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Four Techniques to Identify Up Trends in the Short Term

Updated on 2013-05-30 by Guest

Success in capital market investments is all about deciding the right stock and the right time to invest the funds. Investors generally rely on fundamental analysis and technical analysis tools to make their investment decisions. Fundamental analysis involves scrutinizing the economic conditions, successful industries in the economy and finally narrowing down on the right companies to invest their money. Fundamental analysis is generally used for making long term decisions in the market such as to understand the long term trends of stock prices. On the other hand, technical analysis involves the use of historic prices of stocks in order to develop various trends and patterns. Such trends and patterns are further used to analyze if a stock is to be bought or sold and if it is the right time to enter or exit the market.

The techniques of technical analysis are effectively useful for identifying the short term trends in the market. These tools provide information on whether the short term movement of the market is in uptrend or in downtrend. The technical analysis tools used by investors to identify short term up trends and down trends depend on the type of information used. However technical analysis is based only on the price information of the shares of the company, unlike fundamental analysis which involves data related to macro and micro economy of the country, industrial development and financial conditions of the company.

The major techniques commonly adopted in technical analysis to identify short term trends are

1. moving average
2. relative strength index
3. Odd lot interests
4. Breadth of the market

While the first two indicators are used for identifying uptrends and downtrends in the share price of individual companies, the latter two indicators are commonly used to identify trends in the market as a whole. These tools are popular among investors, especially day traders who look out for information on perfect times for buying and selling of stocks. Analysts prefer to buy when the prices are low and sell when the prices are high. Thus informed professional investors would tap the market at right times by buying at troughs and selling at peaks. The four major tools mentioned above are used to identify whether the market is moving in an up trend towards or in a down trend towards trough.

1. Moving Average

The moving average of a stock is calculated by averaging out the price of the share for determined period. The period for which moving average is calculated would vary from short term of three, five or seven days to long term of three months or six months. The short term moving average is calculated to identify short term up trends in the company’s share price. The basic purpose of calculating moving averages are to smoothen out heavy price fluctuations in the share price of a company and thereby lookout for patterns in the price movements.
Once the short term moving average is calculated, the moving average line is drawn along with the price line on a chart. This is further used for identifying short term trends in the share price of the company. For example, if you observe that in a declining market, the short term moving average line moves upwards while the price line is still falling, then you could be sure that there would be an uptrend in the share price of the company. As the moving average is calculated for short term, this pattern in the line chart would identify short term uptrend in the stock price behavior.

2. Relative Strength Index

Relative Strength Index is another important tool used for identifying short term trends in the share prices. This is a momentum indicator which is basically used to identify overbought and oversold zones in the company’s share price. The overbought zones would indicate that the share price would move to down trend and the oversold zones indicate that the price would move to short term uptrend. This indicator aims at comparing the magnitude of recent gains with those of recent losses in the share price of the company. The relative strength index is calculated using the formula,
RSI = 100 - 100/(1 + RS)

Where RS = Average of n days' gains / Average of n days’ losses
The relative strength index of the share price would thus range between 1 and 100 with lower values indicating more sales in the company stock and higher values indicating large purchases in the share. As a rule, it is decided that if the value of Relative Strength Index is greater than 70, then it indicates an overbought zone. This would further infer that the share price of the company would further move to short term down trend. On the other hand, values of RSI less than 30 would indicate that the share price had touched the oversold zone and thereafter the company would move into an uptrend in share prices.

3. Odd lot interests

As mentioned earlier, the odd lot interest is a technical indicator used for identifying short term trends in the market as a whole. Odd lot investors are those who purchase or sell shares in small volumes without any proper information based on fundamental or technical analysis tools. Thus odd lot investors would be very quick to react to the market movements by displaying herd behavior. They would be engaged in activities opposite to that of professional investors. Thus, if professional investors are selling at market peaks or during up trends, the odd lot investors would be purchasing the shares with the confidence that the market would further move up.
Odd lot interest is the ratio of number of odd lot purchases to odd lot sales that happened in a day. If the odd lot interest is less than one, then it means that odd lot sales are higher. This further indicates that the market is moving towards its trough and thereby an uptrend in the short term is likely to follow.

4. Breadth of the market

Breadth of the market is another technical indicator for analyzing the market as a whole. Breadth is calculated as the difference in the number of advances (shares which closed higher than previous day) and the number of declines (shares which closed lower than previous day) and the breadth line is drawn against the market index line. If the breadth line is moving upwards, when the market line is still declining, then an uptrend in the market in the short term could be identified.

Thus with the use of such effective technical indicators, the investors can effectively analyze and identify short term trends in the market and thereby make their investments at the right time.

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