A long-term investor can buy when the Nifty falls below 5177 and goes over 6000
Every long-term market trend incorporates corrections; periods when prices move in the opposite direction. In a bull market, profit booking leads to price falls. In a bear market, short-covering triggers price rises. This interplay of impulse and correction occurs across all timeframes.
One problem with a major trend reversal is a tendency to misread the first move as a correction in the previous trend. This is why most people avoid buying stocks at bear market bottoms and don’t sell near the bull market peak.
There is no reliable method of identifying major trend reversals, without a big time lag. Technical analysts use trend-following indicators like breakouts above / below 200-day moving averages (DMA). This signal incorporates 10 months worth of trading history, so it is usually reliable confirmation. By the time a 200-DMA signal triggers, the prevailing major trend has often been in force for several months.
Another method of judging major trend reversals is the Dow theory of measuring successive peaks and troughs. A pattern of rising peaks and troughs is a bull market, while a pattern of falling peaks and troughs is a bear market. This is also a lagged indicator since at least three peaks and troughs must form before trend confirmation is available.
A major trend reversal usually starts with a big impulse wave that could last months. That impulse is followed by a correction. Then there’s a second impulse wave, another correction, and so on. By the second impulse wave, confirmatory signals should kick in.
We seem to be currently in the second impulse of a bear market. The Nifty peaked in November 2010 at 6338. It dropped to a low of 5177 – 20 per cent correction- by February 2011. The first impulse wave lasted four months.
Along the way, the Nifty broke well below the 200- DMA and gave sell signals – a confirmation of a new major bear market. Between February and April 2011, there was an uptrend that topped out between 5900-6000. That correction confirmed bearishness via registering lower peaks and troughs.
In the last week, there was a second downside break, below the 200-DMA again. This seems to be second impulse wave of the bear market. If it runs true, prices will drop below 5177 as a pattern of lower lows is reinforced. If there is a major trend reversal toward getting bullish again, it will be signalled by the Nifty rising above 6000 to create a new pattern of rising peaks.
This above analysis offers little timeframe analysis and it doesn’t try to guess maximum downside targets. But it does give investors and traders some targets to plan their strategy around. The long-only investor should preserve ammunition for one of two scenarios.
The first scenario: Buy heavily as and when the market drops below 5177. Second scenario: He should also buy, if the market rises above 6000. In the former case, he has the cushion of lower valuations for safety. In the latter case, there is momentum in his favour. In-between 5177-6000, the investor should minimise fresh exposures.
A trader should aggressively seek profits from the downtrend. The best way to do this is by using index derivatives. Given deep pockets, one method is to sell long-term Nifty calls at higher strikes and use that cash to take long puts in short-term contracts. For example, a July 6000c can be sold at a premium of 48 at the time of writing (May 6), with the Nifty at 5520. The premium can fuel long positions in near-term, near-strike May puts. This strategy requires keeping lots of margin in reserve. There could be big (theoretically unlimited) losses if the 6000c is struck.
A safer way to play this game is create a reversed bearspread by selling the July 6000c and buying the July 6200c (21). That offers 27 as initial premium and limits maximum loss to 173. Again, the adverse risk:reward ratio should deter anybody without deep pockets.
A trader with less resources could buy long puts around the July 4900, 5000, 5100 strikes. The July 4900p costs 46, the 5000p costs 63 and the July 5100p costs 78. Bearspreads taken with say, a long 5100p and short 5000p would cost about 15 and leave a position with a potential maximum gain of 85. This is a good risk;reward ratio.
All these strategies, including the long-only investment perspective, carry risk. However, they are proactive ways to exploit likely situations. If the bearish view makes sense in fundamental terms and it does, for many reasons, one of these or something similar is worth trying.
