Why does price reverse at resistance and Support price for stock

Support and Resistance are concepts used by technical analyst to predict the price movement of the instrument.

A support is level where the price which the instrument tends to stabilize on the downside and is expected to reverse direction in upward direction. Resistance is opposite of the support level meaning the price is more likely to "bounce" off this level rather than break through it.

Let us take the example of a stock, say ABC Bank. Support the current price of stock is Rs 425 and the results of ABC bank are declared which are exceeding the market expectation. The price of the stock will increase due to reason of higher demand from the purchaser of stock, i.e. they are willing to pay a greater price for purchasing the share. Suppose the price rises to Rs 500. At Rs 500, the demand for purchasing the stock may decrease as the buyer will feel the prices of the stock are on a higher side. The supply at this price is greater as more sellers will be keen to sell the stock at this price. So now the stock is feeling resistance to cross the price of Rs 500. This price of Rs 500 starts acting as resistance for the stock.

Since trade happens when expectation of buyer’s demand meets the seller’s supply, the prices tend to fall on reaching the resistance level. The price does tend to fall until a new equilibrium is attained. Again after a certain price, say at Price RS 400, the seller will not be inclined to sell stock, as they might feel the price is too low to sell the stock, although the demand for the stock will be higher as compared to the supply for the stock.

Since the supply for selling is low at this support, stocks usually takes a support at this level and tends to rise from this support price. Usually support and resistance can be tracked by trend line.

The support and resistance can be tracked for different time period. Let us understand this will buying apples. In the peak season, the price of apples remains in between Rs 50-80, Suppose the peak season lies for three months. The support and resistance price for apple will be Rs 50 and Rs 80 respectively for a medium term. In daily prices, the support/ resistance can be Rs 50-Rs 55. In the whole year, if the prices of the apples remain between Rs 40-120, These are the support and resistance for the long term.

Once an existing support or resistance level is broken, the system tends to find new levels for resistance and support. The support and resistance can be defined for different time durations as discussed above. Normally once a support or resistance is broken, the existing support acts as new resistance and vice versa.

Changing Value of money with time - time value concept

Regularly on television, we see an ad on pension plan, where the lead actor says whether the funds you invest  in the mutual fund today will be enough in future. We can associate the same with our daily life. During my childhood day, a plate of chicken biryani at my favorite restaurant was RS 50(some 10-15 years back). I visited the same restaurant few days back, the price of chicken biryani was Rs 200. So the purchasing power of Rs 200 has reduced from what it was ten years ago and it is much higher than what it will be ten years from now. 10-15 years ago, I would have brought four plates of chicken biryani for Rs 200, but now only one L

In this article, I will try to understand and share, why the purchasing power of money changes with time. We will try to understand the time value of money.  The basic concept behind time value of money is “a given sum of money is more valuable the sooner it is received” due to the potential of earning interest from the money.

Let us take another example. Suppose I had Rs 100 with me and invest it in some government bank under a fixed deposit plan which is giving me almost risk free 10% of interest rate (Please do not ask which bank is offering such interest rate, I have taken 10% for ease of my calculation).

Suppose I invested the money in the fixed deposit for 5 years. The value of the investment at different time will be:

The relation between Present value, future value and the interest rate is as follows:

FV = PV * (1+r)ⁿ

As shown in the calculation above, the future value depends on the rate of interest. Next let us understand how the interest rate is calculated.

Interest rate depends on following factors or components:

a. Risk-Free Rate – A risk free investment is one in which the actual return over a tenure are always equal to the expected return over the period. For e.g.  Government securities can be considered risk free investment and the rate they provide can be considered as risk free rate.

b. Expected Inflation - Inflation refers to the rate at which prices for goods and services rises. Any investment should beat the rate of inflation to make it profit.  

c. Default-Risk Premium – When we invest money in some instrument, we are actually lending money to another party. One component of interest is to consider the capacity of counterparty to repay the investment. This component will be high or low depending on the creditworthiness of the person or entity involved, i.e. what is the probability of the counterparty to default. That is the reason why the bonds of private institutions provide higher interest rates compared to government bonds. Rating provided by rating agency to the instrument is an indication of the risk of default for the instrument.

d. Liquidity Premium- Liquidity of an instrument is considered to be low if the instrument cannot be converted to cash easily. For e.g. Consider there are two bonds, a bond with higher liquidity will have low premium compared to another bond with low liquidity. Higher liquidity means the instrument will be easily convertible to cash and will follow the fair price for the stock. A less liquid instrument should offer a higher interest rate to compensate as liquidity premium.

e. Maturity Premium - Maturity risk premium applies to any investment that pays a fixed rate of interest and has a fixed maturity date. Buying any investment with a longer time to maturity increases the probability that interest rates could rise within the period between today and maturity.

Summarizing the time value of money increases with time based on the interest rate. The future value of any investment depends on the interest rate. Interest rate is directly proportional to risk free interest, increase in inflation rate, and time to maturity of the instrument and the probability of default by the counterparty, and illiquidity in the instrument.

Key Indicators defining the monetary policy

Today I was watching a news channel and heard that Repo Rate has been reduced by the Reserve bank of India Governor. So I thought of investing some time on the concept of Repo rate, Reverse Repo Rate and CRR and what they mean to a layman like me.

So when I start reading, I get to know including these, there are some more key indicators defined in the monetary policy for the country defined by the central bank of country. In India monetary policies are defined by the Reserve bank of India and are presented from time to time by the RBI governor.

Below are the key indicators defined by the RBI.

Repo Rate is defined as the rate at which the Reserve bank lends money to commercial banks. Repo means Repurchase Obligation agreement. In a repo transaction, a holder of securities (e.g.: the commercial bank) sells the securities to an investor (e.g.: the reserve bank of India), with an agreement to repurchase at a predetermined date and rate. So Repo Rate is the rate at which RBI purchases the securities from the commercial bank with obligation on commercial bank to repurchase the securities at the prevailing repo rate at the agreed rate. This is an interesting topic and deserves a separate article for detailed discussion. Lowering of Repo rate implies banks can now borrow money from the reserve bank at a lower rate. Reverse Repo Rate is the rate at which RBI borrows money from commercial bank. 

Another term we hear regularly during policy commentary is CRR (cash reserve ratio). Cash reserve ratio is the minimum amount of funds that the banks have to keep with the Reserve bank. 

Reverse repo rate and repo rate are used as instrument to keep a check on inflation. The flow of supply from central bank to commercial banks will reduce in case if the repo rate is increased or reverse repo rate is decreased. 

Statutory liquidity ratio (SLR)  is the percentage of money that commercial banks needs to maintain as reserve in the form of gold, cash or government securities before providing any credit to loans. This again is determined and maintained by Reserve bank or central bank

SLR restricts the bank’s leverage in pumping more money into the economy and keeps a check on minimum amount maintained to pay the liabilities that are deposits maintained with the bank. CRR is maintained in cash form with central bank and is used to manage inflation

Bank Rate is the rate at which RBI in India or Central bank of a country allows finance to commercial banks. In case the reserve bank increases/decreases the bank rate, it is an indication of the banks to make changes to interest rates and lending rates.

 In case reserve bank wants more money to flow in the system, it reduces the repo rate. This reverse repo rate is always lower than the repo rate. Reverse repo rate can be increased to reduce flow of money in the system.

Fundamental Analysis basics of stocks in Share Market

Before investing or trading in stock, we need to analyze the stock to derive some expectation on the future performance of the stock

The analysis of stocks falls in two main categories: Fundamental Analysis and Technical Analysis In this article we will try to understand the Fundamental Analysis

Fundamental Analysis analyses a stock from its financial statement, bank statements, and the cash flows. It interprets the future performance of a stock based on the cash flow statement, balance sheet, and income statements and the brand and management. So Fundamental Analysis considers both the qualitative Analysis (Management and Company Brand) and quantitative Analysis (P/E ratio, fair price, intrinsic value and other information extracted from the financial statements)

 If you are an investor, based on fundamentals, you can ask yourself following few questions before making an investment in the stock.

• What is the fair Price of the Stock - What Based on the analysis, Investors try to identify the fair value of a stock. Fair Value of the stock can be defined as the potential value of a stock or the expected value of the stock based on the financial statements of the company. Based on the comparison of fair value with current market value, we can take a call on whether to invest in the stock or not. A stock with fair value > Market Price is a good candidate to invest in (an Undervalued stock), whereas fair value < Market Price (an Overvalued Stock) is a good candidate for sell. But it is one of indicator of Fundamental Analysis, and investment can depend on multiple other factors before investing.

• What is the debt to equity ratio of the stock – When we look at the liability section of a company financial statement, it has mainly two components, Debts and equities. Company with low debt to equity ratio is a better candidate to invest into. If we compare the debt to equity ratio of two different companies, we should compare the ratio of companies in the same sector. Comparing the debt to equity ratio of IT Company with Capital good company will not give the current indicator.

• What are the profit margins of the company and the pattern of profit margin of a company over a larger period of time is an indicator of company management of business

• How long the stock is in market. Larger the span of a stock help to analyze how the stock has performed during different cycle. E.g. a stock in market before 2007 Recession, we can get an estimate of company fundamentals during lean period.

• What is the revenue growth for the company?

• How the company is better placed compared to its competitors. What is the brand value, how has management handled the company assets and what is the general outlook for the sector in which the company is a player. What is the business model of the company?

• What is the market Share of the Organisation,How much customers does the company serves to.

Questions about shares in Stock Market

• What is a share – Purchasing a share is equivalent to owning a part in the organisation. Suppose an Organisation ABC has 1000 outstanding shares and I as an individual own 150 shares. I have 15% ownership in the organisation. With Ownership in Organisation, An Individual owning share is eligible to the profit as organisation as well as voting rights if attached?

•  Why will an Organisation share its asset and profit with public – Organisation requires money to run it operations or to start on a new opportunity. Suppose my Organisation want to add on infrastructure and requires some capital for the same.

• How does an Organisation gets the money it required – An Organisation can get the required money in two ways. Either by burrowing money in terms of debt (generating bonds is a example of debt) or selling stocks of the organisation. Organisation invites capital investments in terms of public issue of shares.

•  Are stocks a liability or Asset to the Organisation – Stocks are on liabilities side of a company. In broader terms in Accounting. Assets of an Organisation should match the liabilities of the organisation. i.e. Assets = liabilities = debt of the organisation + stocks of the organisation+ other liabilities. This gives value of stock as Assets – debt of instrument – other liabilities

• Where does an organisation sell new stocks – An organisation floats new stock in a primary market. In case organisation sells its equity/stock for first time to the public, a security is created and initial public offer (IPO) is offered in the primary market with an issue price which is offered and number of shares for the stock for public.

• Together with IPO, an already listed Organisation can also gather money from the market in terms of stock by issuing further Public Offering. Difference between IPO and FPO is while IPO are usually offered by an unlisted company in Stock Exchange, FPO is offered by already listed company in the stock exchange. An FPO can be either of fresh issue of shares or an offer for sale. An offer for sale is offered by company, in which organisation sells its share of stocks to public. Also a company can issue right issue or preferential issue.
  

•  Once a price is decided in the Primary market to the allocated shared to public, Investors trades on the shares of a stock in the secondary Market.

•  Once a fresh issue is made to the public, based on the current market price, Market Capitalization is calculated as:  Market Capitalization – Current Market Price * Total Number of shares of Company.This includes Promoters share holding in the Organisation together with public.

• Trading in general happens when a buyer meets a seller for an agreed price and for an agreed quantity. Similarly in stock market, a trade happens when ask Price (price offered by the seller to sell a share) and quantity matches the bid price (price offered by the buyer to buy a share) and bid quantity matches

•  And Last, but not the least, investment in Shares is subjected to market Risk. :)

Understanding Derivatives :Futures and Options

Hi, In this series on financial market, we will learn on concepts in financial market. Concepts on Equity, bond, derivative which will be very useful for beginners in trading.

In this article we will discuss on derivative basic concepts. Derivative is a financial instrument which derives its value from other instruments which are also known as underlying assets. Underlying Assets can be bond, stock, currency, or commodity to name a few.

Stock derivatives derive its value from the stock shares. Movement in equity is responsible for change in derivative pricing. Similarly Currency derivatives derive its value from the movement in derivative market. Similarly we can have derivatives in commodities and other instruments. The basic purpose of derivative is it acts as a basic instrument for handling financial risk and acts as insurance to the financial instrument.

Let us understand an example of derivative. Suppose there is an instrument which depends on interest rate fluctuation or other market condition. So we have an underlying asset.

For trading in any instrument, we require two parties, one who agrees to buy at an agreed price, and another party to sell at an agreed price. This agreement between seller and buyer can be termed as a contract. One buying the contract expects the price to go up from the agreed price. The seller of the contract wants to insure the risk of the underlying asset.

The common types of stock derivatives are as follows: 

1. Future and Forwards - Future and Forwards are contracts deriving value from underlying asset with an obligation for trade on the agreed price and agreed date. Futures are traded on an organized exchange for e.g. NSE; Trading on an organised exchange makes future contracts a better alternate compared to Forwards. 

2. Options - Options are similar to futures with only difference it removes the obligation clause from futures. Instead of obligation, a fee is paid to the option writer (i.e. one selling the contract) by the option holder (i.e. one buying the option).

Understanding future and Options with an example:

Let us assume, there is equity of XYZ Bank currently trading at Rs 1000. Suppose there is future contract of the Bank at RS 1020. Now if I buy a lot of xyz Bank. A lot is the contract size, Suppose 250 shares of ZYZ Bank makes a Lot. Buying a lot of future will cost the buyer 250 * 1020 = RS. 255000.

Instead of buying a future, suppose user buy an option derivative. Option contract can be a put or a call option

Suppose he buy a call option of Rs 1000, you will pay a fee of Rs 50/Share. So the total cost of the contract will be Rs 50*250 = 12500.

Suppose instead of buying a call option, buyer buys a put contact of Rs 1000 with a fee of Rs 40/share, so total cost will be Rs 10000.

Now assume on the expiry date, the sharing is trading at Rs1220, a boom in the price.

The gains/ loss in the three purchases will be:

a.)   Future : (1220 – 1020) * 250 = Rs 50000 Profit

b.)  Option Call :  (1220-1000-50)*250 = Rs 42500 Profit

c.)  Option Put : (40)* 250 = Rs 10000 Loss

Since the buyer of contract do not have obligation for the contract, he will Pay the fee of Rs 10000 as loss in the above example