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3 basic questions you should answer before investing.

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.

Here’s 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 it’s so easy to access. If you approach a traditional bank, you’re 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 shouldn’t 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..

happy investing !

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Never attempt short selling

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 don’t 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 stock’s price, the investor’s 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 can’t 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 stock’s price. By shorting, you are taking huge risk for a small profit.

CONCLUSION

Short selling is never recommended and it’s not a good idea to sell someone’s 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.

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Say no to day trading !

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. That’s far from truth. A little “gambler’s 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, you’ll realise that you’ve been a gambler only when you look back at what you’ve 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 haven’t 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 it’s 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. Don’t let yourself or those you care about get sucked into day trading.

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Cost Averaging- A strategy you should use carefully.

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 what’s going on within the firm and its industry. You should know if a drop in the stock’s 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 don’t. 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’ you’re going to invest in and employ the cost averaging strategy. For example- there are certain industries where India as a country’s 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 doesn’t 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 you’re investing stocks, averaging down probably doesn’t 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.

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