Follow the trend while setting stop-losses to get out
Technical analysis involves a concept of “traps”. A bull-trap is an upmove that sucks in optimists. Then the trend suddenly collapses. Similarly a bear-trap is a downmove that gets shorters into action, just as the trend turns sharply North.
This has relevance right now. The market has risen almost 10 per cent, from a low of 5348 on March 21, to a high of 5872 on March 31. It’s a strong rally accompanied by high volumes and net institutional buying. Key trend-following indicators, such as the 200 Day Moving Averages (DMA) — have given buy signals.
Balanced against this 10 day phase, there’s been five months of bearishness. The Nifty hit a two-year high of 6338 on November 5, 2010. It dropped to a low of 5177 on Feb 11 — a retraction of over 18 per cent. It also decisively breached the 200 DMAs on the downside. (Given different ways to calculate Daily Moving Averages, 200 DMA values are between 5575-5700 now).
Is this a bull-trap, or a sustainable upmove? An optimist would hope that the correction between November 2010- Feb 2011 was sufficient and now expect a rally to new highs. A pessimist would see it as a bull trap. If the overall long-term trend remains bearish, the low of 5177 will be broken on the next downmove.
Confirmation either way means waiting. If the market lifts above 6338, that confirms bullishness. However, a bull who waits for that leaves 450 points on the table. On the downside, a bear must wait for drops below 5550, south of the 200 DMAs. That’s a 300-point move.
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A time theorist or Fibonacci follower would be bearishly inclined. The last bull market ran from March 2009-
November 2010, or from October 2008 - November 2010, depending on interpretation. The absolute bottom of 2252 was in October 2008 but the market moved sideways till March 2009.
Given a bull run of 20 months, or 26 months, and an upmove of roughly 4100 points, the following bear market would be expected to last at least 6-9 months. The correction should be at least 37 per cent, implying a valid bottom at around 4800, or even lower.
A fundamental analyst may also see some cause to be unhappy. Inflation isn't easing off quickly. Reforms are too slow. Global GDP projections have pared down since the Arab revolts and the Japan tsunami. Equity valuations are high.
But it’s possible that all this negative information is discounted by price-volume action, since it's known. Indian equity may also have been a beneficiary of worsening global projections. In comparative terms, Indian GDP and corporate earnings will grow quicker than the rest of the world and that might attract inflows.
While those opposed arguments are both logical, there’s no way to tell which has greater weight. The most practical approach is to go with the trend while setting stop-losses to get out, if this is a bull-trap.
Using a common trend following system like a 20DMA crossover signals versus a 55DMA, there,s been a buy signal only in the last three sessions. Again, using various stop loss methods based on volatility, we get possible stop loss ranges between 5600-5750. The trader's personal view on pain versus gain (risk:reward) influences the exact setting of a stop loss.
The simplest stop loss system of a new 20-Day low in this case, means an exit if the market drops below 5348. That may be unacceptable since it means being prepared for 450-point adverse moves.
A standard trading strategy would be the following. A long Nifty futures, acts upon the buy signal. A stop loss that exits the long Nifty position is set at say, 5700. To cater for a deeper downmove, add something like a long April Nifty put with a strike at around 5500p (current premium 27 with the market trading at 5825).
If 5500 is hit, the put premium will jump to around 90. If the market falls to 5600, the 5500p will still rise to around 60. The combined position has a breakeven at 27 points above the futures value (27 is the maximum loss on the put). On the downside, losses are held to the 125 points of the futures' stop loss (5825-5700), less profits from the expanding long put premium.
On the upside, potential profits are unlimited.
There’s no certainty that such a strategy will work. The chances of being correct are roughly 50:50 But this sort of hedged, two-way strategy is liable to make steady money in the long run. The point is that it yields more profits when it works, than it loses when it doesn’t.