Last Time This Happened, Nifty Dropped 24% in 21 Days - Views on News from Equitymaster

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The Equitymaster Research Digest

Last Time This Happened, Nifty Dropped 24% in 21 Days
Apr 17, 2017

  • Longest winning streak in ten years
  • Managing risk in Swing Trader
  • Swing Trade in TVS Motors

The Nifty is on a winning spree since bottoming out at 7,893 in December 2016. The index is up 17.4% from the low of 7,893 to the high of 9,273.

The index has been in an uptrend for more than three months, and the best measure of it is a moving average. The index crossed above the 21 EMA (exponential moving average) on 28 December 2016. Since then, it has consistently closed above the average and is still going strong.

The index has closed above the 21 EMA for 71 consecutive trading sessions. This is Nifty's longest winning streak in ten years. You can see in the chart below that corrections have been very shallow during the last three months.

Nifty Above 21 EMA for 71 Sessions
Nifty Above 21 EMA for 71 Sessions  

The index has bounced back as soon as it was about to touch the 21 EMA. This bodes well for the bulls. It shows that they are in complete control.

But for how long? You know markets never move in one direction.

They go through intermediate corrections even in strong uptrends. And over the last three months, the index hasn't seen even one meaningful correction. This puts the Nifty in a slippery position, as sooner or later profit booking will kick in and lead to a fall.

But the question, again, is when? Let's look at another chart...

Consecutive Close above 21 EMA in Nifty
Consecutive Close above 21 EMA in Nifty 

I have plotted the daily Nifty closing price since January 2006 in blue. The red triangles at the bottom represents the number of consecutive days Nifty closed above its 21 day EMA. So, the taller the triangle the longer Nifty traded above its 21 EMA.

On the bottom-right corner you can see a tall red triangle. This triangle represents the current rally in Nifty which has closed above the 21 EMA for 71 consecutive trading sessions. This is the longest winning streak since June 2006, when the index closed above the 21 EMA for 75 consecutive trading sessions.

The only problem was, once the index closed below the 21 EMA, it lost 24% in just 21 sessions. Will history repeat itself? Frankly speaking, I don't know. But should we be prepared for a correction?

Yes. Definitely.

The Nifty has been moving higher without correction since it bottomed out in December 2016. Of the 700 most liquid stocks, only 14% (100 stocks) are trading below their 200 DMA. This is a sign of an overheated market...which means chances of further upside are limited.During last week, foreign institutional investors (FIIs) sold equities worth Rs 24.55 billion. It's their largest weekly sell figure in 2017. The momentum indicator RSI is already diverging negatively with price, which means momentum is already slowing down. I spoke about this in detail in my weekly video update for my Swing Trader members (requires subscription).

The only missing component is price action. If the Nifty closes below the 21 EMA, then price will confirm the indicators, which are already suggesting it's time for a breather.

Now, whether the index breaks its trend or continues higher is anybody's guess. But as traders, we must balance risk and reward. It's our job is to manage risk well. If we can do that, profits will follow.

Here's how we manage risk in our short-term stock recommendation service, Swing Trader...

We do it at two levels. First at the individual stock level and then at the group level.

On the individual stock level, we always recommend a trade with a stoploss. We also recommend to risk no more than 0.5% of the trading capital on one trade.

For example, say your entry price in a stock is 100 and stoploss is 95. The risk per share would be the difference between your entry price and stoploss (100-95), which is Rs 5. Now, say you've allocated Rs 3 lakh for trading. You should risk only 0.5% of 3 lakh on each trade. That means you won't lose more than Rs 1,500 (0.5% * 3,00,000) if the trade doesn't work in your favour. To contain risk, you will buy only a fixed number of shares. We will divide our absolute value at risk (Rs 1,500) with the risk per share (Rs 5). This will give us a quantity of 300 (1500/5). This means you will buy 300 shares worth Rs 100 each from a total capital of Rs 3 lakh.

Risking only a small portion of the capital ensures a single trade won't make or break your trading capital. It ensures long-term survival.

At the group level, we recommend limiting risk to the minimum and bringing it down as soon as possible. Take our recent Swing Trades for example. We have seven live trades on our list as I write. We have revised our stoplosses higher for five of them.

We have revised our stoplosses closer or above our recommended price in four stocks...and far above it in one stock. We won't lose much if the market drops below the 21 EMA and any of these seven stocks fall along with it - as we have protected ourselves by revising our stoplosses higher.

Our risk is only 1% of the capital (0.5% each in the two stocks whose stoplosses are not yet revised). Even if things went wrong, we'd lose no more than 1% of our capital. This gives great mental comfort, but it goes without saying that this will work only if you follow the stoploss and exit the trade when it is hit.

It allows you to sleep well and think clearly about markets. You can take fresh positions and even aim for bigger profits by letting the trades run if you've limited the total risk.

TVS Motors is an example where we maximised our profits with good risk management. I recommended it to my Swing Trader subscribers on 9 February 2017 at a price of 409 with a target of 12.47% and a stoploss of -5.13%. The stock went live on 13 February 2017 at 409.

Swing Trade in TVS Motors
Swing Trade in TVS Motors 

I revised our stoploss up to 410 on 23 February as the stock hit a new lifetime high of 436. The stock traded sideways for a month, but we didn't have to worry as we had revised our stoploss higher and the trend still looked positive.

On 5 April, it broke out of the sideways consolidation and I revised our stoploss up to 436 and target up to 470. We hit the revised target on 7 April and closed the trade for a profit of 14.9% in 53 days (better than our expected profit of 12.47%).

That's how managing risk with a periodical revision of stoploss helped us book a solid 14.9% profit. You can use the same technique in your own trading. Or you can simply sign up for our Swing Trader service and allow us to recommend stocks and guide you in managing risk.

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