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Monday, August 31, 2009

How retail investors lose money


The reason is simple - a retail investor is driven by greed or fear. Never logic.
  • Retail investors are always the last to enter a bull run
  • "Smart money" enters markets long time back when markets are at its bottoms, there is frustration all around and no one wants to discuss markets
  • When markets start booming and indices make new peaks, the retail investor "wakes" up. At this stage, he is still not sure and is a fence sitter.
  • Lastly, there is optimism all around. Every one is bullish and talking markets. Stocks which were never traded in a year, suddenly start moving and start reaching "new highs"
  • At this time, the retail investor starts buying as he does not want to miss out the "action"
  • The retail investor will display a marked preference for "low priced" stocks because these are "cheap". He will stay clear of index stocks as these are "expensive"
  • This is also the time when "smart money" starts moving out
  • When a correction happens, it is usually quite severe
  • The retail investor does one of two things. He either decides to wait (the optimism is still there) or he starts "averaging" his costs. Averaging is nothing but trying to "catch a falling knife"
  • At some time or the other, panic sets in. The retail investor will then sell off all holdings as a distress sale.
  • Sometimes the retail investor will do nothing but wait for the markets to rise
  • When the markets do rise, he will sell off all his holdings at the first available opportunity and thus miss out on the new bull run

Other facts

  • In a bull run, the retail investor is usually the first to sell off his holding. This investor seldom waits for the bull run to continue
  • Those who have never participated when the rally started will invariably jump in towards the end of the bull run
  • Retail investors rarely follow stoplosses. Circumstances eventually force them to take a bigger loss
  • Lastly, retail investors spend an insignificant amount of time researching an investment as compared to buying a mobile or fridge.

Using trendlines


Trendlines offer a great way to draw lines of support or resistance.

The red (falling) trendline shows resistance and a break out of this is a good reason to buy.
Similarly, the blue (rising) trendline offers support and a break of this is an indication to book some profits.
Incidentally, some stocks tend to have very clear trendlines while some, either because of volatility (or poor liquidity) have extreme spikes which complicates task of drawing trendlines.

Support and Resistance


What is support

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.
Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.

What is resistance

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.
Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.



Support becomes resistance (and vice versa)

Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.
The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.



Conclusion

Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it is sometimes difficult to establish exact support and resistance levels, being aware of their existence and location can greatly enhance analysis and forecasting abilities. If a security is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security is approaching a resistance level, it can act as an alert to look for signs of increased selling pressure and potential reversal. If a support or resistance level is broken, it signals that the relationship between supply and demand has changed. A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.

The Elliot Wave theory


Elliot discovered that the ever-changing path of stock market prices reveals a structural design that in turn reflects a basic harmony found in nature. From this discovery, he developed a rational system of market analysis.
Under the Wave Principle, every market decision is both produced by meaningful information and produces meaningful information. Each transaction, while at once an effect, enters the fabric of the market and, by communicating transactional data to investors, joins the chain of causes of others’ behavior. This feedback loop is governed by man’s social nature, and since he has such a nature, the process generates forms. As the forms are repetitive, they have predictive value.

Wave Patterns

In markets, progress ultimately takes the form of five waves of a specific structure. Three of these waves, which are labeled 1, 3 and 5, actually effect the directional movement. They are separated by two countertrend interruptions, which are labeled 2 and 4. The two interruptions are apparently a requisite for overall directional movement to occur.
At any time, the market may be identified as being somewhere in the basic five wave pattern at the largest degree of trend. Because the five wave pattern is the overriding form of market progress, all other patterns are subsumed by it.
The 5 wave pattern is often followed by 3 corrective waves labelled as A-B-C.


Wave Mode

There are two modes of wave development: impulsive and corrective. Impulsive waves have a five wave structure, while corrective waves have a three wave structure or a variation thereof. Impulsive mode is employed by both the five wave pattern and its same-directional components, i.e., waves 1, 3 and 5. Their structures are called “impulsive” because they powerfully impel the market. Corrective mode is employed by all countertrend interruptions, which include waves 2 and 4. Their structures are called “corrective” because they can accomplish only a partial retracement, or “correction,” of the progress achieved by any preceding impulsive wave. Thus, the two modes are fundamentally different, both in their roles and in their construction, as will be detailed in an upcoming section.

Wave subdivision

Waves can be repeatedly subdivided into lower degrees as follows:


Some observations

  • Wave 4 never overlaps or enters the area of wave 1. An overlap means one shd consider the possibility of A-B-C corrective
  • An exception to the above is a 5th wave ending diagonal
  • Wave 3 is never the shortest.
  • Wave 3 & 5 are related to wave 1 by a Fibonacci ratio (equality or 1.618 or 2.618)
  • In any corrective, wave C is related to wave A by a Fibonacci ratio (equality or 1.618 or 2.618)
  • In any corrective, wave B is related to wave A by a Fibonacci ratio (0.618 or equality)
  • Compared to impulses, correctives are difficult to trade. There are more than 23 types of patterns. Sometimes the best thing to do is let the market make up its mind and then decide what to do.
  • In an impulse, it is common for a wave 3 or wave 5 to extend.
  • Any correction following a 5th wave extension will typically end at wave 2 of the extension
  • Alternation: if wave 2 is a sideways correction, wave 4 will be fast/ straight/ swift (and vice versa).
  • Waves are fractal and principles apply across all time frames. A 1-2-3-4-5 impulse could be a part of larger A which in turn can be a part of a larger 1

Trading tips

Follow the trend for profitable investing
  • The trend is your friend. Always trade in the direction of the trend
  • Add more positions only if current position is profitable
  • Never buy or sell just because the price is low or high
  • Never average a loss or hedge a losing position
  • Always use stop loss orders. Never cancel a stop loss after you have placed it
  • When in doubt, get out, and don't get in when in doubt
  • Be willing to make money from both sides of the market
  • Never change your position without a good reason
  • Avoid trading after long periods of success or failure
  • Don't try to guess OR time the tops or bottoms. It never works!
When you lose, don't blame your luck!

Why trade the nifty

If you really want to earn money in the stock market, then don't deal in stocks - trade the nifty.
For all the technical analysis I do, I rarely trade in stocks...I trade the nifty.
Years of trading experience has taught me one simple thing...it is far easier to take a directional call on the broader market than individual stocks. If the economy is doing well, the market (nifty) will anyway do well (and vice versa).
Stock movements tend to cyclical, news driven or rangebound for considerable periods of time. Not only do you have to identify the sector correctly, you should also be able to pick the right stock. And then there is this possibility - everything else rallies except what you have bought.
From a fundamental perspective, this means you don't have to worry about crude oil, interest rates, FII inflows (or outflows), quarterly results, sectors, analysts talk and whatever you can think of.
Some advantages of trading the nifty:
  • Index is the barometer of the stock market. If the market does well, Nifty will anyway rise (and vice versa)
  • All FIIs and Mutual funds have an exposure on index and index stocks
  • All good and bad news is reflected in index (nifty)
  • You can play both sides of the market and profit from rallies as well as corrections
  • You can daytrade in nifty (not recommended) or carry forward positions till expiry
  • Low brokerage / nil demat costs
  • Excellent liquidity: The daily turnover of nifty futures and options is 2-3 times that of ALL stocks traded on BSE.
  • Low volatility: no wild swings. Because the nifty index is made of 50 stocks, it is always less volatile than the individual stocks. Check latest volatility statistics.
  • Low investment: as nifty is least volatile, NSE margins are lowest. This reduces investment amount substantially.

Trading strategies

Trend
Action
Inv. Amt
Profits
Bullish
Buy futures
Rs.35000/-
Profits increase as index rises (and vice versa)

Buy call options
Rs.10000/-
Substantial profits if index rises (loss limited to inv. amt.)

Write put options
Rs.35000/-
Profits limited to premium (risk of substantial losses)
Bearish
Sell futures
Rs.35000/-
Profits increase as index falls (and vice versa)

Buy put options
Rs.10000/-
Substantial profits if index falls (loss limited to inv. amt.)

Write call options
Rs.35000/-
Profits limited to premium (risk of substantial losses)

Time decay in options: If index remains unchanged, the option premium will decrease and become nil on expiry. Here, the option buyer has lost his money and the option writer has profited.

Is there any catch?

Nifty futures and options being derivatives, have an expiry period (the last Thursday of every month). You cannot take "delivery" and hold positions indefinitely the way one can do with stocks.
You can however exit a position any time you feel like...same day, same week, etc. So you can daytrade or carry forward positions till expiry date.
With stocks, you can take delivery and hold positions indefinitely. Very often, this is how traders become investors and short term investors become long term investors!
Futures trading is a leveraged transaction. In case of Nifty, every 1% change leads to 8% change in your profit (or loss). So while you can earn fantastic profits, you can also lose money.
Options trading is tricky. For buyers, investment is less and profits unlimited. But the real profit depends on the option bought, days left to expiry, implied volatility and how fast the underlying moves. The time decay can knock off your entire investment. But if you follow the trend and always buy in-the-money options, then you need not worry. Most retail investors lose money because (a) they trade against the trend and (b) they have absolutely no idea about option pricing.
One can earn 100% or sometimes even 200% return in a month (buying option). On the other hand, a wrong trade can reduce capital.
Transaction costs (brokerage) is not an issue as we are not looking at intraday trades. Since positions are carried forward for many days, this really does not matter.
Rangebound markets are a problem as technically there is no way to predetermine this situation. Unfortunately there is no solution here and one has to live with this. Fortunately nifty seldom trades in a range.
Summary: Irrespective of what you trade in - stocks, futures or options, you will earn money only if you follow the trend. If you trade against the trend, you are almost sure to lose money. So the problem is not with the instrument but with the trading style.