The P/E (price / earnings) ratio is one of the key measures of market sentiment towards a stock. It measures the relationship between market price and current profits (earnings) and can be calculated as follows;

                     Where EPS = Earnings per share

For example if a stock trades at 20Rs and current Earnings Per Share (EPS) is 2Rs, the stock has a P/E ratio of 20/2 = 10. This could also be calculated by dividing market capitalisation by total profits.

The P/E ratio expresses the cost of purchasing the right to one unit of profit. For example, a P/E ratio of 10 means that based on the current levels of profitability an investor must pay 10 units in order to acquire the rights to 1 unit of profit. A higher P/E ratio means investors pay more per unit of profit than a lower P/E ratio.

Why do stocks have different P/E ratios?

Ownership of a stock implies the (somewhat theoretical) right to a share of future profits. Differences in P/E ratios generally represent a risk premium being applied to the earnings of one company versus another, due to uncertainty around the future. For example, if company A and company B have the same EPS but company A is expected to double profits next year, while company B is expected to have static profits, then company A will trade at a higher price. Because both stocks have the same EPS, but company A trades ar a higher price, company A has a higher P/E ratio.

Typically a stock which is expected to grow profits in the future, will trade at a higher P/E ratio than one which is expected to have static profits. Similarly a company with secure (low risk) future earnings will have a higher P/E ratio than a company with unsecure (high risk) future earnings. In this sense the P/E ratio expresses market perception of the riskiness associated with a stock’s future earnings

What is a high P/E and what is a low P/E?

Typically a P/E ratio of below 8 is considered to be on the low side and indicates the stock is undervalued or unpopular in the market. P/E ratios between 8 and 20 are often to be considered to be fairly valued while P/E ratios above 20 indicate the stock is highly valued (or over valued).

However these are broaad generalisations and can be dangerous to rely on. Investors should not just look at P/E ratios for stocks in isolation as different sectors tend to have different P/E ratios. For example a  P/E ratio which would be considered low for a small communications company may not be considered low for a large oil refining business. A quick and simple way of using P/E ratios is to compare a stock’s P/E with the P/E ratios of its competitors, the average P/E ratio for their sector and the market average. This gives a good indication of how the market views the stock in relation to others.

Using P/E ratios to make investment decisions

Although P/E ratios are extremely important, two pieces of information should be remembered. Firstly, the right to future profits implied by owning a stock does not in itself generate income for the investor. The actual return earned on a stock depends on the dividend yield, which is determined not only by earnings but also dividend policy, and the future sale price of the stock. Secondly, the current price has already taken account (factored in) future earnings expectations. This means that in order for the price of a stock to rise (over a prolonged period of time) expectations of future earnings must improve or be exceeded.

Basically, a high P/E ratio may imply earnings are expected to rise in the future, but if they do rise this does not automatically mean the price will also rise because the increase was expected and already factored into the current price. Because of this, investors often shy away from stocks with extremely high P/E ratios (25+) because in order to make a decent return, the company must improve upon the already extremely high expectations.  In fact value investors, such as Warren Buffet specifically look for stocks which are under priced and often invest in stocks with low P/E ratios (although this is by no means the only criteria). The important thing to remember is that the P/E ratio of a stock is the true measure of price and even an extremely good company may be a bad investment if the price is too high.

“Hedging” or opening up a “hedge position” is the process of establishing an exposure to a particular risk in order to offset an existing but opposite exposure. The term originates from the game of roulette where the lines between betting squares are called hedges. A bet place on the “hedge” wins if the ball lands on one of the numbers either side of it but the payout is lower than for betting on the number itself. The phrase “hedging you bets” became common parlance in English and over time has become established finance terminology.

Hedging in business

People generally hedge in order to remove risks they do not wish to be exposed to and have no expertise in managing. For example, at the beginning of a growing season the amount of money a farmer will make depends on his crop yield and future crop prices. He has no control over the future price of his crop and no expertise in predicting it.  He may hedge the risk that prices fall using a futures contract, leaving him free to focus on maximizing crop yield. Similarly he may take out an insurance policy which hedges the risk that his crops are damaged by a flood.

Hedging in investing

For an investor there are numerous risks which they may be exposed to and numerous complicated methods and products to help them hedge. Some complex hedging strategies are not available to retail investors, but some are.

Industry risk

An investor wants to invest in company X because they have recently discovered a way to cut 20% from production costs but the sector they operate in is very volatile. The investor could hedge the industry risk while exposing themselves only to the company risk by buying shares in company X and using the futures market to hedge the industry risk, either by taking short positions in their direct competitors or in an exchange traded fund which tracks the sector in question.

Currency risk

An investor may want to invest in a specific USD denominated asset because it offers an attractive return but does not want to be exposed to movements in the exchange rate. They can hedge the currency risk in the forex futures market and leave themselves exposed only to the risk associated with the asset itself.

Inflation risk

In times of high inflation an investor may wish to hedge against the risk that inflation erodes the value of the money they receive when redeeming an investment. There are many ways to do so, one of which would be investing in stocks which are resistant to inflation such as mining and commodity companies who see an proportionally higher increase in revenues than costs when the price of raw materials rises. Another option would be to invest in inflation linked bonds which pay a higher coupon as inflation rises

Equity market risk

Similar to industry risk, an investor who holds stocks in high performing companies in a bear market may hedge the risk that the market as whole falls, by shorting an exchange traded fund in the futures market.

Natural portfolio hedges - diversification

An investor who holds a portfolio of oil drilling stocks may wish to hedge against to risk that the price of oil falls. This can be done by taking a long position in stocks which benefit from low oil prices, such as airlines and haulage firms.

It can sometimes appeear as if the universe of investment strategies is characterised by linear dimension and polar opposites. You’ either go long or you go short, you’re a day trade or a long term investor, you’re a risk taker or a risk avoider.  Some would add to this collection your either a value investor or a growth investor. Even the professionals seem keen to pigeon-hole themselves as one or the other. Scratch the surface however and you’ll find very similar principles at the heart of both.

What is value investing?

Value investors rely primarily on fundamental analysis to identify stocks which are underpriced and which trade at a discount to intrinsic value (the value derived from the security itself rather than the market price). When the value approach first gained prominence, value investors argued for investing in stocks which traded at a discount to book value, the size of the discount was referred to as the stock’s margin of safety. However, modern technology and the importance of intangible assets in business mean that for many sectors book value is no longer a good measure of intrinsic value.

Intrinsic value is now widely accepted to be the present value of the future cash flows associated with owning a security. For stocks this is the discounted flow of future dividend payments. Clearly calculating this requires assumptions about future earnings, dividend policy and interest rates, so is largely subjective. Despite this, value investors typically buy securities with low P/E ratios, low price-to-book ratios and high dividend yields.

It is easy it is to identify potential value stocks by studying these ratios, the crucial step is identifying those which are undervalued not just those which have a low value; some stocks with low P/E ratios are just bad companies. The secret to successful value investing is identifying companies with sound long run economics, effective management and which trade at a discount due to pricing inefficiencies. In other words, value investors look for stocks where the market has got it wrong.

What is growth investing?

Growth investing is a strategy which focuses on companies which exhibit above-average growth or which demonstrate significant future growth potential. Typical growth investments focus on emerging markets, special situations, small and medium cap stocks or expanding sectors such as technology. Growth stocks are often characterised as those which have a Prospective PEG of between 0.75 and 0.66, although there are other measures. The identification of growth stocks is again a subjective matter.

Growth investors often buy stocks with much higher P/E and price-to-book ratios than value investors and are much less concerned with the current dividend return on a stock. This is because they believe that the stocks ability to deliver above average revenue growth will result in significant price rises and a capital gain.

Value Vs Growth: How different are they?

It is often argued that growth investing is fundamentally different to value investing because it advocates investing in stocks which seem expensive when looking at metrics such as P/E ratios, while value investors focuses on stocks which appear cheap based on these measures. Despite this, the theoretical basis for growth investing does not in itself contradict value investing. As Warren Buffett once said “growth and value investing are joined at the hip”. Both schools of thought are essentially trying to identify stocks which the market has under priced

The primary difference between the two is that value investors tend to take little or no account of future growth in their calculation of intrinsic. Value investors argue that attaching a premium to a security in the hope of future growth is risky because if growth fails to live up to expectations, the price of the stock may plummet. On the other hand, growth investors argue that extraordinary returns are made by investing in the extraordinary companies of the future and these can only be identified by searching for companies with a track record of delivering growth.

During the 90’s, growth investing became an extremely popular approach but following the collapse of the dotcom bubble, “growth at any price” has fallen from favour. The primary aim of growth investors now is to identify those stocks with significant earnings growth and a reasonable price tag which demonstrates the common ground between the two approaches.

Companies which sell staple goods like food generally have low Betas while luxury goods companies typcially have high Betas. Negative Betas are rare but can be found in some gold, mining and oil companies. In a bull market high Beta stocks typically outperform the market and in a bear market low Beta stock lose value less quickly than the market while negative Beta stocks generate a positive return.

During a rising trend bulls dominate the market and during a downward trend the bears dominate. In a reversal period, where the trend is changing from an upward one to a downward one (or vice versa), there is a temporary balance between the two groups. These transitional periods are often characterized by price patterns which can be used to identify when a prevailing trend is reversing. 

The rectangle 

The rectangle represents a sustained period of balance between buyers and sellers where the price is range bound between two horizontal lines. The rectangle can form either a reversal pattern or a continuation pattern, meaning that when the pattern breaks the trend continues in the same direction. As a rule you should always assume a continuation pattern until the price breaks below the support level or unless a reversal is confirmed by some other indicator. It is also prudent to wait for a 3-4% breach of either the price support or price resistance lines before concluding that the pattern has broken.

Typically the closer the support and resistance lines, and the longer they remain in tact, the stronger the break-out of the pattern is likely to be. Volume should also be watched closely and you typically see volumes decline as the pattern becomes stable and increase at the point of breakout. Volume can therefore be used as a signal that a genuine break-out of the pattern has occurred.

The Head & Shoulders pattern

The Head & Shoulders pattern is one of the most reliable indicators of a reversal and can come at either the top of an uptrend or the bottom of a downtrend. The Head & Shoulders distributive pattern is characterised by three rallies, the second being greater than the first, but the third being a similar size to the first (smaller than the second). The line which joins the two troughs either side of the head is called the neckline.

Volume is a key indicator of a Head & Shoulders pattern with an expansion of volume at the peak of the first rally and then a smaller expansion on the peak of the head; indicating the uptrend is running out of steam. The third rally (shoulder 2) is then characterised by low volume.

The reversal is confirmed only after a significant price break below the neckline with the strength of the breakout often determined by the distance between the peak of the head and the neckline; the larger the distance the more dramatic the breakout. If the price fails to break the neckline or temporarily breaks it and then rises back above it, the Head & Shoulders pattern is said to have failed and a dramatic rally often follows.

The accumulative Head & Shoulders pattern (at the bottom of a downtrend) looks the same but flipped upside down with the head and shoulders being three troughs (second one lowest) and the neckline being the line which joins the peaks either side of the largest trough (the head).

Double top and double bottoms

Double top and double bottoms are similar to Head & Shoulders Patterns. The distributive double top pattern is characterised by two peaks separated by a trough, the key identification method is that the second high is achieved with significantly lower volume.

The distance between the top of the two peaks and the trough in between (like the neckline) gives an indication of how far the price is likely to fall before finding a new resistance level, the higher the peaks the greater the drop.

The double bottoms pattern, which signals the reversal of a downward trend is characterised by two equal troughs, separated by a peak.

Triangles

Triangle patterns are characterised by converging peaks and troughs showing the trading range narrowing and the lines of support and resistance converge. Triangle patterns come in many different forms and can be difficult to interpret. The most clear cut triangle pattern is the right angle formation where either the support or resistance line is parallel to the horizontal axis. Right angle triangles are typically signals of a reversal whereas other triangle formations are often be continuation patterns. The common right angle distributive pattern, signalling the reversal of an uptrend is shown below.

In fact however apprehensive domestic sentiment may be, the rest of world seems to be waking up to a new reality; most of the world’s large economies are in recession and the vast majority of short-term economic growth will be generated in India and China. This means that no matter how tough 2009 will be compared to 2007 and no matter how much the international investor has reduced their appetite for risk, foreign funds will inevitably flow back; there’s simply nowhere else to invest.

I would even argue that the dramatic outflows witnessed in 2008 were not caused by any fundamental loss of confidence in India but were due to an extraordinary liquidity squeeze in the global markets forcing the hands of major institutions. As this pressure works its way through the system, and hopefully resolves itself without further dramatic collapses, those with funds left to invest will once again begin sending their money East in search of the investor’s holy grail; economic growth.

Pick Details

This stock pick was made by the MoneyVidya.com member Karan almost 15 days ago, when the closing price for the pick was Rs. 21.80. The current price is 25.60 - indicating a Rs. 3.6 or almost 17% return. He has indicated that after buying this stock should be sold in 1 year. The pick has officially ‘closed’ - that is since 14 days have past, the reccomendation is quite old, therefore given market changes, it may not be advisable to follow this pick. He has also suggested a stop loss of Rs. 10. 

Pick Analysis (Unedited, word for word):

I believe that NIIT Ltd would be a great company to own in one’s portfolio, both from a short as well as long term perspective. NIIT, as you all are aware, is a leading IT education and training institute. Many of us may have personally utilized the services (while my C++ skills are quite questionable, I know that it was my laziness and not the NIIT course, which is to blame), which is an important fact when you consider the age old Warrent Buffet dictum of “Only buy businesses that you understand”. In fact, the company has been showing very impressive (triple digit) growth in profits, both in recent quarters, as well as over the long term. The following are some salient statistics, related to the company:

Growth at a reasonable price (GARP)

Earnings Growth (average of last 4 quarters): 145%
Sales Growth: 22%
CFO growth: 195%
P/E: 7.9x
P/B: 0.9x
P/Sales: 0.6x

Going forward, I think NIIT offers promise of continued growth. In an economic downturn, people often turn to education as a means of supplementing their CVs, and adding to their skills. That apart, the training industry in India, I believe will continue to expand, taking into account the enormous skills shortage and political initiative towards education, especially if Congress returns to power in 2009. NIIT continues to launch innovative software solutions and courses, both in India and abroad, suggesting that it would remain at the forefront, ahead of main competitor - Aptech.

As on September 30, NIIT’s order book stood at almost Rs. 500 crores, 65% of which is executable over the next one year, thus offering decent visibility to earnings (last years sales were Rs. 467 crores). The company offers safety as well, with very little debt on its balance sheet and solid growth in Cash Flow from Operations (the ultimate test of earnings manipulation). Considering that its price and market cap have reached close to 2004 levels, the promoters of the company have been accumulating stock through the downturn, which is again a confidence inspiring fact.

I believe that stock exhibits a favourable reward-to-risk ratio at current levels. On the downside, it could trade around Rs. 17-20, with short term resistance around Rs. 35 (60% upside) and Rs. 100+ in the long-term. I recommend accumulating the company’s stock on declines.

Efficient-market theory (or Efficient Market Hypothesis EMH) argues that in the long run it is impossible to “beat the market” because the current price of a stock always factors in all available information.

According to the theory, stocks always trade at fair value and it is impossible to buy undervalued stocks or sell stocks for inflated prices. Therefore it is impossible to outperform the market by stock picking or market timing; the only way to earn higher returns is to buy riskier investments. The theory gained prominence in the mid-1960s and in 1970 Eugene Fama refined it into three distinct forms: weak, semi-strong and strong.

Weak form

All past prices are reflected in today’s stock price. Share prices so not follow pre-defined patterns and future price movements are determined entirely by the appearance of new information. They are therefore essentially random. As a result, technical analysis cannot be used to predict and beat a market. Weak form efficiency argues that only fundamental analysis can be used to identify stocks that are undervalued or overvalued.

Semi-strong form

Share prices adjust to publically available information rapidly and efficiently so that all public information is reflected in a stock’s current price. Therefore no abnormal returns can be earned by analysing publically available information and neither fundamental nor technical analysis can be used to beat the market. Only information that is not publicly available (insider information) can be used to earn abnormal returns.

Strong form

All information, whether public or private, is reflected in a stock’s current price. Technical analysis, fundamental analysis and insider information cannot be used to beat the market and over a prolonged period of time abnormal returns cannot be made, regardless of the amount of research or information investors have access to

Review of the theory

Supporters of the theory argue that most managed funds actually fail to outperform the market, implying that that if markets are inefficient, the costs of exploiting them outweigh the advantages. They believe an index tracker with low management fees delivers the best return an investor can hope for.

However, supporters of Behavioral Finance Theory, Technical, and Fundamental Analysis argue that market outcomes do not imply fully efficient markets. They believe that all markets contain inefficiencies caused by the slow spread of information, the large influence of a few players and the emotional biases of market participants. They point to investors like Warren Buffet who consistently outperform the market by identifying situations where market price fails to reflect all available information.

Another criticism of the theory is that it fails to explain extreme market volatility and the different stock valuations compared to fundamentals which are typical in bull and bear markets.

Although the theory fails to fully explain market outcomes, it remains a central part of modern finance theory and many academics argue that large liquid markets are semi-strong form efficient the majority of the time. Although opportunities to profit form situations where the theory breaks down are few and far between, they do exist and can be extremely profitable.

Well done Arunthestocksguru.

Here is a summary of his performance:

1) BUY BAG Films and sell it in 2 years up - 1.87%

2) BUY KLG Systel and sell it in 2 years up - 9.48%

3) BUY Nitin Fire Protection Industries and sell it in 1 year up - 11.42%

4) BUY Adhunik Metaliks and sell it in 1 year up - 6.93%

5) BUY Core Projects and Technologies and sell it in 1 year - up 4.09%

6) BUY Crew BOS Products and sell it in 1 year - up 1.07%

7) BUY IndiaBulls Real Estate Services and sell it in 2 years - up 10.49%

To see the rest of his picks… register your interest in MoneyVidya.com and we’ll send you an invite!

Pick Details:

Since MoneyVidya.com user Rads made the pick, it has gained 4.6%. She has made the pick for 2 years, but suggests buying the stock at a price not above Rs. 400. She has set a stop loss of Rs. 300 and a target price of Rs. 525.

Analysis (Verbatim):

I think that Apollo is a good long term buy for the next 2 years because:

1) Management expects strong growth for FY09

According to this mint article the management is confident that it will see a 20-25% revenue growth for FY09. 

2) Recession Proof Defensive Stock

The hospital business is not really cyclical. People get sick all the time – no matter if the economy is booming or is at a bust. In fact I would think that in a recessionary economy, stress related illnesses would have increased (it sounds funny, but is probably true!). 

3) Economies of Scale increases profit margins

Apollo has huge scale. It not only is the largest owner / manager of hospital beds in India, but is also the 3rd largest globally. This would make the hospital chain far more efficient – as the administrative overhead per bed would be much lower.

4) Strong Dollar will drive medical tourism

I expect that the strong dollar in the December quarter, and possible also for the March quarter means that medical tourism would see a boost in this period. 

5) Recessionary global economy will drive medical tourism

As more people get laid off, and therefore find it increasingly difficult to afford healthcare, I see a solid increase in medical tourism, which will drive revenues for all Indian hospital / healthcare providers.

6) Falling real estate prices to help drive profit margins and expansion

Because of the fact that real estate prices are falling – this reduce the cost of renting and acquiring more property – and I imagine this constitutes a significant component of the hospital chain’s costs.On the downside, the stock is a little expensive at a trailing PE of nearly 23.

The mistake often made by retail investors of trading too often so that transaction costs erode the gains they make in the market. Brokers who are paid on a transactional basis are often accused of churning client accounts in order to drive up commission payments at the expense of the client

Pick Details:

Note that this pick has ‘closed’ - that is, it is not reccomended that you follow it because quite some time has passed since it was made. 

MoneyVidya.com member ‘RubberDucky’ made a pair trade, which is a bet on relative performance of two stocks over a period of time. The pair trade was a BUY on Pantaloons Retail and a SELL on Shoppers Stop for a 8 month time horizon. This means that RubberDucky believes that Pantaloons retail will outperform Shoppers Stop in the specified period. He has not defined any stop losses or target prices. Currently RubberDucky is up 2.55% on Pantaloons Retail and up 0.93% on Shoppers Stop.

Analysis (Verbatim):

Do not follow this in isolation. It is part of a pair trade - I am only forecasting relative performance (read below)!

This ‘sell’ pick on Shoppers is part of a pair trade with (a ‘buy’ for) Pantaloons, for a time frame of 8 months.

A pair trade is a bet on the relative performance of two stocks. Buy making a buy pick on one stock and a sell pick on another for the same value (as far as i understand this site tracks percentage changes so technically we can think of two picks as ‘the same value’) for the same time frame you are essentially betting that as long as the stock that you put a ‘buy’ on does better than the stock that you put a ‘sell’ on you will make money from this trade. 

I believe that Pantaloons, because of Big Bazaar will do better than Shoppers Stop in the next two quarters. We haven’t seen a massive cut in consumer spending yet – with wider consumer sentiment still reasonably intact. I do believe however, that with poor results in the next couple of quarters expected from corporate India, the hiring freezes will be converted to job cuts. With job cuts, falling real estate prices and falling equity prices, there will not only be a real negative income effect on consumers but also a major wealth effect – that is that because the value of consumers’ assets (financial and real estate) has fallen – they will feel poorer and therefore spend less. The first thing that they’ll cut down on are going to be luxury purchases – branded clothing, footwear, home and beauty products. These, unfortunately are the domain of Shoppers Stop and Home Stop.

These are also the domain of Pantaloons luxury retail store ‘Pantaloons’ but the downside is mitigated significantly by the fact that Pantaloons retail has Big Bazaar – the discount retail chain – in its portfolio. Traditionally, discount retailers to well in recessionary / bear markets. This is because while consumers can cut down on luxury or branded goods, they cannot cut down on food and other basic necessities. Therefore while the flagship Pantaloons departmental store might suffer from poor demand, my expectation is that Big Bazaar will actually benefit from the slowdown.

In fact in a Business Standard recently reported that (www.business-standard.com/india/storypage.php?autono=339678) Big Bazaar and Food Bazaar’s turnover for October had shot up by 87% compared to the same month last year – registering the highest month on month growth in 3 years. On the same store level (not accounting for growth from new stores) the value formats have seen nearly a 50% increase. Expectedly, the lifestyle format stores saw a low 66% total growth and 33% same store growth. 

Currently Shoppers Stop is trading at a ridiculous 93 and Pantaloons is trading at quite a high but far more reasonable 30. Both stocks have halved in price over the last 6 months, in percentage terms, Shoppers has had less of a fall. I think that the market has judged these two wrongly when compared relatively. Shoppers Stop should have suffered much more badly than Pantaloons given their relative performance.

For Shoppers Stop, while Gross Sales were up 6% for the year ending June 2008, on the year ending March 2008, Adjusted Profit after Tax (APAT) was down a whopping 263%. EPS growth for the same period was -43%. In comparison, Pantaloons did much better. Its Gross Sales for the same period were up 8%. Its APAT was up 26%, and its EPS growth was 10%.

For the year ended September 2008 compared to June 2008, Shoppers Stop’s Gross Sales growth was 5%, and its EPS growth was -10%. For Pantaloons, the Gross Sales growth was 8% and EPS growth was a small, but still positive 3%.

Such poor results for Shoppers Stop is not surprising given the fact that its interest payments have been increasing quite sharply for the last three quarters. Interest for the year ended March 2008 increased by 124% compared to the year ended December 2007. For y/e June 2008 vs. y/e March 2008, it increased by 64%, and for y/e September 2008 vs. y/e June 2008, it increased by 48%. Pantaloons, however, saw much smaller increases of 15%, 21% and 18% respectively. Surprisingly, Shoppers stop has a much lower debt to equity ratio of 48% compared to Pantaloon’s worryingly high 112% for the year ended March 2008.

I think, in fact, that results next quarter may be flat for Pantaloons, but negative for Shoppers Stop. I think that thereafter, because Kishore Biyani, the promoter of Big Bazaar is taking full advantage of the economic condition – results will be positive for Pantaloons in the March quarter, but still poor for Shoppers, because it doesn’t have any real ‘discount retail’ presence. 

According to the BS article, in order to ‘beat the economic slump’ he is focusing on low cost models such as Big Bazaar and ‘KB’s Fair Price Stores’. He has also diversified into small convenience store formats called Big Bazaar Best Deals. On September 30, the retail chain opened 3 new Big Bazaars and plans to open a further 6 by year end – just in time for the slowdown.

The (MACD) Indicator is a technical analysis method first developed in the 1960s by Gerald Appel, a prominent author in investment and trading strategy. MACD stands for Moving Average Convergence-Divergence and is based on the comparison of fast and slow exponential moving average  prices. Proponents of MACD Indicator methodology argue it can be used to identify trend changes in stocks and indices.

However, recent research has suggested that trading solely on the back of these signals has a tendency to result in loss making strategies and the methodologies described below are most commonly used as part of a more complex strategy or as a monitoring tool rather than a primary trading strategy. 

How it works

The first step in deriving MACD Indicators is to plot a slow and a fast exponential moving average (EMA) of closing prices. The standard method is to use 12 and 26 day periods. The shorter 12 day EMA gives more weight to recent prices than the longer 26 day measure.

The next step is to calculate and plot the difference between the two exponential moving averages; MACD = EMA(12) – EMA(26)

A subsequent smoothing is applied by calculating and plotting a Signal line. This is done by taking a further exponential moving average of the MACD line. The standard is to use a 9 period EMA. Therefore; Signal line = EMA(9) of MACD.

The final step is to calculate the difference between the MACD line and the Signal Line. The standard representation is to plot the MACD and signal lines on top of a histogram which represents the difference between the two. In the example chart below the top section shows the actual prices with the 12 and 26 period EMA lines superimposed. The lower portion shows the MACD line (red), Signal Line (blue) and the difference between them (histogram)

Basic signals - MACD line crossing zero 

Because the MACD line is created from the 12-period and 26-period EMA lines, when the MACD line crosses zero from below, the shorter-term 12-period EMA simultaneously crosses the 26-period EMA from below. As the shorter 12-period EMA gives more weight to recent prices, when it crosses the 26 period EMA from below it indicates recent prices have trended higher than less recent ones, this is seen as a bullish signal.

When the 12 period EMA crosses the 26 period EMA from above, the MACD line will cross zero from above. This indicates that recent prices have trended downwards and is seen as a bearish signal. If we apply these signals to the 6 month Nifty chart below we see the following;

It could be argued that the trading signal identified a bullish trend starting in the 2^nd half of March and a bearish one starting in the 2^nd half of May. However it is clear that the trends were identified long after they had begun. In this example the MACD line cross-over trading signal resulted in a small loss because the trader would have got into the bull and out of the bear too late.