Fooled by Nifty

There's one observation that always beats me: Indian market participants are low on the money management quotient. The only management they seem to know is the prototypical 'stop loss'.

It either whips the trader by reversing the trend after getting triggered or it doesn't get triggered at all in volatile times.

There are no quantitative, objective training programmes to educate players and there aren't any brokerage houses which come up with some money management rules for existing portfolios.

The only report that we see in this regard are the long 'support - resistance' grids - S1 and S2, and R1 and R2. Highly qualitative reports talking about unpalatable target prices look good only on PDF documents.

To muddle issues further, we have the range-bound markets like the one we are witnessing currently since January 2004. There is a clear range of 100-200 points on the Nifty.

An inability to see the trading zone can cause further damage to the Nifty portfolio. In brief, we not only have a business opportunity here to save those traders from going bust, but have an opportunity to avoid getting fooled by Nifty.

Nifty, as we know is moving in a trading zone - a 1,700-1,900 range from January-May 2004 and the current trading zone from 1,500-1,600 range since then.

Till the time Nifty breaks out decisively from this zone the price range will prevail and getting 'bullish' or 'bearish' just looking at a 2 per cent Nifty rise or fall respectively is an exercise in vain. What one can do is looking at indications from volumes and open interest (OI) and other F&O sentiment indicators.

Volume indicator (VI), as illustrated below, highlights a high resistance and a clear range-bound behaviour. Trading volumes since January 2004 have registered on average higher levels in a downtrend than in an up-trend.

For example the budget day in July registered the highest volumes on F&O at 0.5 million contracts. Though the volume bias continues to be negative in Nifty, a positive close this week - a test of sub 1,600 levels (high of the trading channel) - cannot be ruled out since the five-day moving average indicator is still above the 20-day moving average value.

On the OI front, the month-over-month trend is still down. This indicates a lack of confidence of the index outstanding above the 1,600 mark. At 54,000 contracts OI in Nifty futures have declined by 30 per cent since May 2004.

Overall, price, volume and OI on an aggregate basis make a case above 1,600 levels doubtful at this stage. And above all this we have the put-call ratios which remain bearish and suggest that all upsides will be short lived.

Let's come back to the money management aspect of the Nifty. Acquiring a trader's mindset takes time and experience and an event generally occurs when it's least expected. There is a list of traits one should develop to avoid being 'fooled'.

While trading, one should have the ability to focus on the present reality and not how one would expect the reality to be and a disregard irrespective of which way the market breaks or moves. One should always look to improve skills with an open mind, keeping opinions to the minimum and shouldn't try to control or conquer the market.

Above all, one can adopt the 2 per cent per trade risk rule - i.e. the total risk taken on a certain transaction should not exceed more than 2 per cent of the account size. This means that for a trade of Rs 300,000 one should not look at a maximum trade risk of more Rs 6,000.

This rule will keep one out of trouble, provided the trading system can produce a win-to-loss ratio of at least 55 per cent.

Assuming this ratio, one can proceed to calculate risk. The 2 per cent per trade risk rule is calculated by taking the difference between your trade entry price and initial stop-loss exit price and multiplying it with your trade size (shares or contracts). This rule can be adopted with a trailing stop loss.

These techniques can make a big difference to the trader's bottomline and the concept can be extended to sector specific portfolios. For example one should not trade more than 2 per cent risk in any given sector and not exceed an overall 6 per cent risk at any given time.

Some finer aspects can be like not to trade on borrowed money, scaling out of positions to boost trading gain percentage and above all not have a trading account size greater than 10 per cent of one's total net worth. The rules look simple. But then everything that looks simple has a risk and reward angle to it - higher the risk higher the return.

In conclusion, whether market breaks out decisively above the 1,600 mark this week or not, I am not going to punt overzealously on the direction. I am going to keep the level of risk at a 2 per cent of my account size, as I have no intention of being 'fooled by the Nifty'.

(The author is derivatives strategist with HDFC Securities. The views expressed here are his personal views and not those of HDFC Securities. He can be contacted at: mukulpal@yahoo.com.)