Which way is the market headed

Last Updated: Thu, Nov 22, 2012 05:53 hrs

There are times when prices develop trends and other times when they swing between levels of support and resistance. Different trading methods work better during different phases. If it's a trending pattern, trend-following indicators like moving averages will work. If it's a range-trading period, oversold-overbought oscillators such as the Relative Strength Index or Williams%R will work.

If a trending pattern is correctly identified, the trader will go long or short until it's exhausted. If it's a range-trading pattern, the trader will buy at support and sell at resistance. Range-trading is more predictable and range-trading patterns tend to be more common. But the potential gains from trending periods are much larger, whereas range-trading gains are limited.

Some traders use only trend-following methods. Others use only range-trading oscillators. This is a question of personal comfort. Some traders enter both range-trading and trending situations, changing indicators as required and hoping that they have made the right diagnosis.

Since there are transitions from range-trading to trending and vice-versa, the trader must switch methods, or exit, when the pattern changes. A breakout or breakdown from range-trading often means a switch to a trending pattern. Vice-versa, when trends end, they can reverse or range-trading patterns develop. The transition points are crucial. That is when the most money is made or lost. If you identify a pattern early, you make more profits. But you also accept the risk of larger losses.

The current situation illustrates the difficulty of identifying transitions. The Nifty was range-trading for weeks, between 5,625 and 5,815. Last week, it dropped below 5,600 and it has stayed below 5,600 for three sessions. If this is a genuine breakdown, going short will be profitable. If it's a false breakdown, the Nifty will climb back above say, 5,650 level, and it may start range-trading again.

Waiting for confirmation carries an opportunity cost. If the market is trending, it will drop some more and there will be less in the way of potential profits. Indicators typically are giving conflicting signals as they do at transition points.

Short-term moving averages suggest a continued downtrend. Oscillators indicate an oversold market and predict a bounce. If it's a trending market, the oscillators may wrongly signal oversold as the index runs South. If it's a false breakdown, the moving average signals will be wrong.

I would back the breakdown hypothesis and short with an initial stop loss at say, 5,675. This would limit losses if the breakdown is false. The potential returns could be higher than the potential losses if it turns into a full-fledged downtrend rather than a small correction.

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