Traders who follow Technical analysis keep talking about the relative strength index (RSI) of a stock. It measures the magnitude of recent price changes but how can a regular investor/trader who does not follow the mathematical aspect of trading can use this concept to make smart investment decisions. I try to keep things simple and so in Price Action investing, it means following the stocks that are outperforming to find a buy signal and ignoring the stocks that are underperforming. Let me explain this concept with two stocks – L&T and M&M and how by keeping a close eye on performance data we can make the right decisions.
Case Study: L&T
L&T was a nicely uptrending stock between June 2021 and Jan 2022. It used to take support at 100 dma which then changed in Feb 2022 when the stock broke down below it and with it started the period of Underperformance.
When the stock breaks down, it loses its relative strength (bullish interest). The stock since then followed a predictable script of lower lows and lower highs.
Here’s what happened: The stock followed the Nifty. It declined with the Nifty but whenever Nifty used to find a bottom, L&T found one too. It then used to bounce with the Nifty but always underperformed on the way up but every time the Nifty dipped, L&T declined more than the Nifty. Just to give you an illustration: the Nifty retested its lows on May 12 but L&T made a fresh low.
Performance Date: Returns between March 07 and May 12 – Nifty 0% while L&T posted -6.6% returns
When a stock underperforms, you ignore the stock till you see the stock making a real big move. This time when Nifty found support on June 17 and bounced, L&T has bounced with huge intensity. This time, Nifty is up 6.1% since June 17 while L&T is up 13.3%.
With this move, L&T has neutralized bearish sentiment and the stock is more neutral as it attempts to rally back to 1850 (an additional 9% from current levels). L&T has become neutral but if you follow a trend, the stock has still not given a buy signal. Let us understand how the concept of relative strength can be used to buy a stock with an example of M&M.
Source: Chartalert.com
Learn Science of Stock Price Action
Fundamentals don’t drive stock prices.
How people perceive those fundamentals drive stock prices.
As a market participant/trader, keep an eye on how the market views the fundamentals than being obsessed with your own version of fundamentals. It means look at the price action and it tells you without bias what the market thinks about the stock. Once you read the price action, go and find the reason why the market has such a view on the stock, and be aligned with it.
This is the level one mind training every individual requires to be in sync with market thinking. This is the real fundamental of Investing. I call it Science of Stock Price Action
If price action fascinates you – then Science of Stock Price Action is a great place to start. I only cover Indian stock market here.
Disclaimer – The state of the market notes is Deepak’s perspective on the market. The column is purely for educational purposes. Nothing contained herein is a solicitation to trade or a recommendation of a specific trade. By reading this publication you agree to make no trade relying in whole or in part on the comments of the writers