Strategy during Falls in the Market

One Strategy you should seriously consider adopting in falling markets is to buy into defensive stocks - FMCG (Fast Moving Consumer Goods) and Pharmaceuticals. They usually tend to move up and worst case, outperform the Index significantly.

Traditionally, FMCG and Pharma provide a buffer to the markets in falls. In any case, FMCG should form a part of your portfolio, but a bit more in falls. If you notice, even Warren Buffet has good holdings in this sector.

Never Question why the Market Moves in a Certain Way

It is never wise to speculate too much on the market movement and why it will move in a certain direction violently or otherwise. On the contrary, listen to the market and do what it is saying. If you catch a good wave, just concentrate on riding it with risk and money management.

In the short term, markets move under the influences of demand and supply. You do not need to be an expert of Fed Rate cuts, Dollar Movement or any other external factors. I have observed that novices spend endless amounts of time trying to dissect economic, technical, and many other sources of information. What is baffling to them is that they still get in at the wrong time leading to losses.

Relentless Slide

Why does the market relentlessly slide sometimes? What to do if you are caught on the wrong side in one such slide?

The market moves in one direction, is hammered (in a fall) constantly, and keeps making new lows. This is typical in what is called a 3rd wave fall. In Elliot wave theory, the 3rd wave is the most persistent and longest lasting among the 5 waves in the major direction. You do not have to be an expert to escape or catch a 3rd wave, but you can definitely avoid wrong moves or make use of such opportunities.



As you probably experienced by now, averaging down (for a buy side strategy) is not such a good idea. Most buy side funds get caught in the 3rd wave down after buying into the 2nd wave thinking that a new high will be made. The simplest clue that the market gives before a 3rd wave fall is a lower top or a double top. This is usually a hint at an impending fall. Look for this. If the fall is of the a-b-c type, the lower top will never be close to the absolute recent top. This means that the "a" wave is sharply down and the "b" (upward wave) is nowhere close to the top. Look for this formation to avoid getting caught in a 3rd wave fall or to make use of a 3rd wave up to invest.

Trading in tough times

Let's pause for a while and think about the events happening right now. The only words you hear these days are bankruptcy, take over, rescue package, jobless claims, and so on. Lehman goes bust, Washington Mutual taken over by J P Morgan, AIG almost going bust if not rescued, Merril Lynch gone, Investment Bankers become house cats.

What can a trader do at such times? Well, the answer is definitely not in black or white. Never keep an open position without a stop loss. Do not expose yourself to a huge loss. At the same time, volatile times are best for making profits once you set a good stop loss order. Make money but at the same time, play safe. It is definitely possible.

Stochastics

The Stochastic oscillator compares where a security’s price has closed relative to its price range over a specifically identified period of time. This is a predictive indicator in that it gives advance signals for buying and selling.

The indicator has been developed from the basic observation that prices tend to close near their high in an upward trending market and near their lows in a downward trending market. Further, as an upward trend matures, price tends to close further away from its high; and as a downward trend matures, price tends to close away from its low.

How is Stochastics Used ?

This indicator is often used to predict trend reversal. The indicator tries to determine when prices start to cluster around their low of the day for an up trending market, and when they tend to cluster around their high in a down trending market. Lane's theory is these are the conditions, which indicate a trend reversal is beginning to occur.

The stochastic indicator is plotted as two lines. They are the %D line and the %K line. The %D line is more important than the %K line.

Ranges

The stochastic is plotted on a chart with values ranging from 0 to 100. The value can never fall below 0 or above 100. Readings above 80 are strong and indicate that price is closing near its high. Readings below 20 are strong and indicate that price is closing near its low.

A very powerful move is underway when the indicator reaches its extremes around 0 and 100. Following a pullback in price, if the indicator retests these extremes, a good entry point is indicated.

Reversal

Ordinarily, the %K line will change direction before the %D line. However, when the %D line changes direction prior to the %K line, a slow and steady reversal is usually indicated.

When both %K and %D lines change direction, and the faster %K line subsequently changes direction to retest a crossing of the %D line, but doesn't cross it, this is a good confirmation of the stability of the prior reversal.

Many times, when the %K or %D lines begin to flatten out, this is an indication that the trend will reverse during the next trading range.
These are just some of the important and popular oscillators and indicators. There are many more. You need to study and pick the one that best suits your personality, apply the indicator and specialize to maximize profits.

Relative Strength Index (RSI)

RSI, unlike what the name may suggest, is an indicator of a security’s strength to itself. It does not compare a security with an Index or a security with another security. The formula for RSI is:

here, U - Average of upward price change
D - Average of downward price change

How is Relative Strength Index Used ?

RSI is an indicator that follows price and ranges between 0 and 100.
The most popularly used Relative Strength Index is the 14-day RSI. Other regularly used ones are 9-day and 25-day RSIs. The lower the number of days used for calculation, the shorter the time frame it can be used for. It also tends to be more volatile. The practical application of RSI needs some experience as it cannot be applied directly.

Trading Range

The RSI usually ranges between 30 and 70 in an ideal market. The tops and bottoms are usually formed before the underlying price. In a bull market, this range may be 40 to 80. Similarly, in a bear market, it may range from 20-60.

Chart-type Patterns

RSI very often displays chart-like pattern such as double top, inverted head and shoulders and so on even though they may not show on the actual price charts. One can identify such patterns to trade successfully.

Failure Swings

This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough).

Support and Resistance

Supports and Resistances are sometimes more clearly on the RSI chart than on the price charts.

Divergences

When the price makes a new high but the RSI does not do so, it is called a divergence on the RSI chart. Eventually, prices correct and move in the direction of the RSI. Thus, divergences are indications of impending reversal. When the RSI turns and falls below its most recent trough, a confirmation of the reversal is obtained and a “failure swing” is said to have occurred.

Bollinger Bands

First proposed by John Bollinger, Bollinger Bands are one of the most popular overlays. This indicator gives you an idea of how the volatility for a security is related to the price levels over a specific period of time. An integral part of the Bollinger Bands is Standard Deviation. Standard deviation ensures that volatility is immediately factored in. The bands can expand or contract based on the volatility.

Bollinger Bands are actually made up of 3 distinct bands. The attempt is to capture a majority of a security's price movement within the bands. A simple moving is at the core of the band and is at the middle. The upper one is the SMA + 2 standard deviations and the lower one is the SMA -2 standard deviations. An example is 20 SMA with 20 SMA + 2 standard deviations and SMA – 2 standard deviations.
The SMA and the number of deviations can be adjusted to suit the personality of the security that is being analyzed.

Parabolic SAR

The Parabolic SAR indicator was proposed and developed by W. Wilder, who also discovered the more famous RSI and DMI indicators. Parabolic SAR displays the suggested trailing stop losses in visual terms. I'm leaving out information on the formula because its very complex and may distract the user. We'll focus more on the behavior of the indicator and how to make the best use of it.

The indicator also helps you in taking a position by displaying the indicator and the price on the same chart. The buy and sell signals are generated when the upper or lower SAR cross the price line.

The main variables that make up the Parabolic SAR are Step and Maxmum Step. Wilder suggests keeping the values at 0.02 and 0.20. Parabolic SAR performs best in trending markets

The higher the value of the step, higher is the sensitivity of the indicator with respect to price change, but that does not mean that a very high step is desirable. When it is too high, the indicator is too volatile and this limits its usefulness. The Maximum Step is used for adjusting the SAR as price moves. The lower the Maximum Step, the higher the distance to the trailing stop from the price.

Technical Analysis Indicators and Overlays

Indicators and Overlays

Indicators are the lines formed out of calculations based on the price, volume, time, or another related parameter.
Indicators that are derived and plotted over the price chart use the same scale as the price and are known as Overlays.
Some of the popular Indicators are the following:

• Moving Average Convergence Divergence (MACD)
• Relative Strength Index (RSI)
• Stochastics
• Williams %R

Some popular Overlays are the following:

• Moving Averages
• Moving Average Envelopes
• Parabolic SAR
• Bollinger Bands

Advanced Technical Analysis - A Series

In this series, I'll cover advanced Technical Analysis topics. It is assumed that you know the basics of Technical Analysis and have some experience actually trading real money. If you do not have experience, you can easily find study material by googling around. As for trading experience, start a paper trading account if you do not have a trading account already. Do not experiment with real money if you haven't done that already.
It is well known that Technical Analysis is useless without the proper combination of Risk and Management. I'll add Mind Management to this list.
My personal choice of indicators are the following:

• MACD
• Stochastics
• RSI
• Williams% R

In this series, we'll focus more on the behavior and the use of indicators, understanding what they are trying to say and not restrict our focus to the math angle.

The most important element also is the study of waves. Study need not be to the depth of an Elliot or O'Nealy, but enough to give practical chances in the market. The aim is always to ride a good position as far as possible and to cut out a bad one early.