Could the Nifty lose another 1,000 points? A market veteran explains.
Summary
- The stunning decline in equity markets last week took many retail investors and traders by surprise. Where will stocks go from here?
Last week Indian equity markets fell through support levels like a hot knife through butter. Are the markets falling to rise (‘correcting’ in market parlance) or are they falling to fall (‘making a top’)? In this article I’ll walk you through market data to help find the answers. These are techniques that real-world traders use daily.
The stunning decline in equity markets last week took many retail investors and traders by surprise as the average Joe had been anticipating ever more bullish price targets month after month. Everything seemed right. Sentiment was gung-ho and markets seemed to be brushing off news of the Gaza war. The fall, therefore, delivered a massive jolt. In my opinion, it sowed the seeds of further declines.
Cause and effect
If you have been trading over the past four months, you will recollect the sudden mini crashes on 4 June (election results), 23 July (budget announcement), 2-5 August (mini sell-off) and 3-6th September (another mini sell-off). The election-result and budget-day falls caused the biggest damage to retail traders.
Though retail traders persisted in partially holding their longs (statistical evidence follows), their confidence levels had eroded by the end of September. That was confirmed by the plunging of turnover in the spot and stock futures segments to April 2024 levels.
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When traded volumes fall, the bid/offer spreads widen. When you check the best five buyers and sellers’ limit orders on your terminal screen, the difference between the buyers’ and sellers’ limits are called “spreads". Widening spreads are the first indication that market trends are probably about to change as they show hesitation among traders. They are quoting prices which they are not sure of being transacted, so they bid very low offer prices. That’s hardly confidence-inspiring.
Hope is a four letter word
Veteran traders know very well that if they have to start hoping for a loss-making trade to turn profitable, that trade is not right for them. Hope is an emotion and emotions cannot be a viable strategy for any commercial activity. Electronic financial markets “talk" in numbers. The numbers tell us that at least a dozen stocks in the futures and options (F&O) list have fallen 20% or more in the past three months. Another 44 stocks are down more than 10% in the same period.
The Dow theory of technical analysis tells us a fall of more than 20% from the peak indicates a bear market in that scrip while a fall of more than 10% indicates a major correction. There are 179 stocks in the derivatives (F&O) list. So 6% are in a bear market and another 25% are undergoing deep corrections. If optimism still permeates traders’ sentiments, hope is a major component of it.
Beware the ‘crowded exit’
See the chart below. It plots the market wide position limits (MWPL) in the F&O stocks on the NSE. MWPL measures the percentage exposure used by traders out of the total limit set by Sebi.
The higher the element of hope and/or greed, the higher the MWPL reading. The weekly chart covers 20 weeks of data and shows routine falls post expiry, followed by a gradual peak thereafter.
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At 45%, MWPL is at its highest in several quarters. Do remember this is happening in the backdrop of falling prices. Retail traders are resorting to a popular strategy – “buy the dips".
High MWPL is a double edged sword. While it indicates buying conviction, it also opens up the possibility of a “crowded exit". Should any adverse news trigger emerge, this high level of greed will not take long to turn to fear and trigger a stampede to get out. The price action on 4 June is an example.
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Price is god
Purist traders like to keep it simple. Prices form patterns that are repetitive in nature. This repetition makes the price predictable since people tend to expect history to repeat itself. It may be a subject of debate that price patterns repeat themselves because lots of traders are trading in that direction. To that extent it may be a self-fulfilling prophecy. Be that as it may, these patterns tend to work.
Technicals
The Nifty (spot) daily chart below shows a “head and shoulder" pattern. The title is self-explanatory when you see the price moves above the blue horizontal trendline.
This pattern has a high chance (over 60%) of succeeding, according to the seminal book Encyclopaedia of Chart Patterns by Thomas N Bulkowski. It’s also known as a “measuring" pattern as it allows a trader to project the target price.
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The greatest price distance covered by the peak price above the neckline is also the equivalent of the potential price decline below the neckline. As of today, the target is 23,250 for the Nifty spot. It need not be achieved in a straight line, in one go. This pattern is known for a pullback or two to the neckline before achieving the final target. The neckline is currently at 24,750.
When will markets bottom out?
The cause and effect theory is simple. As long as the causative factor remains, the effect will continue to show up. There are a few things that are making markets nervous. Falling prices are the primary reason. If prices start rising again, everyone is happy. Who does not like a bull market? Retail hands are replaced and/or joined by stronger hands.
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Currently, foreign investment institutions are selling relentlessly. Local institutions are buying aggressively but only enough to match the sales. Net fresh buying is coming from retail traders, but they have limited firepower. They should be joined by high networth individuals who can absorb a lot more selling.
I would feel more comfortable buying if at least one recent peak in price (for example 25,250) is overcome forcefully with high volumes. Till then, technically speaking, a rally is only a corrective pullback.
Note: We have relied on data from Tradingview.com and my in-house statistical trading model throughout this article.
The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your investment advisor. This article is strictly for educational purposes only.
Vijay L Bhambwani is the author of the first official commodities trading guide in India. He designs statistical and behavioural trading models for his family owned prop trading outfit. He lives in south Mumbai and has been trading since 1986. He tweets at @vijaybhambwani and has a video blog at www.youtube.com/vijaybhambwani
Disclosure: The writer and his prop trading organisation have no exposure to Nifty derivatives contracts discussed here as per Sebi guidelines.