. The default method of valuing stocks is not this one. Its called DCF method or discounted cash flow method. I will explain DCF method in my next set of lessons targeted at intermediate users. Simple valuation method- II by J Victor on February 28th, 2012
This is an alternative to the valuation method we discussed in our earlier post. Lets value an imaginary company which is trading at Rs. 33.50, Earnings Per share of Rs. 2.12 and an average 10 year dividend payout of 4.2%. You assume that the stock will be having the average P/E and dividend payout of the past, in the future 10 years also. The average P/E of 10 years is assumed to be 18.7. The expected annual return is 12%. You want to invest in this company with a target of 10 years. CASH EPS GROWTH RATE From the historical analysis, you estimate that the stock will continue to grow at 13 % per year for the next ten years. Instead of estimating normal EPS growth rate, you can use cash EPS. Cash EPS = (Profit after tax + Depreciation + Other non-cash charges) / Number of equity shares. The logic behind cash earnings per share is, that the depreciation charge is merely an accounting adjustment devoid of any real expenditure on the part of the company The advantage of using cash EPS is that it is a more realistic figure than normal earnings figure. The higher a companys cash EPS, the better it is considered to have performed over the period. You need not calculate cash EPS separately since the data is available in most financial web sties.
Step 1: Forecast share price First of all, you need to forecast its share price ten years down the road. In this case, we project the price for the next ten years using 13 per cent per year growth. Stock price after 10 years = EPS after 10th year x Average P/E (2.12 x 1.13 (10) ) x 18.7 = Rs 134.57 Step 2: Forecast Total Future Value. Secondly, you need to calculate the total future value. If you believe that the company is a consistent high dividend payer, you can consider the potential dividend as well. Dividend Payout = Total dividends / Total EPS Year 0 - 2.12 x 1.00 = 2.12 Year 1 - 2.12 x 1.13 = 2.40 Year 2 - 2.40 x 1.13 = 2.71 Year 3 - 2.71 x 1.13 = 3.06 Year 4 - 3.06 x 1.13 = 3.46 Year 5 - 3.46 x 1.13 = 3.91 Year 6 - 3.91 x 1.13 = 4.41 Year 7 - 4.41 x 1.13 = 4.99 Year 8 - 4.99 x 1.13 = 5.64 Year 9 - 5.64 x 1.13 = 6.37 Year 10 - 6.37 x 1.13 = 7.20 TOTAL EPS = 46.25 Total dividends = Total EPS x Average Dividend Payout Rs 46.25 x 4.2% = Rs 1.94 FUTURE VALUE OF THE STOCK Future value 10 years hence would be the total of future stock price plus the total dividends expected to be paid by the company. In our example it would be as follows: Rs 134.57 + Rs 1.94 = Rs 136.51 Step 3: Calculate Intrinsic Value
You can now calculate the intrinsic value of the stock as follows: Present value of stock = Future value / Expected ROI for 10 years. = Rs 136.51/ 1.12 (10) = Rs 43.95 Step 4: Compare with Current Stock Price
The intrinsic value above is because your goal was to get 12 per cent per annum from this stock. If so, current stocks price, which is Rs 33.50, is acceptable indeed ie, the stock price is below the intrinsic value. But, if you set your goal to get 25 per cent per annum return on investment, the intrinsic value will be Rs 22. In this case, the current stock price will no longer acceptable and you will have to wait till the stock price falls to that level. For this same reason, we can say that current stock price is right to those who are aiming for 15 per cent return per annum. As you can see, intrinsic value can be relatively different from one investor to another depending on the expected rate of return, period of investment etc.. Expecting very high return will limit your investment options. As an investor, it is crucial to set a realistic target on the expected profits. Value investing common sense. by J Victor on March 7th, 2012
Whether you do simple valuation process or very complicated methods, remember that value is a relative measure. What youre trying to find is a bargain. Opportunity to buy shares at a bargain generally arises when something is out of favor. Always look for moderately undervalued shares rather than trying to find out grossly undervalued shares. If a share is grossly undervalued, it means that there is something terribly wrong with that company. You should be able to justify why you bought a share and before buying, make sure you know what would make you sell the stock. Never compare your decisions with others. If you are ready to buy a stock at a particular rate for a reason, theres someone equally ready to sell that stock for some other reason. So, its natural; for others to think contrary to your views. Book profits periodically. All the profits you make are of no use unless you monetize it and put that money in your pocket. Stock markets are full of opportunities every time. You need not worry if one investment you made ends up in loss. Loss is part of the game. Whats important in such circumstances is to recognize the mistake you made and try to book loss and come out. Treat that loss as the cost of the mistake you made and forget it. As and when you find an under valued stock, dont rush and put in all your money in one go. Always invest gradually so that you have some cash on hand for unexpected opportunities or needs. Stock investments carry risk. Thats definite. Risk and rewards are sides of the same coin. If you have taken very les risk, you need to expect only corresponding returns. Do not expect high rewards by taking less risk. Thats an illogical expectation. Less risk, less reward- thats the rule in stock markets. Always try to value companies that do business you are familiar with. It helps you to take better decisions to buy and sell. Deal with businesses you Know. Hold a maximum of 10-15 stocks. The more stocks you own, the harder it is to monitor what happens to each of them. Of course, diversification can limit losses, but it can also limit gains. Its also important to diversify at the bottoms. Buy and diversify more when valuations hit bottoms. You find 3 undervalued stocks- a large cap, Midcap and a small cap. Which one would you opt to invest in? Always opt for large caps first. Larger companies have more analysts following them and greater transparency and are less likely to have trouble someone does not see. Value investing doesnt need the quick reflex of a trader. You have ample time to think and pre plan everything. So, never act on your emotions. Finally always remember these 3 time tested buzz words of value investing patience, patience, patience. Futures and Options The basics. Introduction to Derivatives. by J Victor on December 7th, 2011
Derivatives have become very popular during the past two decades. The real purpose of derivatives is to allow traders to maximise returns and simultaneously limit their risk exposure. However, common investors have developed speculative interest with derivatives. Its a complex subject and here, I am trying to crack down this subject in a step by step approach. May be you are not used with the term derivatives but if I say Futures and options or F & Os or calls and puts Im sure all of you would understand what Im talking about.
GOING FOR THE A.R. RAHMAN CONCERT. The objective of this story is to introduce you the term derivatives. After finishing the story, I will break up the explanation into maximum pieces as possible! Lets begin our story You want to watch the A R Rahman concert scheduled next month. You find from the advertisements that entry ticket costs Rs 1,000. You call up the booking counter only to find that tickets are fully sold out! You approach a friend who is part of the concert team for a ticket and he gives you a reference letter under which if you show the letter you can buy a ticket by paying Rs 1,000. As the concert date draws closer, tickets are being sold in grey market at Rs 1,500. Now, the reference letter you have attains value because of the simple reason that you can buy a ticket, now available in the market at Rs 1,500, for Rs 1,000. That means your letter is worth Rs 500. Two days before the concert, the price in the grey market shoots up to Rs 2,000, the value of your letter increases to Rs 1,000. But, on the concert day, you get a call from your office. Theres an important assignment to be done. So you decide to sell this letter to someone who is wiling to pay Rs. 1,000 to you. You cant afford to postpone the sale because, once the concert starts, your letter becomes worthless. Forget about what happened after that. Instead, we will discuss more about that letter you had with you. Lets try to understand the features of that letter. That letter gave you a right to buy a ticket at Rs 1,000. When? Anytime before the Concert starts. The Letter gained value. How? Grey market rate of the tickets shot up. The value of the letter kept changing. Why? Because the price in the grey market kept increasing. So, the value of the letter is derived from the value of the ticket it represents. In pure financial language, this letter will be called a derivative instrument. A derivative instrument is nothing but a contract (in this case the letter) whose value is derived from the value of the underlying asset (in this case The concert ticket)
FINANCIAL DERIVATIVES Now I hope you are clear about the term. The concert ticket was an imaginary derivative instrument. We generally dont find such ticket derivatives in real life. The real ones are derivatives in financial markets. These derivatives are widely traded to guard against price fluctuations. We will discuss the uses of derivatives against price fluctuation in a different chapter. For the time being, lets wind up this article by discussing what a financial derivative is - Derivative is a general term. Derivative literally means derived from. These are nothing but financial instruments that can be bought and sold. Futures and options are types of derivatives. What it carries is a right. When you buy derivative, you buy a Right. In normal stock market trading, we buy and sell shares. But in this case, the stock is not traded instead; the right to buy or sell a share is traded. Note that, the right may be The right to buy or the right to sell. But, this right, to buy or sell, cannot be held on forever. The exchange sets a cut off date before which you have to either exercise your right or sell off the right to another person. The cost of buying a right is very less compared to the actual stock price. For example you hold the right to buy Infosys at Rs. 2000 per share today. You bought the right for Rs 200. Now, after a few days, Infosyss shares are trading at Rs.2500. But you can buy it at Rs 2000 since you have purchased the right to buy Infosys at that price.Naturally, since the price in cash market is Rs 2500, you can exercise the right to buy at Rs.2000 and sell it at Rs.2500. So, your investment of Rs 200 gave you return of Rs 300 ( Total cost = 2000 + 200) because the underlying asset (shares of Infosys) went up in value. So, buying a derivative does not result in acquiring a share, but it results in buying the right to buy a share or to sell a share. In other words, the buyer of a derivative gets a right over an asset (shares) which after a certain period of time might result in the buyer buying or selling the asset. Not only shares, the base asset can be anything like commodities, foreign currency, treasury bills, bonds or share indices. In fact, any transaction that results in a right without actually transacting the asset becomes a derivative instrument. All derivative instruments are not the same. They differ when it comes to the kind of obligation it creates on the holder. Forwards, Futures , Options and Swaps are the types of instruments that are clubbed under this general term. Will catch up with each of these types in up coming articles.. Types of derivatives 1 Forward contract. by J Victor on December 14th, 2011
Lets catch up with the oldest and the simplest of derivatives. FORWARD CONTRACTS In forward contracts, two persons enter into an agreement for purchase and sale of a commodity / financial asset at a specified price at a specified future date. These contracts are generally used by traders to guard against price volatility. For example- You are a trader of fruits. You enter into a contract with a farmer to deliver 1000 kilograms of apples at 100 per kilo, 3 months from now. Thats a forward contract. Here, apples are the specified asset, 100 per kilo is the specified price and 3 months is the specified future date. So, in short, it is a contract between a buyer and a seller- To deliver some goods / asset at a particular price at a future date, the price being fixed right now. On the delivery date, the buyer pays the price and receives the asset/goods These are tailor made contracts and one can choose the quantity, mode of delivery and time of contract maturity. What if one party to the contract does not oblige?
That risk is always present. There is no performance guarantee in a forward contract. Its up to the buyer and the seller to fight it out! FORWARDS IN OUR DAILY LIVES.. Forwards are part of our daily lives unknowingly. Imagine this Gold prices are rising every year and you want to invest in Gold coins. You go to a jeweler but since gold coins are out of stock, they say that it would take 5 days to deliver. But you want it at todays rate. The jeweler , not wanting to lose a customer agrees to deliver gold coins at todays rate, 5 days later. Technically speaking, this is a forward contract. You and the jeweller has entered into a forward contract The jeweler is obligated to give you gold coins 5 days later when you bring the agreed amount of money. The price , size , delivery date and any other terms and conditions are already locked in through this contact. Payment is made only on delivery-not before that. Lets also assume that this was a written contract. Technically this contract can be called as a Gold forward contract. Four important points to note here is that The seller sold the forward contract. Seller has agreed to sell the coin in the future at a price agreed mutually ON the date of contract. So the seller must deliver the Gold coin in the future at the agreed upon price. You bought a forward contract. You buy the coin in the future at a set price. You are supposed to contact the seller after 5 days from today and must deliver the promised money. The contract is not Exchange traded. Its a private contract. Hence, counter party risk is present. Margin money (advance payment) is generally not made at the time of entering into agreement. However, there is no hard and fst rule that no payment should be made. If both the parties are ok with making an advance payment, they can. WHAT WOULD HAPPEN IF THE GOLD PRICE FALL? Then, the seller would be happy since he sold Gold coin to you for a higher price! Conversely, you would stand to gain should the Gold prices go up. The price of Gold after 5 days is irrelevant. The purchase price was locked and the deal has to be executed at the rate agreed previously. Since forward contracts are not properly regulated, either the buyer or the seller can default in performing his part, should circumstances be unfavorable to him. To continue the above example You may not turn up after 5 days to buy the gold coin at the agreed rate if the price drops. Or, if the price went up, its not necessary that the dealer would settle for the previously agreed price. The jargon for this is counter party risk. Its always present in forward contracts. SETTLEMENT So, finally, one of the parties to the contract stands to gain depending on the price movement. Now the next question is how is a forward contract settled? Forward contracts are usually settled OTC (Over the counter). Hence these are also called OTC contracts. The phrase over-the-counter refers to any settlement process via a dealer network and not through a centralized exchange. The settlement of the contract occurs at the end of the contract. The contract can be settled in two ways- One, actual delivery of the goods upon payment. Second, cash settlement- The buyer and the seller would simply exchange the difference in the associated cash positions. AT THE ORCHARDS. Heres a realistic scenario where forward contracts are used.
Oranges sell at Rs 2500 a ton right now. An orchard is expected to yield 10,000 tons of oranges 3 months from now. The orchard owner however fears that the price of oranges would come down by then, because he expects excess supply of oranges from different orchards to the market. The only way for him to eliminate this risk is to find a buyer who is ready to buy these oranges at 2500 per ton. At the same time, an orange juice company fears that its competitors may buy in bulk and as a result the oranges may be in short supply and so the prices may go up. They cant change the price of orange juice because they fear if thats done the sales may drop. They need to maintain the cost and profit at the present rate. So, these two parties agree today on a forward price of Rs 50 per Kg, for delivery 3 months from now when the crop is harvested. It just an agreement. No payment is made. In 3 months, 10,000 tons of oranges should be delivered to the juice company.When they do it, they can take the price agreed 3 months back. The price of oranges 3 months hence could be Rs 3000 per ton or Rs 2000 per ton but, that price is irrelevant. Both the parties have already predetermined their profits and have eliminated the risk of price volatility and can plan ahead. Types of derivatives 2 Futures contract by J Victor on December 21st, 2011
We continue with our discussion on derivatives As said in my last article, forward contracts have some de-merits. First, The quantity, the mode of payment, the delivery date, the price, everything varies from one contract to another and performance of the contract is not guaranteed. Second, to continue the orange juice example, suppose after some days the orange juice company decides to back off since they feel that they dont need oranges at that price. This would give rise to problems between the buyer and the seller. In short, nothing is regulated in forwards. Its tailor-made according to circumstances and can be written for any amount and terms. Quite easy to understand, I guess.
How about a contract thats regulated in all these aspects? That is, you get a fixed quantity contract, at a fixed rate, for a fixed expiry date. You can buy and sell the contract anytime. Liquidity is ensured and somebody stands in between to regulate and guarantee the performance- Thats futures. So, there is no much difference between forwards and futures, except that futures are well regulated in all aspects. A future is an agreement between the seller and the buyer to deliver a specified quantity of a share/commodity/forex at a fixed time in the future at a price fixed between the parties NOW. An organization called clearing house stands in between to ensure that both the parties fulfill their obligations. How does the clearing house ensure that? Both the parties are required to pay a percentage of the total value of shares/ commodity / forex to the clearing house. This amount is called Initial Margin money. Since the contract is marked to market or linked to market on real time basis, the value changes every now and then. Accordingly, the amount to be maintained by the buyer and the seller with the clearing house also fluctuates on daily basis. The stock exchange (for stocks futures) or commodity exchange (in case of commodity futures) will take responsibility for collecting the payments and making the settlements. There is no chance of default. To achieve this, each trade is split into two parts- Buyer with the clearing house and Clearing house with the seller. So each party has to fulfill their obligation to the clearing house. Even if one party to the trade defaults, the clearing house fulfills performance. In other words, by virtue of a futures contract, when you have the right to buy the clearing house takes a sell position against it and when you have the right to sell the clearing house takes a buy position against it so that the performance is always guaranteed. So in short, future contracts issued by the exchange can be traded just like shares. For example, Reliance October Futures may be issued by the exchange. This contract would have the following features: Specific quantity: Each futures contract has a specified quantity. In this case, lets assume its 100. Specified share: if you have entered into a futures contract to buy 100 reliance shares, you will have to deliver 100 reliance shares and not 100 Infosys shares. Specified date: the date and month of delivery is determined by the exchange. As of now, the exchange has fixed the last Thursday of every month for settlement of contracts. The clearing house plays an important part in trading of futures contracts. It does all the back office operations. It guarantees performance from either side. Hence there is no risk of default. Thus Reliance October futures contract becomes a standard asset like any other asset that can be traded in the market. MARGIN MONEY To enter into these futures contract you need not put in the entire money. For example, reliance shares trades at Rs 1000 in the share market. If you want to enter into one lot of Reliance October futures contract which consists of 100 reliance shares, you need not put 100 x 1000. Instead, you would be required to maintain a small deposit (called margin) with the broker. Margin is decided by the exchange. This margin amount will keep varying with changes in daily prices. If the price goes up the buyers margin is reduced and the sellers margin is increased by an equal amount. If the price comes down, the buyers margin is increased and the sellers margin is reduced by an equal amount. Heres the link to know the margin money requirements of future contracts Heres an example- Let us assume you bought a Future contract of Infosys October (i .e, 100 shares of INFY at current future price of Rs. 2200 per share, settlement date being last Thursday of October) .Lets further assume that the margin money required by the exchange is 20%. So, you pay Rs. 44,000. Now suddenly there is a crash and the price of INFY in the spot market dips to Rs. 1700. So you have lost Rs. 500 per share which, for 100 shares, is Rs. 50,000! This is greater than your margin of Rs. 44,000 so the broker will ask you to provide the extra Rs. 6,000 as an additional margin to keep your contract afloat. Futures are actively traded in the market, and the price of the future is not decided by you so once you have bought the future, you can SELL the contract to someone else. Lets say the contract you bought at Rs. 2,200 is now trading at Rs. 2,700 instead. You can sell the contract itself, and make the Rs. 500 as profit per share for 100 shares; thats Rs. 50,000 profit. You get a net profit of Rs 6,000 ( Rs 50,000 44,000) The exchange will also give your margin back, and take a margin from the new owner of the contract. Before I end this article, heres a point wise differentiation between forwards and futures:- 1. Size of the contract In the case of forwards, its decided by the parties. In futures, its decided by the exchange. In the case of share futures, a lot is generally 100 shares. 2. Price of the contract In the case of forwards, its decided by the parties. It remains fixed till the end of the contract. In futures, the price keeps floating according to daily price movements. This is called Marked to market in technical terms. 3. Margin money In the case of forwards, it may or may not be required, depends upon how the party negotiates. In futures, margin money is fixed by the exchange. It is usually a percentage of the value of the contract and it has to be paid by the buyer and the seller to the exchange. Since its marked to market; the margin requirements will have to be settled on a daily basis. 4. Number of contracts In the case of forwards, there can be any number of contracts. In futures, the number is decided by the exchange 5. Settlement In the case of forwards, the settlement is through OTC. In the case of futures, the settlement is through exchange. 6. Mode of delivery In case of forwards cash settlement or delivery. In the case of futures most of them are cash settled. I hope youve got some understanding about futures and the difference between forwards and futures. Its important to understand these two instruments clearly. Till my next article on options Types of derivatives 3 Options contract by J Victor on December 31st, 2011
We discussed forwards and futures. The next derivative instrument is options. Before we move on, here are two stock market games for you to play. TWO GAMES AT YOUR OPTION ! Game 1. Share price of a company, say Wipro, is at Rs 300 now. For a small fee of Rs 3 per share, you will be given the right to buy 1000 shares. The condition is that if price moves up and strikes Rs 390, you keep the gain on 1000 shares. If price falls, you need not suffer the loss on 1000 shares. You lose only that small amount you paid for participating in the game. So, if you win, you make a lot of money. For example If the price moves up to Rs 390, you gain Rs 90,000 (1000 x 90) less Rs 3,000(3 x 1000). If price falls, youll let go a small amount of Rs 3,000 for playing that game. The benefit is- Unlimited gains. Limited loss.
Game 2 Share price of a company, say Wipro, is at Rs 300 now. The price of the share is expected to fall to Rs 250 per share. For a small fee of Rs 3 per share, you will be given the right to 1000 shares. If price falls as expected, you keep the difference on 1000 shares. If price moves up, you lose that small amount you paid for participating in the game. So if the stock strikes 250, you gain Rs 50,000 (1000 x 50) less Rs 3000 (1000 x 3). If the price went up contrary to expectations, you lose the small amount paid as fee. Limited gains. Limited loss. In reality, Do we have such games ? The answer is , yes. The game is called options.
CRACKING THE GAME CODE. Game 1 is called a call option. What you did is, buying a call option. Game 2 is called a put option. What you did is, buying a put option. As a buyer of calls or puts, youre henceforth called the holder. Where is this game played? In the stock market, of course. Options are bought and sold at the stock markets. Who starts the game? The stock exchange. The exchange would introduce the game and set the ball rolling. Which game should you play? If you expect the stock price to rise, you play game 1, that is, you buy a call option. If you expect the price to fall you play game 2, that is, you buy a put option. Who sells? Thats right. The game is played in the stock exchange and all I am taking about is buying call options and put options. But how can you buy unless there someone to sell the same? There are sellers. They are also called writers. Those are game participants who think contrary to your views. They expect the price to fall, so they sell a call option (Recall game 2 Alternatively, they could have bought a put option). If they expect the price to rise, they sell a put option. (Alternatively, they could have bought a call option) A logical doubt As implied from the above paragraph, if someone expects the price to rise, they sell a Put option. Alternatively, they could have played game 1- buy a call option. Both have the same effect, I am right? No. Why? Both actions are based on the calculation that a stock price will rise. The buyer of a call and the seller of a put share the same opinion about the price direction of the stock. But thats where the similarity ends A person chooses to buy a call when he reasonably thinks that the prices are moving up. If he was 100% certain that the price would move up, he would have bought the shares itself, and not options! Similarly, a person chooses to buy a put when he reasonably thinks that the prices are moving down. But sellers of calls and puts basically do it for some other reason. They are actual shareholders who want to protect themselves from price volatility and at the same time make some money out of it. Since they sell the right , Sellers are obligated to perform their part. Theres no option. Option strategies will be discussed in later articles. For the time being, it important to keep things simple. Before I finish this introductory article, heres the summary of what weve discussed. Its cut into 3 parts. Make sure you understand part by part. Section 1 Option contracts are introduced by the stock exchanges. There are two types of options call option and Put option. Call = right to buy, put = right to sell. You can buy or sell any of these options. If you are a buyer, youre called the holder of an option. Buy= hold If you are a seller, youre called the writer of an option. Sell = write Section 2 You can hold a call or hold a put. As a holder of option, you have the option to buy or sell and not an obligation. o Depending on the price movement, a call holder may get unlimited gains or limited loss. A put holder has only limited Loss and limited profits. o You can write a call or write a put. As a writer of option, you are obligated to perform. You have an obligation to sell if youve written a call and you have an obligation to buy if youve written a put. o Depending on the price movement, a call writer may suffer unlimited loss or limited profit. A put writer has only limited loss and limited profits o Writing, since it carries obligation, is risky. Section 3 When youre bullish on a stock, you BUY CALL OPTIONS which gives you the right to buy that share at the present price at a future date. So, in future, when the price moves up, you stand to gain. Contrary to your expectations, In future, if the price of the stock falls, you will not exercise your right to buy at present price. The only loss is the commission paid for buying call options. When youre bearish on a stock, you BUY PUT OPTIONS which give you the right to sell that share at the present price at a future date. So, in future, when the price moves down, you stand to gain. Contrary to your expectations, in future, if the price of the stock shoots up, you will not exercise your right to sell at the present price. The only loss is the commission paid for buying put options. You WRITE options to control risk of shares you hold or to lock in profits or to gain from writing. Who plays in this market? by J Victor on March 13th, 2012
There are at least 5 categories of players in derivatives market. Irrespective of what you intend to do in the market, you would fall in any one of the 5 categories mentioned here. CATEGORIES OF PARTICIPANTS. As mentioned above, there are 5 categories: 1. Hedgers 2. Arbitrageurs 3. Speculators 4. Spreaders 5. Amateurs HEDGERS They are the real users of derivatives. In fact, derivative instruments were invented solely for the purpose of hedging or risk management. Hedgers are investors who want to reduce the risk of price fluctuation on their investments. The meaning of hedging, its uses and the way its done would be discussed in another post. Hedgers are basically risk averse investors.
ARBITRAGEURS Arbitrageurs are participants who are always on the look out for spot price anomalities between futures contracts and their underlying assets or between spot price of an asset in two different markets in order to reap a risk free return. Arbitrage is a source of risk free income. For example lets assume that you have invested in 600 shares of Reliance. On one trading day, you notice that Reliance is trading at Rs 2000 on the BSE and Rs 2010 on the NSE. You sell your 600 shares on the NSE at Rs 2010 and simultaneously buy back the 600 shares on the BSE at Rs 2000. You profit in this case is 600*10 = 6000 less brokerages if any. This is one form of arbitrage. Arbitrage too, is discussed in a subsequent post in detail. SPECULATORS. As in the case of any markets or business, there are speculators in derivatives market too. These are risk seekers, willing to risk their capital to make that extra buck, quickly! They dont do this blindly. In fact, experienced speculators know when to hold or to walk away from a trade. These guys engage in trades that involves substantial risk but at the same time has the potential to return huge profits if things work out to their advantage. SPREADERS This is a category of very professional people who specialises in trading derivative contracts in combination with other derivatives or spot assets with the objective of reducing risk and making money in the process. Spreaders are experts in derivatives who would create complex transactions by smartly combining futures, options and spot markets. This is a very professional and specialised field. AMATEURS People who enter the derivatives segment just to know whats going around, to get a first hand feel of the derivatives market. There could be students, aspiring derivatives traders etc..Everyday in the market, there is a small segment of people who are lured in by advertisements or by brokers and advisors. So, thats the last of 5 classes of players in this segment. Whichever way you enter derivatives market, youre sure to be included in any one of the 5 categories mentioned above. Why do derivatives market exist? by J Victor on March 14th, 2012
As we saw in the introductory articles, derivatives are complex financial instruments and dealing with derivatives is often riskier than dealing with the underlying asset themselves. If they are so complex to deal with, then why do they exist? Why are so many interested in it? What purpose do they serve? Well try to find answer all this in this post. Before that let me clarify a point. There is a common misconception that derivatives would bring financial ruin. Thats not true. Derivatives by them selves do not bring in any additional risk to the economy. Improper handling of derivatives can cause damage now, isnt that true with anything we handle in life? So the root cause of any loss through derivatives is not the problem of derivatives.
Of course, the financial ruin of America started with the complex transactions on derivatives.. President Barack Obama recently said that he will veto legislation that does not bring the derivatives market under control so that he can assure that America does not have the same kind of crisis that they have seen in the past. However, the problem was not with derivatives. The problem was with the people who used it in an uninformed and reckless manner. DO WE REQUIRE DERIVATIVES? Do we require derivatives? The answer is yes. Its required because of its advantages to the economy. Derivatives in any economy serve three basic functions: 1. Price discovery 2. Risk management 3. Speculative activity All the three functions are required for any economy to function properly. PRICE DISCOVERY Derivatives play a crucial role in discovering the present and future price of any commodity or financial asset. This is an essential part of an efficient economic system. Prices of stocks and commodities tend to move in the same direction as the expectations of market participants. Hence, the price in the futures market reveals the demand supply expectation in the future and thus undertakes the process of price discovery in the spot market. For example take the case of a sugar manufacturer. He doesnt know what could be the price of sugar two months down the lane. By closely following the futures market rates of sugar he would be in a position to figure out the future demand-supply relation of sugar and plan his production accordingly. Or, take the case of jewelers in Mumbai and Delhi. Assets like gold may be sold for marginally different rates in Mumbai and Delhi.Gold Derivative contracts on the NSE would have only one value and so traders in Mumbai and Delhi can validate the prices of spot markets in their respective location to see if it is cheap or expensive and trade accordingly. RISK MANAGEMENT. Organizations or individuals financial uncertainties expose them to unexpected losses in many ways. Derivatives are instruments meant to cover risks. Corporates, traders and individuals use derivatives as a tool of risk management to cover the vagaries of price fluctuations. For example: Lets assume that today is May 1 st and you hold shares of reliance now trading at Rs 500. You expect the price of shares to come down in future. Reliance futures are available at Rs 525 right now. You can sell shares at Rs 525 and lock your profits. Should the spot price of reliance fall to Rs 375 as expected, you gain Rs 150 per share. In the normal case, you would have been sitting with a loss of Rs 125 per share. The above process is technically called Hedging. ie,making an investment to offset the potential loss of another investment. Lets take another scenario. June 30 Reliance call options are available on the NSE at 500 strike. That means, buying that call will give you the right to buy reliance shares at 550. Now, at the end of June, if the share price remains at 550 or less than that, you will not exercise your right and will consider the amount paid to buy the option ( called premium) as loss. That amount of premium is the maximum loss he would suffer. Hence, loss is always limited. On the other hand, if the share price of Reliance goes above Rs 550, ( say current market price is 600) the call will be exercised. You will buy the shares at 550 and sell it at 600 and make profit. You profit will be 50 (minus) premium paid. The possibility of gain can be unlimited. Imagine the profit if the share price increased to 950 by the end of June. it would be 400 (950-550) less the premium paid. Assuming that the premium paid is 30, your profit would be *400-30 = 370 per share x number of shares in one lot. So, derivatives help informed investors take advantage of favorable price movements. SPECULATIVE ACTIVITY. Speculators, due to their volume of activity, drives prices in one direction and then, in the other causing upward and downward movements in prices. What drives them is not fundamentals but mass sentiments. Irrational speculators may get lost in the process of speculation. But, rational speculators would jump in on any mispricings in the market and this results in the price being brought back to equilibrium. For example, if a speculator thinks that the price of a certain stock is over priced and hence may fall, he would immediately jump in and sell the stock. The masses follow the trend and that results in a huge sell off and thereby it brings the stock back to its actual worth. They also add liquidity to the markets. So speculative activity is required to maintain that balance. Futures: Types of contracts by J Victor on March 20th, 2012
Depending on the type of underlying asset, there are different types of futures contract available for trading. They are Individual stock futures. Stock index futures. Commodity futures. Currency futures. Interest rate futures. INDIVIDUAL STOCK FUTURES Individual stock futures are the simplest of all derivative instruments. Stock futures were officially introduced in India on 9 th November 2001. Before that, the local version of stock futures called badla were traded which was eventually banned by the Securities Exchange Board of India in July 2001. The Badla system: the badla system was almost similar to the futures contracts we discussed. In simple terms- A badla trader can delay the settlement of a trade by one week for payment of a small fee. So if you bought a particular share for Rs 100 and if you are bullish on that stock, you can delay the settlement by one week if you pay a fee. This carry over can be done for any number of times. Later on, unlimited carry over facility was restricted to 90 days at a time. Badla system had its downsides lack of transparency, data regarding volume, rates of badla charges, open positions etc were not available. There was no margin requirement and badla charges varied from seller to seller. So, chances of manipulation were more. Badla was pure Indian version of futures but did not provide the advantages of price discovery or risk management that organized futures market provide. STOCK INDEX FUTURES. Understanding stock index futures is quite simple if you have understood individual stock futures. Here the underlying asset is the stock index. For example the S&P CNX Nifty popularly called the nifty futures. Stock index futures are more useful when speculating on the general direction of the market rather than the direction of a particular stock. It can also be used to hedge and protect a portfolio of shares. So here, the price movement of an index is tracked and speculated. One more point to note here is that, although stock index is traded as an asset, it cannot be delivered to a buyer. Hence, it is always cash settled. Both individual stock futures and index futures are traded in the NSE. COMMODITY FUTURES Its the same as individual stock futures. The underlying asset however would be a commodity like gold or silver. In India, Commodity futures are mainly traded in two exchanges 1. MCX (Multi commodity exchange) and NCDEX (National commodities and derivatives exchange). Unlike stock market futures where a lot of parameters are measured, the commodity market is predominantly driven by demand and supply. The term commodity is a very broad term and it includes Bullion gold and silver Metals Aluminum , copper, lead, iron, steel, nickel, tin, zinc Energy-crude oil, gasoline, heating oil, electricity, natural gas Weather- carbon Oil and oil seeds crude palm oil, kapsica khali,refined Soya oil, Soya bean Cereals- barley, wheat, maize Fiber- cotton, kapas Species-cardamom, coriander, termuric etc Pluses chana Others- like potatoes, sugar, almonds, gaur CURRENCY FUTURES. The MCX-SX exchange trades the following currency futures: Euro-Indian Rupee (EURINR), Us dollar-Indian rupee (USDINR), Pound Sterling-Indian Rupee (GBPINR) and Japanese Yen-Indian Rupee (JPYINR). INTEREST RATE FUTURES. Interest rate futures are traded on the NSC. These are futures based on interest rates. In India, interest rates futures were introduced on August 31, 2009.The logic of underlying asset is the same as we saw in commodity or stock futures in this case , the underlying asset would be a debt obligation debts that move in value according to changes in interest rates (generally government bonds). Companies, banks, foreign institutional investors, non-resident Indian and retail investors can trade in interest rate futures. Buying an interest rate futures contract will allow the buyer to lock in a future investment rate. FROM WEATHER TO TERROR..!! Weather influences everyones lives. Right from daily lives to agriculture to corporate earnings everything gets affected if the weather is not favorable. For example lets assume that this year cold winter is expected in most parts of the United States. What happens is that the price of heating oil goes up. Heating oil futures are traded in commodity markets depending on weather forecasts. The fear of terrorist strikes had even made Pentagon think of creating a futures market to help predict terrorist strikes. Their theory was that possibility of terror strikes in a particular area for example possibility of a terror strike in New York would be traded as if it was a commodity. Higher the price, higher the possibilities of a terror strike. This way they thought, would help them in finding potential threats. Or take another example the assassination of Israel prime minister futures which would be available for trade as a commodity. Higher the price, the more likely the event. However the attempt was scrapped by pentagon in the initial stages itself. Futures: Understanding the basic terms by J Victor on March 28th, 2012
UNDERLYING ASSET The underlying asset that gives value to a futures contract could be shares, share market indices, commodities, currency, interest rates, weather etc. LOT SIZE The exchange specifies a particular lot size for each type of derivatives. When you buy or sell futures, you do that in lots. This lot size is not divisible. For example the lot size of reliance futures is 250 shares. So, taking 1 lot of reliance futures would involve 250 shares. So if Reliance shares are trading at Rs 1000, then the value of 1 lot is Rs 250,000 (Rs 1000 x 250 Numbers) The exchange specifies the lot size. Lot size would be different for different stocks/commodities. Not all stocks traded in the exchange have equivalent futures contract. Stock are selected on the basis criteria specified by the SEBI
VALUE OF A LOT The value of one lot would be the price of the share x lot size. In most cases, it is approximately Rs 2-3 lakhs. MARGIN MONEY When a person enters into a futures contract, he need not pay the full value of the contract upfront-only a small percentage needs to be paid. That payment is called margin money. Usually margin money would be a percentage ranging from 10% to as high as 35 or 40% in times of heavy volatility. For example the margin required for buying 1 lot of reliance futures now is 15.70%. I.e., approximately Rs 29,000.00 The actual margin money required to be maintained changes every day, specified by the NSE. LIFE OF A CONTRACT The life of one contract is 3 months. At any point of time, 3 futures contract will be available for trading with different time limit to expiry 1month, 2 month and 3 month contract. ( Also called near month, mid month and far month contracts) DIFFERENT TYPES OF FUTURES Stock futures and stock index futures traded on the NSE Commodity futures traded on MCX / NCDEX Interest rate futures traded on NSE OPEN INTEREST Open means yet to be settled. Open interest is the number of yet to be settled contracts. The term used to describe a pair of buy and sell. In live futures market, for each seller of a futures contract there must be a buyer of that contract. Ie, there must be a pair. Thus, a seller and a buyer combine to create only one contract. For example if Mr. x buys 5 futures contract from Mr. Y (seller of the contract), then open interest rises by 5. The total number of open contracts x lot size is called open interest. The open interest cannot exceed the number of shares a company has. An increase in open interest may mean that more money is flowing in. MARKED TO MARKET Futures contracts are monitored regularly by the authorities. Hence, Futures prices are marked to market. It means that every change in value to the investor is shown in the investors account at the end of each trading day. The implication is that, if your futures position is in profits on a particular day, your account is credited with that much of profits (which would be taken away, if the prices fall on the next day). This process would keep going until you settle the contract. At the same time, if your position is in loss, the loss will be shown in your account on the end of the trading day and if such loss is beyond your initial margin youve given, you will have to pay the difference. DISPLAY ON THE TRADING SCREEN Futures are displayed on the trading screen just like equities. Each future contract will be in a coded form just like equities. Future contracts are displayed in alphabetical order. For a particular share / index / commodity, 3 contracts will be displayed. The near month contracts are listed first. The trading screen would also show the open price, high, low, traded quantity etc. LONG AND SHORT POSITIONS Unsettled or open purchase position at any point of time is called a long position and unsettled sales position at any time point of time is called a short position. SPOT AND SPREAD. The cash market price is called the spot price and the prices of futures contracts are called the futures price. The term spread used to describe the difference between two prices. For example reliance October futures may be trading at Rs 750 per share and reliance December futures may be trading at say, Rs 765. The difference is called spread. In fact, spread is a general term. It should be understood in the context in which it is used. The difference between the bid price and ask price is also called spread. Futures price will be greater than the spot price in a normal market. EXPIRY DATE OF A CONTRACT Any futures contract would expire on the last Thursday of a month. On that date the contract ceases to exist and all the obligations must be fulfilled and the rights, if any, become invalid thereafter. Near month contract expire on the last Thursday of that month. For example Infosys July contract (1 month) would expire on the last Thursday of July while Infosys September contract which is available for trading in July (3months contract) would expire on the last Thursday of September. If the last Thursday happens to be a holiday (like Christmas), the expiry will be fixed for the next day. In case of unforeseen circumstances the maturity date may be shifted to another day by the SEBI through a notification. At the expiry day, all contracts are automatically settled. One the next day after the maturity, a new 3 month contract will be introduced. SETTLEMENT In most futures markets, actual delivery never takes place. Futures are cash settled. Futures are used by traders for hedging price risks or by speculators for betting against price movements. Generally nobody is interested in taking delivery of the underlying asset. For example lets take the case of a person who has taken two futures long positions of reliance at Rs 750. At the expiry of a futures contract, if the price of an underlying asset (reliance shares) is more than Rs 750, the exchange will pay the difference plus the initial margin as settlement value. If the price of reliance has dropped below Rs 750, the trader will have to pay the difference to the exchange. So, settlement takes place by taking an opposite position to the one you have. When your contract is settled or liquidated, the initial margin you paid plus or minus any gains or losses will be credited back to your account. Futures: Understanding Open interest. by J Victor on April 4th, 2012
OPEN INTEREST. Open interest is one of the most confused terms in derivatives . In simple terms, open interest is the number of unsettled contracts. This term should not be confused with volume. A Common misconception amoung investors, especially beginners, is that open interest on any day represents the volume of future contracts traded.This needs to be corrected. HERES AN EXAMPLE With the help of an example, lets try to understand the term open interest and why it is different from volume . Our friend Mr. X is a guy who would like to speculate in the futures market. Having made a killing from Nifty futures last month, he starts his game afresh. This week, this is what he has done in the first three days Monday bought 500 nifty futures. So, volume is 500, number of open contracts 500.He could buy 500 contracts because there was someone on the other side (say, Mr. Y) to sell the same. In futures market, every long position (buy position) has to have an equivalent short position (sell position). Tuesday bought 500 nifty futures. Volume for that day is 500, the number of open contracts rises to 1000. Note that we are counting volume from 0 everyday but open positions are counted as a running total. Secondly, when 500 contracts were bought by our friend, 500 contracts were sold by someone (Lets assume Mr. Y is the seller ).To count the volume, we did not add up 500 buy +500 sell. We counted a pair of BUY and SELL as 1. Same logic follows for open interest as well. Wednesday sold 600 Nifty futures. The volume for that day is 600. However, the number of open position or unsettled contracts may fall to 400 (1000 long -600 short) or remain the same depending upon who purchased the futures from Mr.X.If what Mr. X sold was purchased by Mr. Y, then the open interest would get reduced to 400. But, if it was purchased by a new entrant (say Mr. C), then the open interest remains at 1000. Why? Thats because, when Y purchased, it has the effect of squaring up open positions. So, open interest gets reduced to 400. But when C purchased it, X still has 400 contracts (buy) to settle, Y has 1000 (sell) to settle and new entrant C has 600 (Buy) to settle. The net effect is open positions remain at 1000. The rate of purchase or sale of futures or the amount of profit made or loss suffered on the deal is of no importance. What matters is the number of unsettled contracts. LONG OR SHORT-IT DOESNT MAKE ANY DIFFERENCE. Open interest on the long side or short side? Open interest thats reported daily on the newspapers and websites is the net open positions on the long side. Equivalently, its also the number of short positions in the market. So it doesnt make any difference. For example- if the media reports that open interest of Wipro futures is 2 lakhs, it means that future contracts equivalent to 2 lakh shares were unsettled. There are 2 lakh shares on the long side and equal number of shares on the short side. Now I hope, you are clear about the difference between open interest and volume. Open interest is the total of active positions in the market. So, when traders buy / sell and settle positions in the market, the open interest will keep changing. Its basically a running total. Volume is a totally different figure. Each day, volume is counted afresh from 0. THE USE OF OPEN INTEREST. As a single stand alone figure, open interest is of no use. It doesnt tell you much. The only fact you can guess is that towards the end of the contract cycle, if open interest remains very high, volatility can be expected in the market. However, if you read open interest data with the price changes and volume in the market, you may get meaningful information. Here are the thumb rules- Prices will continue to rise when volume, prices and open interest are rising If prices are rising, but volume and open interest keeps falling- It means that an uptrend would gradually halt. Its a weak market if the prices are falling, but volume and open interest are rising. New money is entering the market in the form of short sellers. And finally, when prices, volume and open interest are all declining, then we can assume that the market has almost bottomed out. Futures: Principles of pricing. by J Victor on April 11th, 2012
At any point of time, Futures price of a share differs from the spot price. As we have already learned, the spot price of a share is determined by lot of factors like demand and supply, performance of the company, broad economic conditions, media news, general market psychology etc. Do the same factors decide futures prices? Or is there anything else we need to know? The answer is yes. We need to learn a concept called continuous compounding.
THE PRICE OF FUTURE. Of course, economic conditions, demand and supply of the underlying asset and countless other factors like hedging and short selling influence futures pricing. But theoretically, the futures price of stocks at any point of time is determined by two factors- Short term risk free interest rates and Dividends. HOW TO FIND THE VALUE OF FUTURES Theoretical futures price when no dividend is expected. Value of futures = Spot price x E (R x T)
Where E is the exponential value R= risk free interest rate T= time to maturity For example The share of X ltd is Rs 200 in spot market. The risk free interest rate is 8%. What would be the theoretical price of X Ltds 3 months futures? Value of futures = Spot price x E (R x T)
Spot price = Rs 200 Risk free rate = 8% or 0.08 Time to maturity = 3 months or 3/12 or 0.25 So, R x T = .08 x .25 = .02 E (.02) = 1.0202 ( from natural logs table) Value of futures = 200 x E (.02) = Rs
204.04 Note: To get the value of E (.02) refer to the E +X table of natural logarithms. Log tables are nothing new. We all have used log tables in our school days. Its also available online in many math sites. Whats mentioned above is the price of futures, theoretically. The method we used is called continuous compounding. This is one of the vital principles in futures pricing. In some cases, the security in which a futures position is taken may generate income. For example- dividend on shares. In such cases the above formula has to be modified to include the expected dividend. Theoretical futures price when specific dividend is expected. In this case, we have to consider the dividend expected from the stock. The logic is that if dividend is paid by the company, then the amount required for investment would be lower. Value of futures = (Spot price- expected dividend) x E (R x T)
If the dividend expected is expressed as a percentage, then the above formula may be modified a little bit as follows Value of futures = spot price x E (R-Y) T
Where Y is the expected rate of dividend or dividend yield. To sum it up, if the expected dividend is expressed in terms of money, we deduct the same from the spot price. Whereas, if a specific dividend yield is expected, then adjustment is made on the rate of return. There are two crucial aspects here 1. The accuracy of dividend forecasts.Depending on the accuracy , the value computed may vary. 2. Future dividends, expressed in rates or absolute values, have to discounted to the present value. The discounting process of dividends is the exact reverse of continuous compounding discussed earlier. Examples are given in the next post. RISK FREE INTEREST RATE. The topic was discussed elsewhere in our earlier posts. Risk free rate is the rate of return that any individual can achieve by investing in risk free assets. Generally, government bonds are considered to be risk free and the rate of return on such bonds are considered as the risk free rate of return. COST OF CARRY Its a jargon used in futures. Cost of carry is theoretically the risk-free interest rate that could be earned by investing your money in a safe investment such as government bonds. So, it represents the cost of carrying or holding an investment.In the above example the cost of carry would be Rs 4.04 ARBITRAGE OPPURTUNITIES Mispricings in the theoretical vale of Single stock futures unearths arbitrage opportunities. Such mispricings can be used effectively to earn risk free profits. More on that in our next post. Futures: Compounding and discounting techniques. by J Victor on April 17th, 2012
We discussed continuous compounding in the last post. Derivatives pricing are done using this method of compounding. The justification is that returns on assets like shares change continuously-on a minute by minute basis. However, in real life, since interest rates are expressed as an annual percentage, conversion to continuous rate is necessary to make accurate calculations. We also saw in the last article that interest rates and dividends are the two factors that determine the theoretical pricing of futures. The correctness of calculations therefore depends on how accurately youve assumed these two figures. HOW TO FACTOR IN EXPECTED DIVIDENDS In the case of dividends, you can only make a best guess by studying the past dividend history and the present financial strength of the company. Thats where it ends. Dividends have to be discounted at appropriate rate to find the present value. The technique used for this is continuous discounting the reverse process of continuous compounding.
The formula is: Present Value of future dividends = Future dividends x E -
(R x T)
For example The dividend expected on the X Ltds stock 3 months from now is Rs 10,000. What would be the present value of dividends if the risk free continuous compounding interest rate is 16% Per annum? Present value = 10,000 x E (0.16 x .25)
= 10,000 x E (0.4)
10,000 x 0.96079 = Rs 9607.90 Note: Just like E (+x), E (x) values are available from the natural log tables. INTEREST RATES Risk free interest rates would be expressed as a percentage on an annual basis. The question is- How do we convert interest rates expressed on annual or semi annual basis to continuous basis? The mathematical formula that helps to achieve this task is as follows: M x NL (1+ Normal rate/ M) Where, M = frequency of compounding and NL = Natural logarithm Here are two examples: 1. The risk free interest rate is quoted as 18 % P.a. What is the equivalent continuous compounding rate? M x NL (1+ Normal rate/ M) Where , M= 1( annual compounding), normal rate = 18% 1 x NL (1+ 0.18/1) = 1 x 0. 16551 = 0.16551 or 16.551% 2. The risk free interest rate is quoted as 18 % P.a. with half yearly compounding. What is the equivalent continuous compounding rate? M x NL (1+ Normal rate/ M) Where , M= 2( half yearly compounding), normal rate = 18% 2 x NL ( 1+ 0.18/2) = 2 x 0.08618 = 0.1724 or 17.24% Futures: Arbitrage & its meaning. by J Victor on April 25th, 2012
ARBITRAGE Buying in one market (say, spot market) and simultaneously selling in another market (say, futures market) to make risk free profits when there is substantial mismatch between two prices is called arbitrage. Arbitrage is described as risk free because participants are not speculating on market movements. Instead, they bet on the mis-pricing of a share/asset that has happened between to related markets. In short, when you earn by selling and buying same security at different rates in different markets, it is called Arbitrage. It is a highly technical field. Markets mis-pricing is taken advantage by traders to make risk free gains. Mispricing? How? The futures price has a definite relationship with the spot price. In normal market conditions, futures price would be greater than the spot price because of the effect of cost of carry and it moves in tandem with the price of the underlying asset. So, broadly we can say that if the spot price of the share moves up by Rs 5, the futures position would also have made a profit of Rs 5. The correlation is not very accurate but, almost so.
Thus, based on the cost of carry principle, if the spot price of a share on a given day is x then, the futures price on that day would be x + the interest for holding the spot to the duration of futures contract ( minus) any dividend accrued on the spot. So, to compute the cost of carry accurately a participant needs accurate information on interest rates and expected dividends. However, futures market is not so perfect where all the requisite information is readily available to all. Imperfections are common and that results in a mismatch between spot and futures price based on the cost of carry principle. When the relationship between spot and futures does not hold, the futures are incorrectly priced and that results in arbitrage opportunities. Example-1 AT THE GOLD SOUK. Gold coins sell at Rs 2500 for a gram right now. 1 year gold futures are available at Rs 3750 for a gram. (I.e. Gold coins deliverable after one year from now). Lets also assume that personal loan interest rates are 15%. Given the above situation, is there a way to make some guaranteed profits? The answer is yes. Lets see how. You borrow Rs 2500 at 15% interest for a year and buy in the spot market. At the same time, youd also sell futures at Rs 3750. A year later, to fulfill the futures contract ( remember, you were the seller of futures contract) you deliver the gold for Rs 3750 and out of the proceeds, you pay back your loan of Rs 2500 with interest which works out to Rs 2875. Net of Rs 875 (3750- 2875) is your guaranteed profit, whatever may come. What youve done is technically called arbitrage. You made money because; the futures were priced illogically higher than the spot price. The actual fair price of the futures should have been Rs 2875 (spot + cost of carry). But since futures were priced higher, you got the opportunity to make money. Example 2. The risk free interest rate is 6% right now. Shares of Toobler Ltd are available in the cash market for Rs 2000 whereas the futures contract of Toobler due for expiry in 3 months from now is available at Rs 2030 which is a 1.50% premium over cash market. This 1.50% works out to an annual risk free cost of 6% based on cost of carry principle. There is no arbitrage opportunity right now as the relationship is theoretically correct. Opportunities arise when the market over reacts to some news or events disturbing this equilibrium. For instance, lets assume that the government raises the interest rates to 8% and Toobler Ltds share price in cash market slumps to Rs 1970. The futures of Toobler Ltd, which is traded by speculators, may fall 3% to Rs 1969. You might get an arbitrage opportunity here since the theoretical spread between spot and futures has to be maintained by the market. Either the spot market has to fall or the futures price has to rise thereby maintaining the spread between the two. Here, if you buy futures and sell spot, you may make some risk free profits when the market comes back to normalcy. THE TWO RULES OF ARBITRAGE. We sum up the two rules of arbitrage. Rule 1. Buy spot and sell futures if the actual futures price is greater than the theoretical futures price. Rule 2. Buy futures and sell spot- If the actual futures price is lower than the theoretical futures price. Example 3 The shares of Toobler Ltd are quoted at Rs 2000 in the spot market. The risk free interest rate 12% per annum continuously compounded. Toobler is certain to pay a dividend of Rs 125 per share 3 months from now. 3 month Toobler future contracts are available. What would be the value of futures? If Tooblers futures are available at Rs 2100, what would be your strategy to make risk free profits? Fair futures price: The present value of divided to be declared 3 months from now would be Rs 125 x E -(0.12 x .25)
Rs 125 x E (0.03) = Rs 125 x 0.97045 = Rs 121.30 Therefore, adjusted spot market price would be Rs 2000 121.30 = Rs 1,878.70. Fair value of futures would be Rs 1878.70 x E ( R x T)
Rs 1878.70 x 1.30345 = Rs 1935. Since the futures are over valued at Rs 2100, you should sell futures and buy spot. (Rule 1) Example 4. If we assume that Toobler Ltds futures are available for Rs 1800. What would be the strategy to make risk free gains? Since futures are undervalued at Rs 1800, we apply Rule 2. You should buy futures and sell spot. Futures: Risk levels of participants. by J Victor on May 9th, 2012
Future contracts, as we have already seen, are instruments used for transferring risk. In other words, future contracts are basically used for Financial risk management. That brings us to one basic question. When and for whom is risk management necessary? Risk management is necessary only for those who have a risky asset position. I.e., when you have assets (shares / gold / currency / commodity etc) which fluctuates heavily in value. The uncertainty of price movements that surrounds such investments necessitates the use of derivatives. Many examples were discussed in our early posts on how derivatives help investors in reducing the risk they face. The point i would like to bring here is that you should be very clear about why you are using derivatives.
Many investors, Ive seen, use derivatives purely in pursuit of windfall gains. This is where the danger is.Many individuals and corporates have gone bankrupt because of reckless speculation in derivatives market. Way back in 1936, the dangers of speculation was explained by economist J M Keynes. The excerpt is given below- JOHN MAYNARD KEYNES ON SPECULATION Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not the faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of ones judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.J.M Keynes- From his book The general theory of employment, interest and money. The above situation holds true for all those uninformed traders who take positions in derivatives market expecting to make huge money. World over, the misuse of derivatives is on the rise. Misuse of these financial instruments contributed significantly to the global financial crisis in 2008. Newspapers and internet carry advertisements of advisory firms which provide futures and options calls with 90% or more success rate. Nave investors are lured to trade in derivatives by these firms. When many participants unnecessarily bet in different directions, the volatility in the market increases. Add to that those events like scams that occur across the finance world. All put together, sudden upward surges and downfalls occur which wipes off the wealth of many families and corporates. Speculation is part and parcel of every market. No system can control or curb speculation. In fact,there is no need to control them. Speculators of the first and second degree are required for the smooth functioning of the markets. They provide the much required volume and liquidity. But, when you put your money anticipating what average opinion expects the average opinion to be, youve gone too far. Opt for derivatives only if you have a genuine purpose of doing so. If you have a cash position or a heavy portfolio, youll have to protect it from the vagaries of price fluctuations. In such cases, you can use the derivatives route to reduce your risk so that when you lose on one, you gain on the other and thus neutralize the effect. You may also gain from favorable price movements. If you are using derivatives as a quick route to huge wealth, you are totally caught on the wrong side. In this case, your risk is substantial.Derivatives have the potential to evaporate all your money in seconds. In short, amateurs and speculators are the participants who would lose/ earn money depending on their stars or destiny. For them, the risk level is high. Other participants like arbitrageurs, spreaders and hedgers are in with a purpose. Futures: Hedging & its importance by J Victor on May 15th, 2012
HEDGING. Imagine this situation- you just bought a fundamentally good stock at a bargain. You know that youve done your home work and have bought the share at the right price and time. But still, in a surprise move, the market may think other wise and would send the stock price crashing. You may not even understand why the stock price tumbled. Such pitfalls are common in stock markets.What a weird place to be. isnt it? Now, is there a way to protect your money in such cases? Yes ! There are many methods. One such method is to use futures to hedge your position. Before we explain that, lets understand the meaning of hedging. Hedging is any act that trys to protect an investment from price risk to the maximum extend possible.So, its just like insurance. We insure our life - against death , against serious health problems, dont we? But, we dont take insurance for cold & cough. Similarly, hedging is not a strategy to employ for small investors because of the cost and effort involved. Hedging is effective when your investment involves a substantial amount.
HEDGING WITH FUTURES. To hedge with futures, just take the opposite of the position taken in the spot market. i.e. if you are long in the spot market, short futures. If you are short in the spot market, go long in futures. If the price in spot market falls, you lose in spot and gain in futures. If the price in spot market is up, you gain in spot and lose in futures. Either way, you would gain in one market and lose in the other. This never guarantees a huge return but it helps you to offset the loss incurred in a position and eliminates the price risk. EXAMPLE. 1. You bought 2000 shares of ICICI currently trading at Rs 700. Since the market is turbulent you fear that the stock price would fall and hence want to protect your investment from price risk. Futures of ICICI can be bought or sold at Rs 710. What would you do to hedge your position? SHORT HEDGE Sell 2000 shares of ICICI futures. Lets assume that the stock price falls to Rs 670 and consequently, the futures too, falls to Rs 673. You lose Rs 30 per share in the spot market and would gain Rs 37 (Rs 710-673) per share in the futures market. Contrary to whats said above if the stock price in the spot market rise to Rs 730, with futures trading at Rs 733, you would gain Rs 30 per share in the spot and lose Rs 23 per share in futures. Either way, you stand to gain Rs 7 per share. Your gain from the deal is Rs 14,000 (2000 x Rs 7) minus brokerage. 2. Youve shorted 1000 shares of HDFC currently trading at Rs 500. But soon after, some good news hits the market and the sentiments seem to be in favor of HDFC. You fear that the price in the spot market may go up and hence, want to protect your money to the maximum extent possible. Futures of HDFC are available at Rs 505. What would you do to hedge your position? LONG HEDGE Buy 1000 shares of HDFC futures. Lets assume that the stock price is at Rs 525 and consequently, the futures trade at Rs 530. You lose Rs 25 per share in spot market and gain Rs 25 per share in futures. You nullify the effect of price that went against your calculations. Now, suppose, there was no such good news and the stock price comes down as expected. HDFC now trades at Rs 475 and futures are trading at Rs 480. You gain Rs 25 in the spot market and lose Rs 25 in the futures market. So again, you nullify the effect of price fluctuations. PERFECT HEDGE AND CROSS HEDGE If a position taken would eliminate the risk of an existing position, or if a position can eliminate all the market risk from a portfolio of investments, it is called a perfect hedge. In order to be a perfect hedge, a position would require a 100% inverse correlation to the initial position. Such positions are a rarity. Any hedge thats not perfect is called an imperfect hedge. In real life, it may so happen that the asset which is being hedged may not have a corresponding contract in futures segment. For example, futures are not available for A ltd, in which you hold 5000 shares. After a lot of observation and research, you find that A ltds shares moves in tandem with another company in the same line of business, B ltd. B ltds futures are available for trade. So, in order to hedge your position in Altd, you can go short on B ltd. Such a hedge is called Cross hedge. FULL HEDGE AND PARTIAL HEDGE. We dont think theres much to explain here. Full hedge is when you take exactly equivalent opposite position in order to protect 100% of your portfolio. Partial hedge is when you decide to hedge only a part of your holdings against risk. For example, an investor may be confident in 25% of his investments in blue chips, but may fear about the price risk of the other 75% invested in midcaps and small caps. Hence he may decide to hedge only 75% of his holdings.What he has done is called partial hedge. Thats the basics for you. The purpose of this post was to explain hedging. In real life, however, it may not be possible to create a perfect hedge due to various reasons. Hedging decisions are not simple as it is explained in this post. Its also not totally risk free as we saw in the examples. The reason lies in a concept called basis risk coming up in our next article. Futures : Understanding basis risk by J Victor on May 17th, 2012
BASIS. By creating a long or short hedge using futures, if you thought your cash position is safe, you are wrong. As we saw in the previous posts examples, hedging eliminates price risk. But it opens up a second risk called Basis risk. To understand that, first you should understand the term Basis. The difference between spot price and futures price at any point of time is called Basis. BACK TO EXAMPLES. Lets go back to the HDFCs example from our previous post. The basis at the beginning was Rs 5 per share. (Hows that? Cash price- futures price, Rs 500 Rs 505). In situation 1, the stock price moves up to Rs 525 and the futures were at Rs 530. Hence, the basis works out to Rs 5. In situation2, the stock price crashed to Rs 475 and the futures were at Rs 480. Again, the basis remains unchanged at Rs 5. The effect in either situation, the loss was offset by the profit made.
Take note: Basis at the beginning and at the end were same, i.e. Rs 5. When the basis doesnt change theres no risk. The hedger neither makes a profit no incurs a loss. The end result is, either way the loss/profit in cash market is exactly offset by profits/loss in futures. Now, our second example in the case of ICICI, the basis at the beginning was Rs 10 per share. In situation 1, When the stock fell to Rs 670, the futures were at Rs 673. So, the basis works out Rs 3 ( cash price Rs 670- futures price Rs 673) In situation 2, when stock price went up to Rs 730, the futures were at Rs 733; hence, the basis at that time is also Rs 3.The effect was that you made a profit of Rs 7 at the end in either situation. In contrast to the first example, note that: Basis at the beginning and at the end were not the same. (at the beginning it was Rs 10, at the end it was Rs 3) When the basis changed (favorably this time), the hedger made a profit. The end result is that since the basis changed favorably, in either situation, the hedger makes money. Hope you understood what basis is. Basis is a crucial factor in futures. Its a source of risk for hedgers who use futures to safeguard their position. From the above examples we also come to the conclusion that when the basis doesnt change, the hedge is perfect (as in the case of HDFC); but when the basis changes over time, it could turn favorable or unfavorable to the hedger (as in the case of ICICI). BASIS RISK Basis risk is described by many as the mother of all risks. It occurs when futures and cash prices fail to move in tandem. Depending on this relation between basis at the beginning and basis at the end, certain unavoidable risk scenarios may arise as explained below. IF YOURE A SHORT HEDGER Senario1. Cash Price Decreases Faster than the Futures Price. When cash prices drop faster than the futures price, you incur a loss which is equal to the difference between cash price at beginning (C0) cash price at the end (C1) and futures price at the beginning (F0) futures price at the end (F1). Weak basis ; unavoidable loss = {( C0-C1) (F0-F1)} + brokerage Scenario 2. Cash Price Increases Faster than the Futures Price When cash price increases faster than the futures price, you get a windfall gain which is equal to the difference between cash price at beginning (C0) cash price at the end (C1) and futures price at the beginning (F0) - futures price at the end (F1). Weak basis ; windfall gain = {( C0-C1) (F0-F1)} less brokerage Scenario 3. Futures Price Decreases Faster than the Cash Price. When futures prices drop faster than the cash price, you get a windfall gain. Strong basis ; windfall gain = { (F0-F1) (C0-C1)} less brokerage Scenario 4 Futures Price Increases Faster than the Cash Price. When futures prices increases faster than the cash price, you incur a loss Weak basis ; unavoidable loss = { (F0-F1) (C0-C1)} + brokerage Scenario 5. Futures Price Decreases /Increases in tandem with the Cash Price. No change in basis; perfect hedge. Your expense for protection = brokerage paid. Scenario 6. Cash price and futures price stays the same. No change in basis; no hedge. Your profit is C1-F1 less brokerage. IF YOURE A LONG HEDGER Scenario 7. Cash Price Increases Faster than the Futures Price When cash price increases faster than the futures price, you incur a loss which is equal to the difference between cash price at beginning (C0) cash price at the end (C1) and futures price at the beginning (F0) - futures price at the end (F1). Strong basis ; unavoidable loss = {( C0-C1) (F0-F1)} + brokerage Scenario 8. Futures Price Increases Faster than the Cash Price When futures price increases faster than cash price, you get a windfall gain which is equal to the difference between futures price at the beginning (F0) - futures price at the end (F1) and cash price at beginning (C0) cash price at the end (C1) and Weak basis; windfall gain = { (F0-F1) (C0-C1)} less brokerage Scenario 9 Cash Price Decreases Faster than the Futures Price When cash price decreases faster than the futures price, you gain which is equal to the difference between cash price at beginning (C0) cash price at the end (C1) and futures price at the beginning (F0) - futures price at the end (F1). Weak basis ; windfall gain = {( C0-C1) (F0-F1)} less brokerage Scenario 10. Futures Price Decreases Faster than the Cash Price. When futures price decreases faster than the cash price, you incur a loss which is equal to the difference between cash price at beginning (C0) cash price at the end (C1) and futures price at the beginning (F0) - futures price at the end (F1). Strong basis; unavoidable loss = {( F0-F1) (C0-C1)} + brokerage Scenario 11. Futures Price Increases / decreases in tandem with the Cash Price No change in basis; perfect hedge. Your expense for protection = brokerage paid. Scenario 12. Cash price and futures price stays the same. No change in basis; no hedge. Your profit is F1-C1 less brokerage. CONCLUSION: If youve hedged your position at any time, youre definite to face any of the 12 scenarios mentioned above. Theres nothing you could do about it. The only way that you can reduce basis risk is to improve your hedging skills and make right moves to the maximum extent possible. You cannot eliminate this risk altogether. Futures: Contango and backwardation by J Victor on May 22nd, 2012
CONTANGO & BACKWARDATION. Contango and backwardation are two technical jargons used in the futures market. These terms are used to describe the position of futures price in comparison with the spot price. In a normal market, futures price would be greater than the spot price due to the effect of cost of carry. This situation is generally referred to as a Contango market. In our last article, we understood that the basis is difference between spot price and futures price at any point of time. In the case of a contango market, since futures price is more than the spot price , the basis would be a negative figure.
Backwardation is just the opposite of Contango. In some special situations, the futures prices may be decided by factors other than cost of carry. For example- When a stock market scam breaks out, its possible that the stock market would be driven by negative sentiments rather than fundamentals or technicals. In such cases, futures may trade below the underlying assets value. Such situations, where the spot price minus futures price (basis) is a positive figure, is generally termed as backwardation market. CONVERGENCE OF FUTURES AND SPOT PRICES At this juncture, one more point worth noting is that the futures price and spot price would tend to converge as the contract period draws closer. The basis would be more at the time of introducing the contract. As the maturity time approaches, the basis would gradually diminish and finally reach zero. So, the basis risk also will also fall to zero by that time. REASON? The reason for this can be traced back to the theory on cost of carry and arbitrage discussed earlier in this series. In short, the relation between spot and futures market would be backwardation or Contango before expiry. As the maturity draws closer, this difference would be gradually wiped away and the prices would tend to converge. Finally, at the delivery point, the spot price and futures price would be the same. What if the price doesnt converge? Such a scenario will not happen. The reason is simple. If, on the day of maturity, the futures price is more than the spot price, arbitrageurs would immediately step in and sell futures and buy spot and pocket a risk free return on the same day. If its the other way round, they would sell spot and buy futures and pocket the difference. This would again result in price convergence in no time. We also tried the track the history of the term Contango & backwardation. We got some information from wikipedia and were reproducing that here: The term contango originated in mid-19th century England
and is believed to be a corruption of continuation, continue or contingent. In the past on the London Stock Exchange, Contango was a fee paid by a buyer to a seller when the buyer wished to defer settlement of the trade they had agreed. The charge was based on the interest forgone by the seller not being paid. The purpose of the buyer was to speculate in the market. Like Contango, the term backwardation originated in mid-19th century England, originating from backward. In that era on the London Stock Exchange, backwardation was a fee paid by a seller wishing to defer delivering stock they had sold. This fee was paid either to the buyer, or to a third party who lent stock to the seller. The purpose of the seller was to speculate in the market. (Source: wikipedia) Both these deals have similarity with our own badla system in the Bombay stock exchange. Thats contango and backwardation for you. Futures: End note by J Victor on May 24th, 2012
CONNECTING THE LOOSE ENDS. As we come to the end of basic theory on futures , there are some loose ends to be connected. These were collected from the questions that readers have asked us. Not all stocks have corresponding futures. In India, Stock futures are introduced by the exchange and its decided based on criteria specified by the Securities Exchange Board of India. If an existing security fails to meet the eligibility criteria for 3 months consecutively, then no fresh future contracts will be issued in that stock. In the case of existing contracts, if the exchange is of the view that continuing derivatives contracts on a particular stock is detrimental to the interest of the market, it may compulsorily close all derivatives contract positions in that particular stock. The price of futures contract now is not the expected price of the underlying stock on the maturity date. Futures price is determined by the cost of carry principle. However, empirical evidence on cost of carry is not consistent. Studies have shown that the cost of carry principle does not perfectly hold over a period of time and it keeps changing from week to week or even day to day. There will be three futures contracts available for trade at any given point of time. Theoretically, these contracts would be priced applying the cost of carry principle and hence, the far month futures would be priced higher than the near month futures. Backwardation is not just a theoretical concept. Such scenarios are real. Backwardation conflicts with the cost of carry principle. When other economic factors pre-dominate the markets, such imperfections are possible. The most important use of futures is hedging. Hedging protects investors from adverse price movements. At the same time, it also prevents the hedger from participating in extreme favorable price movements. So, taking decisions on hedging calls for a lot of experience and expertise. You have to pay margin money to enter into a futures contract. Margins are of two types 1. Initial margin and 2. Daily margin. The initial Margin is collected to cover the potential losses for one day. The initial margin percentage may differ from stock to stock based on the risk involved in the stock, which depends upon the liquidity and volatility of the respective stock besides the general market conditions. Apart from initial margin, the difference between the cost of the position held and the current market value of that position, if loss, has to be remitted by the party on a daily basis. There are limits for entering into futures contracts at all levels at the client level, trading member level and at the market level as a whole. One person cannot enter into as many future contracts he likes. There is a limit to the gross open position, specified by the exchanges every month. Position limits are introduced for controlling excessive speculation. A trader cannot enter any rate for trade. In the case of stock futures, there is a price range which is +/- 20% of the base price. The base price is nothing but the daily settlement price. However, on the first day of trading, since there is no previous settlement price, the base price would be the theoretical futures price. Orders below or above this operating range of + / 20% from the base price would be freezed by the exchange. A trader cannot enter any quantity for a trade. In case of stock futures, there is a maximum quantity specified by the SEBI. In case of Stock Futures the quantity for each stock is specified by exchange from time to time and single order notional value should not normally be beyond Rs. 5 Crores approximately. Notional value is the futures prices multiplied by the lot size. Corporate actions like bonus, rights, dividends, merger, amalgamations and splits would have an impact on the futures contracts and such actions have to be adjusted accordingly. The effect of corporate actions and how it is adjusted would be explained later. NRIs can participate in derivative Contracts (except currency derivatives) out of INR funds held in India on non-repatriable basis (NRO) subject to the limits prescribed by SEBI. An NRI, who wishes to trade on the F&O segment of the exchange, is required to apply for a custodial participant (CP) code. Thereafter he can open a trading account and start trading in derivatives. Position limits for NRIs shall be same as the client level position limits specified by SEBI from time to time. Futures contracts are always cash settled. On settlement, the settlement price would be the underlying assets closing price. Options: Kick off by J Victor on May 30th, 2012
OPTIONS Options are slightly complex than futures. Weve already discussed the meaning of option contracts. From this article onwards, well proceed to break up various aspects of options just like we did with futures. Options are traded in the exchanges just like futures. At any given point of time , there would be three outstanding contracts near month contract, mid month contract and far month contract. Option Contracts expire on the last Thursday of the expiry month. So, all those features are common between futures and options.
BUYERS AND SELLERS. In any market, there would be both buyers and sellers. The option market is no different. There would be buyers and sellers for option contracts. You can buy/sell two categories of options calls and puts. As already mentioned in our introductory article on options, buyers are called holders and sellers are called writers.Straight and simple. Now, we would like to discuss just two points in this article. EVERYTHING IS AT YOUR OPTION... ( If you are the buyer !! ) Thats the first point. As a buyer, you are the king it doesnt matter if you bought a call or a put if youre the holder, what you hold is a right. The peculiarity of this right is that, it is not at all necessary that you should exercise this right!! You would proceed to exercise the right only if its favorable for you. So, as a buyer you have two choices you can buy a call or buy a put. If youre buying a call That gives you the right to buy the underlying asset (i.e., stocks) within a certain period at a specified price, called the strike price. Its just a right. At the end of the contract, it is not necessary to exercise the right. Its your option. If youre buying a put That gives you the right to sell the underlying asset within a certain period at a specified price (strike price). Again, its just a right. At the end of the contract, its not at all necessary to exercise the right. Its your option. So, if markets move according to your calculations, youd jump in and exercise the right and make money. Or else, youll leave the right to lapse. For example The shares of reliance are trading at Rs 650 and according to your calculations, the stock would move up to Rs 750 in 25-30 days. But since there is nothing called 100% surety in stock markets, you also fear that if some negative news breaks out, the stock would plummet to Rs 590 or below. Reliances near month options are available at a strike price of Rs 670. Now, how do you take advantage of this situation and at the same time protect yourself? Buy reliance call option That gives you the right to buy Reliance shares at Rs 670 anytime within 30 days. Its just a right. At the end of the contract, it is not necessary to exercise the right. Its your option. If everything works out according to your calculations, then 30 days later, the stock would be trading at Rs 750 and youd immediately exercise the right to buy at Rs 670 and sell at Rs 750. The difference is your profit. Now suppose the price of reliance drops to Rs 590. You being the call holder at Rs 670 (strike price) would not be interested in buying at Rs 670 anymore. So youll not exercise the option and the option lapses. NOTHING IS AT YOUR OPTION ( If youre the seller..!!) Thats the second important point. As a seller, youre the slave it doesnt matter if youve sold a call or a put if youre the seller, what you sold is a right. Since rights are sold, if the guy who bought the right from you opts to exercise his option, you are bound to obey. Theres no option. Here also, as a seller of options you can sell a call or sell a put. If youre selling a call That gives the buyer the right to buy the underlying asset from you within a certain period at a specified price, called the strike price. At the end of the contract, he may or may not exercise the right. Its his option. You as a seller have a definite obligation to sell. If youre selling a put youre selling the right to sell the underlying asset within a certain period at a specified price (strike price). At the end of the contract, if the buyer of the put option wants to sell it to you, youre obligated to buy the stock at a predetermined price. So if youre the seller of a put or call, you are always obligated. Your performance is compulsory. As a seller of options, your gain is always limited but your possibility for losses is unlimited. So, selling options is very risky. Its perfectly all right for beginners to get confused towards the end. In that case, go back to the options definition, and the then come back and read once again. Youll get the clear picture. Options: Understanding strike price. by J Victor on June 6th, 2012
STRIKE PRICE
One feature of options contract that may baffle a nave option user is the concept of strike price or exercise price and the range of strike prices that are available in a particular month.
To understand strike price, lets go back to futures once again. The basic idea of futures was that: The buyer agrees to buy and the seller agrees to sell the underlying stock at a price agreed upon now at a future date. There will be only one futures contract for a month. For example RIL December futures. The buyer and the seller can choose to agree at any price prevailing in the futures market. However, option differs in these respects. You can buy / sell the underlying stock only at predetermined prices set by the exchange. These predetermined prices are called strike prices. There will be many option contracts in a month at different strike prices. For example RIL trading at Rs 800 in spot market may have RIL December options at strike Rs 760, Rs 780, Rs 800, Rs 820, Rs 840 and so on. Generally, four or five option strikes prices are available on both sides of the current market price of the stock. The buyer and the seller can choose to agree at any strike price set by the exchange. So, a December call option of RIL at strike Rs 840 would allow you to buy the shares of RIL at Rs 840 anytime upto last Thursday of December (expiry date) no matter what price that stock is then. The strike price for each option is decided after considering the time until expiration, the volatility of the underlying stock and prevailing interest rates. The strike price is part of the option contract it does not change with fluctuations in stock price. The strike price intervals (the gap between two strike prices) may vary depending on the market price and asset type of the underlying. WHY STRIKE PRICES? First, since an option gives the right to buy the underlying asset at a fixed price to the holder, what would be the fixed price if there are no strike prices? So by definition, strike price is required. Second, lets assume that there is only one strike price for call and put options. That one strike price would eventually move in favor of either the holder or the writer. Hence it will become worthless for one party. Such a scenario would affect the liquidity of options. Third, instead of strike prices, lets assume that options are also marked to market like futures. To do that, the strike price will have to be changed everyday according to the price of the underlying stock. In that case, hedgers who want the right to buy or sell the stock at a fixed price will find it unable to do so. Hence in options, multiple strike prices are required. In fact, it is this fixed strike price system that makes options unique. IMPORTANCE OF STRIKE PRICES. The strike price decides the moneyness of an option. Moneyness is a term that describes the profitability of an option in relation to strike price of an option and price of the underlying stock. Depending on the type of option taken and the underlying stocks price, an option can be in profit (in the money) loss (out of the money) or equal to the underlying stocks price (at the money). We will take up Moneyness in our next post on options. Options: Moneyness. by J Victor on June 8th, 2012
MONEYNESS. As described in our last topic on strike price, Moneyness explains the relationship between strike price of an option and the spot price of the underlying stock. There is a gap or a difference between the strike price of an option and the spot price of the underlying stock. Moneyness trys to express the quality of that gap in terms of money value. I.e., whether the gap would result in a profit /loss for the option trader. So, Moneyness basically refers to the current state of the option in terms of profit and loss.
There are three degrees of Moneyness for an option In the money Out of the money and At the money The expression In the money means that the option, if exercised, would result in profits. For the holder of a call option, the strike price should be lower than the market price to be in-the-money. For the holder of a put option, the strike price should be greater than the market price to be in- the-money. Out of the money means that the option if exercised would result in a loss. For the holder of a call, the strike price should be higher than the market price to be out-ofthe-money. Its just the reverse of whats said above. At the money means that the option and the underlying asset are at same price. HOW EVERYTHING IS CONNECTED. Option is a generally a zero sum game, assuming that one participants gains result only from another participants equivalent losses. This means that at contract expiry, the net change in wealth amoung the participants is zero. This has two implications- 1. Since calls and puts are opposites, what is in-the-money for a call holder will be out-of-the- money for a put holder and what is out-ofthe-money for a call holder will be in-the-money for a put holder. This position will be reversed in the case of writers of calls and puts. 2. Since holders and writers are opposites, if the option is inthe-money for a holder, it is out-of- the-money for a writer. If the option is out-of-the-money for a holder, it is in-the-money for a writer. Obviously, if the option is at-the-money for the holder, it should be at-the-money for the writer as well. Both the above positions are summarized below:
WHY IS MONEYNESS IMPORTANT? A clear understanding about Moneyness is required to choose the correct option in a given situation. This is one of the most frequently used option terminology and all the option trading strategies stem from Moneyness. The knowledge of Moneyness will directly impact your decision making process in options. Moneyness decides whether there is an intrinsic value for the option or not. In the case of options, intrinsic value is the money that you will receive when you exercise your options. Only in-the-money options have intrinsic value. For example, a call option has a strike price of Rs 100. The underlying stock is trading at Rs 150. In this case, the call option holder can exercise his right to buy at Rs 100 and sell at Rs 150 and make a profit of Rs 50. You can also say that the option has an intrinsic value of Rs 50. Out-of-the money options does not have any intrinsic value since by exercising such an option, there is no money to be made. In simple terms, An in-the-money option is in profits and has intrinsic value. An out-of-the-money option is in loss and has no value. If the option is in a no-profit no-loss situation, its at-the-money. These options too, does not have any value. Calls and puts / holder and writers are inversely related. Whats in the money for one would be out-of-the-money for the other. As the price of the stock changes, an option contract moves from one Moneyness state to another. An option thats very much in-the-money is also called deep-in-the-money and an option that is very much out of the money is called deep-out-of-the-money. Finally, no option, at expiry, will result in an exactly at-the-money position since costs are involved. What are the costs involved? Thats what we will discuss in our next post on options. Options: Premium by J Victor on June 15th, 2012
OPTIONS: PREMIUM In one sentence Option premium is the price of an option contract. Pay premium to whom? The premium is paid upfront by the buyer of the option to the seller. Option premium is not a fixed amount. It keeps changing according to the Moneyness status of an option. For an in-the- money option, the premium quoted will be more than an out-of-the-money option. As the option keeps moving in the money, the premiums will also increase.. Premium is different from brokerage. The premium paid by the buyer to the seller should not be confused with the brokerage costs normally incurred to trade in options market.
Brokerages are paid separately based on the agreement between you and the broker it could be based on volume or number of transactions or a flat charge per transaction or whatever. All the participants have to pay brokerage. Premium is different. The writer of the option receives premium from the buyer. Only the buyer pays premium. Not the seller! In our first post on options, we said that the buyer purchases the right to buy or sell an option. He enjoys the luxury of opting to buy or sell if situations are favorable to him or else he will let his option lapse. The seller on the other hand, is always obligated to perform. He doesnt have a choice. Hence, the sellers stand is always risky and for bearing that risk, he is compensated by the buyer by paying upfront -thats what we call as premium. Hence, premium is never paid by seller to the buyer. It always paid by the buyer to the seller. Its a source of income for the seller. So premium, in short, reflects what the buyers are willing to pay and what sellers are willing to accept for the option. TWO COMPONENTS OF OPTION PREMIUM The option premium is a combination of two elements.
Intrinsic value: Only in the money option will have intrinsic value. Intrinsic value is the difference between the strike price and the current market price of the underlying stock. Extrinsic value: Extrinsic value is the value of the option over an above the intrinsic value. For example Lets assume that the stock of RIL is trading at Rs 750 and RIL call option at strike 700 is available at a premium of Rs 70. In this case, the intrinsic value of the option will be Rs 50 (Strike price minus current market price) and the remaining Rs 20 will be the extrinsic value. This extrinsic value of Rs 20 is also called the time value. TIME VALUE? .How? Why? The first part of an option premium is clear. There will not be any confusion about how an option gains intrinsic value since it is quite straight when the market price of the underlying stock is greater than the option strike price, the difference results in intrinsic value. The second portion, time value, needs a closer look. An option gains time value from the probability that it can move in the money further and become more profitable by the time the option expires. Longer the time to expiry, higher the probability for profits. Shorter the time to expiry, lesser the chance. Hey! Thats just one side of the coin! Youre Right. The reverse can also happen- there is an equal probability that an in the money option may decrease further and become less profitable by the time the option expires. So time remaining till option expiry and the degree of volatility of the underlying stock decides how much further the option would go in/out of the money. Now, we hope youve got the picture clear. Apart from the intrinsic value, the probability of further profits/losses are also weighed in by the participants and thats how an option gets time value automatically added to it. It is also clear from the above explanation that time value of an option is a function of two factors: The underlying stocks chances of moving up or down in price. In simple words- the stocks volatility , and The time remaining for all this to happen. Longer the time; greater the chances. So, there are two ways to explain what time value /extrinsic value is from the call buyers point of view, it is the price over and above the intrinsic value that he is willing to pay for participating the in the potential upside. From the writers point of view, it is his charge for undertaking higher potential risk. Before we end, here are some more tips Option premium is paid upfront. Premium is paid by the holder to the writer You have to pay option premium regardless of whether or not the option is actually exercised. Premiums have nothing to do with brokerage. The time value decreases as the expiration date approaches. Time value would be 0 on expiry. Out-of-the-money options has zero intrinsic value and hence, time value = option price. Higher volatility of the underlying stock leads to higher time value. Time value also depends on how close-to-the-money an option is. So, two call options having the same time left to expiry but with different strike prices will have different time value. This is because one will be closer to the money than the other. Since dividends affect the market price of underlying stocks when declared, it also plays a part in deciding option premiums. Needless to say, risk free interest rates are always considered for any financial decision and options are no different. To sum it up- The price /value / premium of an option is determined by price of the underlying, its volatility, strike prices of the option, expected dividends, risk free interest rates and time remaining till expiry. Thats option premium for you. Unfortunately, options traded in India are not called Indian options. Irrespective of the geographical location, options traded anywhere in the world are either called American options or European options!! More about that in our next post. Options: Option styles by J Victor on June 21st, 2012
OPTION STYLES. By style we mean the excerciseability of an option contract whether the option contract can be exercised before the expiration date or not. TWO STYLES: American & European. Options traded all over the world are divided into two broad styles called American options and European options. Whats the difference? An American option can be exercised any time before the option expiry. European options can be exercised only on the expiry date.
So, if you have bought a call American style option, you can exercise your right to buy underlying asset anytime between the purchase date and expiry date. Similarly If you have bought a Put American style option, you can exercise your right to sell the underlying asset anytime between the purchase date and expiry date But in the case you have bought a call/put European style option, you can exercise your right to buy/sell underlying asset only on the expiry date. How to find out if a particular option is American style or European style? The SEBI has given the freedom to the exchanges to introduce American or European style options. In India, till Jan 2011, index options were traded in European style while individual stock options were traded in American style. Post, Jan 2011, the NSE decided to switch to European style stock option for all contracts expiring on January 27, 2011 and onwards. So, now in India, all the options available are European style contracts. The option type will be displayed against every option contract available. The codes are CE, PE, CA and PA. These codes are very simple to understand. OPTION CODES. CE = Call option, European style PE = Put option European style CA = Call option, American style PA= Put option, American style. EXCERCISING IS DIFFERENT FROM TRADING. There is one important point to note here. The difference we talked about has significance only in the matter of exercising the right contained in an option. A participant can buy or sell European options in the secondary market any time. The restriction is only on exercising the right. So, dont get confused between exercise and trading of options. For more details on the options contracts available at the NSE right now, here is the link. This link has all the details like contract specifications, list of underlying stocks , permitted lot sizes etc.. Options: Choices of action. by J Victor on June 28th, 2012
CHOICES OF ACTION for the holder and writer. After a person has bought an option, what are the choices of action he has? Thats the next topic we need to discuss. In the case of the holder of a call, He has 3 choices before him Do nothing wait till the expiry Close out reverse his trade. I.e. if he bought a call, write a matching call. Exercise the option ( in the case of American options only )
And, what about the writer? A writer has only two choices. Do nothing wait till the expiry Close out reverse his trade. I.e. if he bought a call, write a matching call. The third option is not there for him as he doesnt have any right to exercise. An option can be closed out and it doesnt matter whether the option is American or European. This was clearly explained in option styles. There are two more points to discuss in this post. As the expiry date approaches, we need to know - What really happens on the expiry date? and What would be the value of options on the expiry date? 1. WHAT HAPPENS ON THE EXPIRY DATE? Only in-the-money options will be exercised on the expiry date. Both at-the-money and out-of- the-money options will not be exercised by the holders since it is not beneficial for them. In India, The National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives segment. The NSCCL acts as legal counter-party to all deals on NSEs F&O segment and guarantees settlement. A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members (TM) on NSE, who clear and settle such deals through them. For example you have RIL CE 650 28 JUNE. You bought it for a premium of Rs 40. What does that mean? You are the holder of Reliance industries European call at strike Rs 650 expiring on 28th June 2012. The value you pay for that option is Rs 40. When you buy that, you get a contract giving you the right to buy RILs shares at Rs 650 irrespective of its settlement price on June 28th 2012. The NSCCL will act as legal counter-party to you and will guarantee settlement. You need not worry about who is going to sell those stocks to you, in case you exercise the option. Example 2- Today is April 3 rd . You write a call that obligates to deliver 100 shares of RIM for the price of Rs 200 within last Thursday of April ( option expiry). Your sell is actually bought by the NSCCL and adds it to the several other option writers in its pool. Suppose, someone, say Mr. A, buys a call in the same series that you sold. He actually buys it from the NSCCL and he get the contract that grants him the right to buy 100 shares of RIM t Rs 200 within option expiry. Now, lets assume that on April 10 th , you decide to close your short position by buying a call with the same terms that you wrote, resulting in a profit or loss. Mr. A on the other hand decides to keep his long position till option expiry. This can be done since, NSCCL is the legal counter party and Mr. A will be guaranteed his shares by NSCCL, should he exercise his option to buy. Thus, the NSCCL allows each investor to act independently of the other. 2. WHAT WOULD BE THE VALUE OF OPTION ON EXPIRY DATE? As we learnt in the article option premium, an option gains value when its in the money. In the case of a call option it means that, if on the expiry date, the stock price finishes above the strike price, the option will have the value which is ( market price strike price).In all other cases, the value of the option will be 0. In the case of a put option, it means that, if on the expiry date, the stock price finishes below the strike price, the option will have the value which is ( strike price market price).In all other cases, the value of the option will be 0. Options: Break-even point. by J Victor on July 8th, 2012
Knowledge about the concept of break even is very important in finance. In F & Os too, identification of break even price is very crucial to take the right decisions. WHAT IS BREAK EVEN? Break even point is that point at which you make no profit or no loss. It is the minimum rate of return that your investment should generate in order to maintain a no profit-no loss situation. However, No profit /Loss is not the point where your purchase price matches with the sale price. Your break-even point must include the recoupment of all fees, commissions and other expenses associated with the purchase and sale of the investment.
BREAK EVEN POINT FOR OPTIONS. When you try to identify the break even point for options there are three factors to be considered
Strike price Option premium Commission and transaction costs. The commission part will be different from one broker to another. So make sure you understand how your broker charges commission on options. BREAK EVEN FOR CALL HOLDER. To find out if your call trade has potential for a profit, apply the following formula: Strike price + Option premium cost + Commission and transaction costs = Break-even price So if youre buying an RIL December call with strike price at Rs 150 that sells for Rs 7.50 premium and the commission is Rs 15, your break-even price would be- Rs 150 + Rs 7.50 + 15 = Rs 172.50 per share. That means, to make a profit on this call option, the price per share of RIL has to rise above Rs 172.50 per share. Effectively, the potential loss of a call holder is restricted to the premium paid and transaction costs. Ie, Rs 22.50 per share. BREAKEVEN FOR PUT HOLDER. To find out if your put trade has potential for a profit, you have to apply the following formula: Strike price - Option premium cost Commission and transaction costs = Break-even price So if youre buying a put on RIL December call with strike price at Rs 150 that sells for Rs 7.50 premium and the commission is Rs 15, your break-even price would be- Rs 150 Rs 7.50 15 = Rs 127.50 per share. That means that to make a profit on this put option, the price per share of RIL has to drop below Rs 127.50 per share. The more it drops, the more profitable your position becomes. Effectively, the potential loss for a put holder is restricted to the premium paid plus brokerage on transaction. So, just because an option is trading in-the-money does not mean that you will make sure profits out of it. The stock price has to cross the breakeven point to result in real profits. In our previous post, we said that an option gains value only when its in-the-money. In all other cases, the option does not have any value. The question is what would happen if the price of options is not in line with the theory? In such cases, arbitrage opportunities will open up. Before discussing more about options arbitrage, there is one question that needs a clarification. Is there any relationship between the value of a call and that of a put ? To answer that, we need to look at one more theoretical topic on options- Put call parity. Understanding this relationship is necessary to get into grips with options arbitrage. Options: Put-Call parity-Part I by J Victor on July 15th, 2012
Is there a relationship between the value of a call and the value of a put? The guy who answered that question for the very first time was Economist Hans Reiner Stoll in his book, The Relation between Put and Call Prices in 1969. The theory is also known as the law of one price. According to him, the prices of a call and a similar put are tied together and when one moves the other should move and vice versa.
HOW? To understand the relationship, lets first take a look at two investors. Both investors have Rs 60,000 with them to invest. Investor 1. He buys RIL CE 600 which gives him the right to purchase 100 shares of RIL at strike price of Rs 60o. He pays a small premium for it and keeps his cash with him. Investor 2 He buys 100 shares of RIL purchased at Rs 600 each. He does not have any cash left with him. However, to protect his holdings, he would buy a put option of RIL at Rs 600 strike. WHOS STRATEGY IS BETTER? To analyse that, lets get into detail on both these strategies. The first investors idea is that he will invest his cash in a risk free investment and will wait to see how the stock prices would move. In case, the stocks price finishes higher than Rs 600 on expiry, he will exercise the option. He will buy at Rs 600 and sell at the current market price and take home the difference. In case, the stock finishes below the strike price hell let the option lapse. Anyway you look at it, he protects his 60,000 bucks. Now, whats the other investors idea? He too, wants to protect his holding from further price slide. He already has Rs 60,000 invested in RIL and will wait to see how the price moves. To protect his holdings, he has already bought a put option of RIL at Rs 600 strike. On expiry date if the price moves up, he would let the option lapse and sell his holdings in the cash market for a profit. If the stock finishes on the lower side, he would exercise his option to sell at Rs 600. Either way, he also protects his capital of Rs 60,000. That means, irrespective of the strategy employed, both the investors protects their capital and plays a risk free game. In other words, a call + equivalent cash (investor 1) was equal to a put + equivalent underlying asset (investor 2)!! So, theoretically, RIL CE 600 June + cash =100 RIL shares + PE RIL 600 June. Both the combinations have the same value on expiry. If, thats true, then logically, both the portfolios would have the same present value also . If there is a flaw in this relation, arbitrageurs would jump in and would go long on the undervalued portfolio and short the overvalued portfolio to make a risk free profit on expiration day. They will buy undervalued calls and sell over valued calls or will buy undervalued puts and sell overvalued puts. This relationship between calls, cash, puts and the underlying asset is called put call parity. The practical value of Put-Call parity always should be zero.This should be a stable at all the times. Or else, as said earlier, arbitrage opportunities will rise. Its also a simple test to validate the various option pricing models. Any pricing model which violates the put-call parity theory is considered flawed. Put-Call Parity and American Options You would have noticed that, the theory was explained with the help of European options. Put call parity does not work in American style options since it allows early exercise. However, if they are held till expiry, the theory would work ! We will take up the formula and examples for put call parity in our next post on options. Options: Put call parity Part II by J Victor on July 20th, 2012
If we recall the strategies of two investors we mentioned in our last post, one was buy a call and invest the present value of exercise price in risk free assets and the second was Buy shares on spot and buy a put. Both these strategies were identical in pay-offs. The basic relationship was also drawn. Now, lets put down that as formula: S + PE = C + PV Where, S = Spot buy price of a share PE = Buy European put C = Buy European Call PV = Present value of cash invested in risk free securities.
Those who are good at maths would have guessed one more thing by now. Since this one is a mathematical relationship, the formula can be re-written in anyway to find any missing variable. HOW TO READ & CONSTRUCT THE FORMULA? When letters pass from one side of the formula to the other, their mathematical relationships will also change. Any positive figure, when taken across the equal sign to the other side, will have the opposite meaning. Lets assume that we want to create a transaction thats the equivalent of PE (Buy a European put). The formula can be turned around to look like this: PE = C + PV S So in the above case, S or spot buy price of the share would become, spot sell. So, by buying a call + investing the money in risk free securities and then selling the share on spot, you create a complex transaction thats equivalent to a long European put (PE). Why do we need such combinations? Such combinations becomes necessary when the option for a share is not available and you need to create one for your benefit. Now, an example. TCS 3 months call option with a strike price of 400 is sold for Rs 36. The stock is trading at 380 right now. The risk free interest rate is 8% per annum. What would be the theoretical value of a TCS put with the same maturity and exercise price? In this case, we have to find PE. Hence the formula will be modified as: PE = C + PV S C = Price of a call option = 36 PV = Present value of 400 invested at 8% for 3 months. S = Current market price of the stock = 380 How to find the present value? This was discussed in one of our basic lessons- time value of money. We are showing the calculation once again here: PV=FV / (1+r) N
Where PV is the present value , FV is the future value r is the rate of interest N is the number of years in investment. ( in this case 3 months or 0.25 years) Applying the formula, the present value will be as follows: PV = 400 / ( 1+ 0.08 ) 0.25
PV = 400 / 1.019427 PV = 392.38 Now that we have got all the values, lets find the value of put. PE = C + PV S PE = 36 + 392.38 380 PE = 48.38 or the theoretical equivalent of call sold for 36 would be 48.38 In other words, by buying a call, investing the value of strike money in 8% risk free deposits and by selling the stock, you create an equivalent put. 48.38 is the theoretical In case the value of put is below 48.38, it means that the put is undervalued. If its above 48.38 it means that the put is over valued. Undervalued puts should be bought and overvalued put should be sold. With this, we complete our discussion on put call parity. Final note: The word parity here means equality in amount. Futures vs. options by J Victor on July 29th, 2012
FUTURES VS OPTIONS Having explained so far, we are hopeful that youll be able to chart out the difference between a futures and options. Both are traded in stock exchanges and both are derivative instruments. Option and futures are highly standardized and liquidity is always ensured by the exchange that stands as a guarantor of performance. Both instruments are used for protecting asset positions held and also for pure speculation. In India, both futures and options expire on the last Thursday of every month. Thats the similarity. Now to the differences:
PAYMENT OF PREMIUM / MARGIN. Futures contract does not require the payment of a premium by the buyer to the seller. Instead, for futures, an amount needs to be kept with the broker called margin money. Since futures are settled on daily basis, the margin money will have to be provided accordingly. Both the buyer and the seller of a futures contract have to keep margin money with the broker. Whereas in the case of options, an amount called premium will be paid by the buyer to the seller. In other words option writing is a way to make some money for option sellers. Only the seller of an option is required to give margin to the broker. THE OBLIGATIONS PART A future contract obligates the buyer to buy the underlying asset on expiry at a pre determined price. The obligation is definite. But in the case of option buyers, they are not obliged. They would buy the underlying asset only if the market movement is favorable to them. For enjoying this luxury, they have already paid a sum by way of premium to the sellers. In case they dont exercise the option, the premium is not paid back by the sellers, its lost. The seller of a futures contract is also obligated in the same manner. He is supposed to sell the asset at a predetermined price whatever may come. Similarly the writer of a call is also obliged to sell the asset at a predetermined price. The difference lies in the fact that the seller of futures contracts doesnt earn anything in the Deal. But the writer of a call collects the premium from the seller. From the obligations part, futures are more destructive than options since the obligation in the case of former is already fixed. LIABILITY If the price moves against a futures participant, his liability is literally unlimited unless he cuts his position in between. However, buyers of stock options lose only the premium paid in case the price of the underlying asset moves against them. RISK AND UNDERSTANDBILITY. As far as the risk part is concerned, futures are more risky than options. The risk arises in futures due to the fixed obligation part. The futures trade must be closed by the trader at expiry and cannot be left just like that. As far as options are concerned, if you dont what to exercise the option, you can forget about it. there are no more formalities. As far as understanding the intricacies are concerned, futures are far simpler to understand, but options, when compared to futures may seem to be complicated for a fresher. These are the main difference between futures and options. That was just a quick reminder. There is a lot more to discuss in options. Option valuation: Introduction by J Victor on August 5th, 2012
From this post onwards we will be discussing the various aspects of option pricing. The price of an option at expiry has been already discussed. Now, we need to find out the value of options before expiry- for that, First, we lay down the factors that affect option price: Strike price You will have to pay a higher premium, if the strike price of a call is low. For example if the value of HDFC call with a strike price of 500 is Rs 10, then the value HDFC call with a strike price of 480 would be higher than Rs 10, say 12. Simple logic, since, a lower strike gives the holder the right to buy that share at a lower price. Hence, its more valuable and premium will be high. Puts with higher strike prices will also command higher premium. The reason is that it gives the buyer a right to sell the stock at a higher price.
Hence, the basic rule would be: For calls: Lower the strike, higher the premium For Puts: Higher the strike, higher the premium. Spot price of the underlying asset- If you recall the article on Moneyness of options, we learned that an option can be in the money, at the money or at of the money depending on how the underlying asset price has moved. Therefore, if the underlying asset price is at high levels, a call option thats in the money should also have a high value. Similarly, if the underling asset price is at very low levels, a put option thats in the money should have a higher value. So spot price of the underlying asset is a major factor that affects the price of an Option. We summarize the position here: For calls: Higher the spot price, higher the premium For Puts: Higher the spot price, lower the premium. Time to expire when you give more time for an asset to float in the market, the chances of its price moving higher is more. Hence, when more time remains for an option to expire, the chances for that option to move in the money is more. That means, more the time remaining to expire, higher the premium. Thus, a three month option will have a higher premium than a one month option with the same strike price. The impact will be- For calls: More time to expiry, greater the premium For puts: More time to expiry, greater the premium. (Same logic will apply) Volatility of the underlying asset we understood from the above two points that spot price influences the options price and more the time remaining to expiry, the higher the value of an option. Now, along with this, if the stock is highly volatile in nature, it further increases the chances to hit highs. Naturally, option holders are in a better position since their risk is one sided. Volatility increases a call holders chances to hit Maximum.In any case, they lose only the premium paid. On the other hand, option writers, in such cases, face higher risk and they have to be compensated more to bear more risk. Hence, higher the volatility of the underlying, higher the premium. For calls: Higher the asset volatility rate, higher the premium For puts: Higher the asset volatility, higher the premium. Risk free rate as the risk free interest rate increases, the present value of future strike price decreases and hence, the option price increases. Thats because, in the case of calls you are deferring an expenditure (buying those shares) and in the case of puts, you are deferring the receipt of income. Thats straight logic. connecting that to calls and puts, the position will be as follows- For calls: higher the interest rate, higher the premium For puts: Higher the interest rate, lower the premium. Dividends- dividends when declared, reduces the share price to that extent. Hence it reduces the value of call and increases the value of a put. Hence, For calls: Higher the dividend declared, lower the call value. For Puts: Higher the dividend declared, higher the put value. There are different models used by option traders to value an option before expiry. Option vales will be influenced by the changes in each of the above factors. In the next article we will look at some more topics which is required to get a grip on valuation of options. Option valuation: Upper bounds and lower bounds Part 1 by J Victor on August 12th, 2012
What are upper and lower bounds of options? One important principle while valuing options is that at any time, the value of a call or a put cannot exceed certain limits on the higher side as well as on the lower side. In option lingo, the maximum limit up to which an option value can go on the higher side is commonly referred to as upper bounds of an option and the maximum limit below which an option value cannot fall is called the lower bounds of an option. These maximum limits will have to be discussed for European and American options separately. We first take up the upper and lower bounds of European calls.
Upper bounds of European call values: Lets assume that the call value of an option is 55 and the underlying stock is trading at 50 in the spot market. In such a scenario, anybody can write the call and sell the stock on spot, and take home the difference of 5 per share. Hence, its clear that the call value at expiry cannot rise beyond the value of the underlying stock. Now, lets further assume that the company has announced a dividend of 5 per share. Dividend, when paid, decreases the value of shares to that extent. Hence on expiry, the stock will be valued at 45 (50 5) in the spot market and logically, the call value cannot exceed 45 per share. This brings us to the first principle in option value the upper bound value of an European call can never rise beyond the value of the underlying stock. When the dividend is known with certainty, the call values cannot rise beyond the spot value of the stock less present value of the dividend. Lower bounds of European call values: What would be the lowest value for an European call? It should be zero. It cannot fall below that, Right? For the call value to be at zero, the stock value should also fall to zero. If the stock value is above zero (say 2) the minimum value of call should be the present value of Rs 2 (strike price). Lets try an example assume that the stock value is at 102. One year European option call at strike price 108 is available. If the risk free rate is considered to be 8%, the present value of 108 discounted at 8% would be 100. In this case, the value of the call cannot fall below 2 (102 100) If it falls to (say, Re 1) then You can buy the call at strike 108 you pay Re 1 You sell the stock at 102 You get 102. Your net gain = 101 From that 101, you invest 100 in risk free bonds and get 108 at the year end. Use that 108 to exercise the call and get back your shares. Get a profit of Rs 1, risk free immediately. May be that was slightly confusing. Go through the calculation one more time and youll get it. As a next step, here also, we need to discus the effect of dividends. Lets take another example where the stock value is at 50 and one year calls at strike price 20 are available. The dividend to be received a year later is estimated at Rs 5 per share. In this case, the value of the call cannot fall below the share value Less (present value of dividend expected + present value of strike value) The present value of 5 discounted at 8% would be = 4.63 The present value of 20 discounted at 8% would be =18.52 Hence, the lower bound value of a call cannot fall below 50-(4.63 +18.52) = 26.85 This brings us to the second principle in option value the lower bound value of an European call can never fall below the difference between stock value and the present value of strike price. When the dividend is known with certainty, the call values cannot fall below the spot value of the stock minus present value of the dividend minus present value of the strike value. Option valuation: Upper bounds and lower bounds -Part II by J Victor on August 19th, 2012
Having learned the upper and lower limits of European calls, next well look at the upper and lower bounds of European put options. Upper bound of European puts. Lets take an example the stock of HFDC is trading at 800 right now. 1year put options on this stock are available at a strike price of 900. If we calculate the present value of 900 at 8% risk free interest rate, well get 833.50 as the answer.
Logically, the upper bound price of a European put cannot exceed that 833.50 which is the present value of the strike. If price of the put is above 833.50, say 860, then You can immediately sell a put and get 860 and Invest 833.50 at 8% to get back 900 at the end of one year. The difference of Rs 26.50 is your profit ion the spot. (860-833.50). Now, if the dividend on stock is known, it doesnt make any difference. The only rule to be remembered in case of upper bound European out prices is that it cannot exceed the present value of the strike price. Not that, in the worst case the maximum loss that a put writer will suffer is the strike price. This loss is mitigated by investing the present value of strike at 8% risk free investments. So that brings us to the third principle An European put cannot have a greater value than or equal to the present value of the strike price. The dividend factor is irrelevant here. Lower bound of European puts. A European put cannot have a price thats lower than the difference between the present value of the strike price and the stock price. For example assume that the stock price is Rs 60 and the strike price is Rs 65. Lets also assume that the present value of strike price is 63. In this case, the value of a European put cannot be lower than Rs 3. That is, the difference between the present value of the strike price and the stock price. If it is less than Rs 3, an investor can buy the put , borrow the present value of strike price and use it to buy the stock at current market price and profit from the deal. Now, we summarize the basic principles for upper and lower bounds of European options: The upper bound value of an European call can never rise beyond the value of the underlying stock. When the dividend is known with certainty, the call values cannot rise beyond the spot value of the stock less present value of the dividend. The lower bound value of an European call can never fall below the difference between stock value and the present value of strike price. When the dividend is known with certainty, the call values cannot fall below the spot value of the stock minus present value of the dividend minus present value of the strike value. An European put cannot have an upper bound value greater than or equal to the present value of the strike price. The dividend factor is irrelevant here. A European put cannot have a price thats lower than the difference between the present value of the strike price and the stock price. Option valuation: Upper and lower bounds -Part III by J Victor on September 9th, 2012
We have already discussed the upper limits and lower limits of European options in our earlier posts. Now, here we discuss the remaining part upper and lower limits of American options. Upper bounds of American calls: We know that an American call option can be exercised at any time during the contract period. The principle of upper bounds of american calls are the same as we saw in upper bounds of European call values. The difference in excersisability will not make any impact on the upper bound values .So, the upper bound value of an american call can never rise beyond the value of the underlying stock. When the dividend is known with certainty, the call values cannot rise beyond the spot value of the stock less present value of the dividend.Its straight forward and needs no further explanation.
Lower bounds of American calls: What would be the lowest value for an american call? An american call without known dividends cannot have a value thats lower than the difference between stock price and the excercise price. Since the calls are executable at any point of time, the present value of excercise price need not be calculated for caculating the lower bound.So, if the underlying stock price is trading at 100 and if the srike price of its american call is at 98 , the call value cannot be less than Rs 2. ie, stock price-strike price. Suppose now, that the call price is less than Rs 2 , say Re.1. A trader can immediately buy a call for Rs 1 and sell the stock for Rs 100 and since it is an american call, excercise the call immediately ( that is, buy the stock at excercise oprice of Rs 98 ) and make a profit of Rs 1 per share. Connecting the points discuused above,its logical that- If the stock price is 0 , then the value of american call must be 0. The lower bound of an american call is the difference between stock price and the excercise price. The minimum value would be 0. An american call cannot be less than an european call. American call = European call for a non dividend paying stock. The early exercise decisions of american calls are based the principle of time value of money. Upper bounds of American puts: The american put cannot have a value thats greater than the strike price.So, if the underlying stock is at Rs 70 with strike price at Rs 75, the value of the put cannot be greater than 75. Thats simple to understand. The existence or non existane of dividends in the underlying stock desnt make any difference in this case. The upper bound will always be the strike price in the case of american puts. Lower bounds of American puts: The lower bound of an american put would be the difference between strike price and the stock price. It cannot be less than that. For example, if the underlying stock is trading at Rs 70 and the strike price id at Rs 75, the value of put canot be less than Rs 5. If the dividend is known with certainity , the value of put cannot be lower than the strike price ( stock price + the present value of dividend), provided the stock is trading cum-dividend. Connecting the points discussed above, its clear that - If the stock price is 0, then the value of american put must be its excercise price. It cannot go higher than that. The lower bound of an american put is the difference between the exercise price and the stock price at start. The minimum value would be 0. The maximum value of man american put is its strike price. The value of american put would be equal to the corresponding european put. Option valuation Method 1. by J Victor on October 15th, 2012
So far, from our earlier posts we learned The nature of option contracts Factors that affect the valuation of option contracts And, certain restrictions on upper and lower bound of options prices. From this post onwards, we proceed to learn the methods of option pricing. The first point we would like to say is that, option valuation, however simple, requires a bit of mathematical calculations. The methods we would discuss in this series are: Risk neutral model Binomial model And, The Nobel prize winning Black-Scholes model.
Each method is an attempt to suggest a price for an option contract, given the time to maturity, strike price, underlying stock price and the risk free interest rate. Among the above three methods, the Black scholes method is the most widely used. Two points to note here is that one, the main factor that influences the option price is the stock price which itself is again subject to valuation. second, Not all the factors that influence the option price are quantifiable. Demand and supply, bids and offers, unexpected events like war, earth quakes or scams can disturb the market equilibrium and drive the prices of underlying stocks to extreme levels. The effect of these events cannot be quantified or forecasted. Hence, what these pricing models suggest is a valuation based on the quantifiable factors. The value thus obtained may be used basically as an indicator to predict the reasonable value of options. The first method: Risk neutral model By risk neutral we mean that the investor is indifferent to risk. In a risk neutral world, the expected return of the investors would be the same as the risk free rate of return or in other words, in a risk neutral environment, investors do not expect anything more than the risk free interest rate from their investments. Hence, it would be possible for us to calculate the future value of an option and discount it to the present value at the risk free rate. For example: lets assume that the stock of XY LTD is trading at Rs 200. You expect the price to move up 20% or fall by 10% in a year. The strike price is Rs 210 and the risk free rate is 10%. How would you calculate the value of option? Step 1. We would value the calls both scenarios. So, if the stock rises 20% as expected, the call should be worth Rs 30 and if it falls 10%, naturally, the call is worthless since its out of the money. So the option values are Rs 30 ( if the stock price moves up 20%) and 0 in the other case. Step2. Consider the upside and downside probability. We know that the stock can go up by 20% or drop down 10%. When the investors are indifferent to risk, the expected return on this stock must be the risk free rate of return ie, 10%. Therefore- Expected rate of return = (probability of rise x 20%) + { (1-probability of rise) x (-10%)} Lets assume that the probability of rise as x. Hence , 0.10 = .20 x + { (1-x) x ( -0.10) } Therefore the probability of rise = 0.667 and the probability of fall is 0.333 Step 3. Find out the expected future value of the call which would be the weighted average of step 1 and step 2. So the expected value of option one year later is (0.667 x 30 ) + ( 0.333 x 0 ) = Rs 20 . Hence, if the investors are indifferent to risk, the value of option is Rs 20. Step4. Now that we got the value of option 1 year hence, discount it at the risk free rate to get the present value of option. The present value of option would be 20/ 1.1 = 18.18 Thats the risk neutral method to value options. A deviation from the above rate would open up arbitrage opportunities.The risk neutral method is very simple. What we have done is we have calculated the expected pay off from the option and discounted it to the present by applying the risk free rate. Option Valuation: Method II (Part 1) by J Victor on October 28th, 2012
In the last post we discussed the risk neutral method of pricing options. In this post we would discuss binomial method of option pricing which, in reality, is just an extension of the risk neutral method. BINOMIAL PRICING MODEL. We will check out binomial model with the help of an example Lets assume that the stock is trading Rs 100 right now. In the next one year, the stock may move up 20% or fall 10%. European options are available at a strike price of Rs 95. What would be the value of a European call if the risk free interest rate is 12%?
Step 1 Value the maximum probable expiry value of call. If the stock price moves up to Rs 120, value of call would be = 120 95 = 25 If the stock price crashes to Rs 90, the call is worthless = value of call = 0 Step 2 Binomial method of option pricing assumes that the investor are risk neutral. Risk neutral implies that the investors are indifferent to the actual probability of payoffs and are only concerned in getting a payoff thats equal to the risk free interest rate. Now, the probability of up move and down is not known but the implied probability of the movement in stock prices can be calculated by using the interest free rate. Lets assume that P is the probability of up move then, mathematically we can also say that (1-p) is the probability of down move, right? Hence the value of P or probability can be found out with the following formula
We get the value as 0.73 Step 3 If 60% is the chances of winning, 40% is the chances of losing right? That means, if p is the chances of winning, 1-p is the chances of losing. Here weve computed the value of p as 0.73 Hence, the value of 1-p = 0.27 Step 4 In step 1, we have already computed the pay offs which is Rs 25 and 0. Now, we can determine the value of call one year hence, using the following formula (25 x p + 0 x 1-p) = 25 x 0.73 + 00.27 18.25 + 0 = 18.25 This is the value of call after one year. Hence we need to discount it to the present using the risk free return rate of 12%. The present value of 18.25 discounted at 12% would give Rs 16.29 as the answer. Thats the value of the call at present. The binomial approach is very simple and assumes that the underlying stock would increase or decrease at a certain percentage until option expiry. It is very useful for valuing American options since American option holders can exercise the right at any point of time. In the above example we have valued options assuming that the stock price moves up or down once. Its equal to the risk neutral method we discussed earlier. The catch here is that, We can extend this theory to more than one period. We will discuss that in our next post. Option valuation: Method II (Part 2) by J Victor on November 25th, 2012
Option pricing method II (Part 2)
The two stage binomial pricing was a simple method. In our example we assumed that the stock was trading Rs 100 and that in the next one year, the stock may move up 20% or fall 10%. We tried the value the European option that had a strike price of Rs 95 assuming the risk free rate was 12%. If we draw a picture, the price movement and pay off probabilities would have looked like this
This two stage process can be generalised to incorporate more realistic scenarios. For example, we can assume that the stock would move up or down in a period of 6 months ( instead of 1 year) . From there, for the next 6months, probabilities can be drawn assuming the same rate of change in price. The binomial model assumes that the increase or decrease in price remains as a fixed percentage of the start point. The calculation would become more complex and cumbersome as we break up the year into more short time intervals. Lets work out an example. The current stock price is Rs 100 and the risk free rate is 8%. The stock price may move up 10% or fall by 5% every single period (6 months). If a call option is available at an exercise price of 105, what would be the theoritical valuation? Assume that the call has one year validity.
Here , as we see from the graph, the time period of 1 year has been split to two zones. In the First 6 months we worked out the probable movement of share price from Rs 100 to 110 or 95. In the second 6 months, we worked out the possibility of share price moving up/down from 110 or 95. The pay off at the end is worked out first which is Rs 16 (Rs 121-105). From there the values are worked backwards step by step. Amoung the final prices, only Rs 121 ends up in the money and hence attians a value of Rs 16 . The other two end up out of the money and hence the value is 0. The second step is the same as we discussed in our previous post. The implied probability under the risk neutral valuation has to be computed. The formula is given below. P is the implied probability.
The formula returns a p value of 0.60 and (1-p) value of 0.40. The pay off of the first year can be caculated as (16 x 0.60) + ( 0 x 0.40) = 9.6. This 9.6 has to be discounted for half a year at the risk free rate of 8%. This gives a figure of 9.23. Hence the position now will be as follows:
For the final column, the p values have to be computed again. Using 0.60 as p and 0.40 as 1-p, the answer would be (9.23 x .60) + (0 x .40) = 5.53. This amount has to be discounted at the risk free rate of 8% per annum. We get 5.32 as the answer (Since 8% is for a year, for 6 months we take half of it i.e. 4% as the discount factor ) So the entire pay off graph would be:
So the value of call at inception is Rs 5.32. This principle of binomial pricing can be extended to any number of periods. Three or four steps can be calculated on papers. But if you extend the periods to more than that, the calculation becomes difficult and youll have to use a spreadsheet. Option valuation : Method III by J Victor on December 9th, 2012
The Black Scholes Model We learned from binomial model that price change in underlying stocks can be chopped to shorter periods like 6 months or even 3 months or 1 month and a chart can be drawn which would show the probable options values. Starting from the end of the tree, we worked backwards until we got the value of the option at the beginning. It may be practical to work back three or four steps using the binomial method. But, stock market is a place where the price changes keep occurring every minute, continually. Hence, a method will have to be found out where this chopping can extended ad infinitum.
Fisher black and Myron scholes came up with a solution to this, which later won them the Nobel prize. The method is called the Black-scholes model of option pricing. The model has 5 inputs- stock price, strike price, risk free return, tenure and volatility. Each of these inputs is very crucial in determining the option value. The formula involves a bit of mathematical calculations. So, for those who are not quite familiar with math and statistics may have a bit of trouble in understanding the whole thing. The black scholes model is also made on the assumption that There are no dividends on the stock, any transaction costs, and taxes, The short term risk free rate is known with certainty and will be constant during the lifetime of the option, Short selling of stock is permitted, Call option can be exercised only on expiry ie the option is European, Stock prices move randomly and the prices of the underlying cannot be negative, The volatility of the asset s known and is constant over the life of the option, And that, trading takes place continuously. The formula. C (value of European option) = Current market price x N (d1) Present value of exercise price x N (d2) We have to compute d1 and d2 separately, which is derived by the following formula.
Where, = standard deviation of continuous compound rate Ln = natural log T = time remaining before expiry date (expressed in fraction of a year) N = cumulative area of normal distribution evaluated at d1 and d2. Although, the model is basically an improvement on the binomial model, it may not be easy to compute for everyone. Hence, a better option is use black scholes calculators that can be downloaded from many websites. The manual method of calculating black scholes using the above formula and websites from where you can download black scholes calculator will also be explained later in our article. Option Greeks by J Victor on February 18th, 2013
Greeks. In options, Greeks means a group of Greek alphabets that are used to represent certain values related to volatility of Option premiums. There are 5 measures of volatility Delta (), Gamma (), Vega (), Theta () and Rho () which commonly used by investors. These are called option Greeks. We already know that option contracts keep changing in values due to changes in one or more of the several variables such as price of the stock, the risk free rate of interest, time to expiry, volatility etc . To explain the relationship between each of these variables and option premium, a Greek letter is used as a short form- for example Delta of an option (symbol ) explains the rate of change in the option price with respect to the underlying share price.
So Greeks basically measure the sensitivity of option prices to various factors affecting it. 5 Greeks. Delta () delta is the rate of change in option premium when there is a change in the price of the underlying asset, assuming that other factors remain unchanged. Gamma () Gamma is the rate of change in the delta for one when there is a change in the price of the underlying asset, assuming the other factors remain constant. Vega () Vega is the rate of change in the option premium when compared to the volatility of the underlying share. Theta () Theta is the rate of change in option premium when there is a change in the time to expiry. Rho () Rho is the rate of change in option premium when there is a change in the rate of risk free interest. Why Greeks are important The rate of change or the effect of change in option premium when each variable changes is a vital information for those who use options for the purpose of risk hedging. For example if the Delta of an option is .50 it means that when the underlying price of the stock changes by Re 1, the option price changes by 50%. This information can be used effectively in various scenarios. For example, an in the money option with higher delta would be give more profits when compared to an in-the-money option that has a lower delta. How are they computed? All option Greeks are computed using the black scholes formula. Deriving option Greeks may not be a feasible idea unless you are academically interested in doing math. It is not important to learn how Greeks are computed at the same time, it is very important to know the application of these measures. As we said in our last post on black-scholes model, option calculators are available online from various sources. Given below is the option calculator link from the BSE. Those who want to value options can use this calculator. Click here for options calculator. In our subsequent posts, we will go into detail on all the option Greeks so as to understand it closely. Understanding Options delta by J Victor on March 29th, 2013
A nave option trader may think that if the underlying price of the stock moves up Rs 1, the option value will also move up Rs 1. This is not true. The price of an option may move in varying degrees according to changes in the underlying stock. This relation between underlying assets price and related option contract is explained by computing the Delta of an option . For example, if a stock option has a Delta of .50 it means that, for every Rs 10 movement in the stocks price, the option price would move Rs 5. This is a very important information for every option trader because, it helps to reasonably estimate the profit / loss if the stock price increases / decreases to a certain level.
Delta may be positive or negative. When delta is expressed for call options, it is expressed as a positive number (between 0 and 1) since a call will increase / decrease in value as the underlying price of the asset increases / decreases. The positive sign is used to denote the nature of relation between call options and underlying asset price. Positive delta gains in value as the underlying price of the stock increases. Conversely, the delta of Put options is expressed as a negative number between -1 and 0. The negative sign denotes the relationship between the put value and the underlying stocks price. As the price of the underlying stock increases, the put option decreases in value. The underlying stock price has to fall for a negative delta to gain in value. The second feature of delta measure is that in-the-money options will have higher delta and out- of-the money options will have lower delta measures. As the option keeps moving deep in- the money, the Delta will tend to move towards 1 quickly. The reverse will happen when the option keeps falling out-of-the money -the Delta measure would quickly drop near to 0. It is also interesting to note that when the time to expiry is less, the delta of in-the-money options will tend to move towards 1 and delta of out-of-the-money option will tend to move towards 0. The reason is that, as the time to expiry decreases day by day, the chances of the stock price to move against the trend is less. In short, one of the main factors that influence the delta measure is the time factor or the time till expiry of the option contract. As you would have logically observed, the delta measure is not a constant figure. It will keep on changing as the time to expiry shortens with every passing day. The third feature is that Delta values would increase as the underlying assets price volatility decreases. This is because, as the price volatility decreases, the asset price is more likely to stay where it is and hence, if the option is in-the- money, the chance of that option to end in-the- money on expiry is greater. This increases the Delta of that option. In short, volatility is the second important factor that influences the delta measure of an option. So, Time to expiry, volatility and underlying asset price are the three factors that influence the delta measure of an option. Delta values may be positive or negative. Delta values will be positive (between 0 and 1) for call options and it would be negative (between -1 and 0) for put options. In-the-money options will have higher delta and out-of-the money options will have lower delta measures. At the money option (whether call or put) will always have a delta of .5 Delta measure will keep on changing.
First, to estimate the sensitivity of option prices to changes in the price of the underlying asset. Second, delta measure tells you the probability of an option staying in-the-money at expiry. For example, if an option has a delta of 1, we can assume that the option has almost 100% chances to be in the money at expiry. An option with a delta of .5 means that the option is AT-the-money or in other words, the option has 50% chance to be in-the-money at expiry. An option with .25 delta means that the option has only a 25% chance to end up in-the-money on expiry. The relevance of this information is that it allows you to take calculated risks. For example if you think that the stock markets are about to rally , choosing to go long on an option that has a delta of more than .5 would be a better idea. Third, to decide the optimal hedge ratio. To hedge means to invest in an asset with the intention to offset the loss that may be suffered in another investment so that the effect of loss is minimized. So hedging is more like insurance. For example you hold 10 call options of HDFC which has a delta of .80 or 80%.That means a 10 rupee rise (or fall) in HDFCs price will have the effect of options gaining (or losing) Rs 8. If you want to mitigate the probable loss, you will also buy puts in such a way that when you lose in one position, you gain in another. So in the above example youll buy 20 put option which has a delta of (-.40) so that the net effect is as follows:
This mitigates the probability of loss should the price of the underlying shares fall. When the price of shares fall, you gain in puts and you lose in calls and hence, nullifies the effect of price fluctuations. Thats a brief idea about delta, its importance and uses. Knowing delta measure of an option enables you to take more intelligent actions in the option market. Delta is only one among many Option Greeks we explained earlier. We will check out Option Gamma measure in our next post. Understanding options Gamma. by J Victor on April 21st, 2013
We learned about the relevance of Delta in our last post on options. We said that Delta measure of an option will keep on changing every day due to various factors. Since Delta is never constant, an option trader will have to keep a close watch on the rate of change in Delta or the volatility factor of Delta. Gamma is a measure that tracks this rate of change in delta. So if the gamma of an option is .1, it means that the delta of that option changes 10% when there is a Re 1 change in the underlying asset. So gamma is just a continuation of Delta or it can be considered as a derivative of Delta.
We know that the Delta of an option will keep moving towards 1 as the option keeps going in- the-money and conversely, it will move towards 0 as the option keeps moving out-of-the-money. Now, the question that needs to be answered is how fast does Delta change? This vital piece of information, which can be used effectively while taking trading decisions, is measured by Gamma. For example, you have to opt between two identical options with the same Delta (say, Delta of .6). Since Delta basically measures directional risk, an analysis of its Gamma will reveal which Delta moves fast and which one moves slow. Delta with high Gamma would be the more risky one. Gamma is a useful tool for traders who take a long or short position in a single option contract. However, the real use of Gamma is in more complex option trading strategies where traders use a combination of long and short positions to make money. Gamma may be positive or negative. If the Gamma of an option is positive, it means that the change in delta would be positive for a positive change in prices. In other words, the delta of an option will increase as the price of the underlying asset increases. Conversely, if the Gamma of an option is negative, it means that the change in delta would be negative for a positive change in prices. In other words, as the price of the underlying asset increases, the delta will decrease.
If you recall our article on delta, we explained that the delta of in-the-money options will tend to move towards 1 quickly and as the time for expiry draws near, it tends to be less volatile. Logically, as the options moves in-the-money, the Gamma measure will move towards 0 since heavy volatility in delta is quite unlikely. Same is the case of deltas that are deep out-of-the money. Deep out-of-the money options are unlikely to be less volatile as the option expiry draws near and hence in this case also, gamma will be near to 0. So, as you might have closely observed, Gamma of an option will be at its highest when the option is at-the-money.
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