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Trend Warnings

In our trading courses, we emphasize the importance of watching the indexes such as the Nifty and the Sensex as an influence for our trades on individual stocks. Many novice traders mistakenly believe that if they just chart their stock, they have done the necessary research. The truth is that the direction of the broad market can have a large impact on the movement of a stock. There are exceptions, but on a longer term basis, roughly 60% of a stock’s move is influenced by the direction of the market, 30% from the sector the stock belongs to, and only 10% is company specific!

That doesn’t mean that we can abandon charting stocks and buy and sell when the Nifty turns. Stocks will move further and faster with the market rather than against it. So, when we are deciding whether the price of a stock is likely to bounce from a demand or supply zone, or break it, we can often rely on the price action of the index to offer additional information.

This market influence will be present whether we are trading on an intraday basis, or a longer time frame where we are holding for weeks to months. However, when trading longer time frames, we may be able to look at an additional tool to judge the strength of a trend and the potential for a direction change.

There are several indexes that are based on the size of the shares contained within them. The Nifty and Sensex contain large cap companies. Capitalization, abbreviated as cap, is a measure of the number of shares of stock a company has issued, multiplied by the share price. There are certain levels that determine whether a company is large cap, mid cap, or small cap. The large cap companies are usually multinational corporations that while based in India, do much of their sales outside of the country. They are sensitive to changes in world economic health.

The small and mid cap companies are not as exposed globally, and generally react faster to changes in the Indian economy. Local inflation and growth or weakness will influence their profits and their share prices. All indexes should move in the same general direction of trend as investors either have an increase in their appetite for risk and want to buy stocks in general, or they find fear prompting them to sell all shares. However, since the different cap stocks have slightly different influences, they may turn at different times.

When this divergence occurs, it could signal trend change. Using a percentage change chart available for free on the NSE website, I can chart the indexes against each other. What I will look for is health of the trend. In the first chart, I have shown the three cap indexes in 2010, just before the start of the current bear market. When all are moving together, the trend is healthy. When they start to diverge, the lines separate, then there is a potential for trend change. The November 2010 top occurred after one such divergence!

What signals a trend change?

Whenever there is a trend that lasts for a few weeks, you will usually see divergence in the indexes just prior to a turning point. These turns should come at supply or demand, but looking at the indexes together can offer you a clue as to which zone will hold.

What does a divergence tell you?

To learn more about how the indexes influence the stocks, join us in one of our classes at Online Trading Academy.

– Brandon Wendell bwendell@tradingacademy.com

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.