Range-trading causes both technical and psychological problems. It is very difficult psychologically to sit and wait out range-trading, even when that is the most sensible plan. Unfortunately it is also very difficult technically to judge the direction and timing of a possible breakout.
A valid breakout will always be accompanied by strong volume action and breadth in the direction of the breakout. An upside breakout will have positive Advance-Decline (A-D) ratios while a downside breakout will have negative A-D ratios.
Once a valid breakout occurs, making target projections is possible. The minimum movement is likely to be around the width of the previous trading range. It may be more if the breakout is “in phase”. That is, a breakout in the direction of the long-term trend is liable to be stronger.
The current situation pretty much meets all criteria. We’ve seen a breakout from a range-trading pattern between Nifty 5,700 and 5,950. The breakout has been accompanied by volume expansion and negative A-D ratios (in the direction of the breakout). It is in phase – the long-term trend is bearish and the breakout is downwards.
The minimum target in the circumstances should be the width of the previous trading range. This is roughly 250 points – that is a fall till 5,450 levels. This was fulfiled on Thursday before we saw a short-covering rally.
Reviewing the situation, we now have a bearish short-term trend, a bearish intermediate trend and a bearish long-term trend. Since the action is in phase, it is quite possible that the breakout will push the index even lower.
The long-term bearishness is confirmed and reinforced by this breakout. The Nifty has established a pattern of falling tops and it also dropped below the 200 Day Moving average. This implies that the market will hit new lows over the next several months. The 52-week low is currently at 5,177.
That 5,177 level is likely to be broken with new lows. It may happen in this movement. It may happen in the next intermediate downtrend. So we can’t really predict timing. An alternative estimation using Fibonacci retracements also suggests a fall till 4,900 levels is quite likely. Investors need to bear this gloomy projection in mind. They’ll have to stagger commitments and average down if it happens. Traders could find a way to exploit such a deep drop via long puts in distant timeframes. For example, the June 2011 5,000p is available at a premium of 29, and the June 5,300p premium is 75. There’s plenty of open interest in both contracts. If the market slides further South, being long in either or a bearspread of long 5,300p and short 5,000p may be a good trade.
The author is a technical and equity analyst
