We are MOVING :)

Its been a nice time with WordPress though its time to move to our own domain. Please update your book marks and hope you continue to visit us as we move on to make available better research with regard to markets and more.

Our new home lies at www.portfolioyoga.com/wp/ (Link)

 

moving-office

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Investing in Markets – Ways and Means

We have hundreds if not more number of studies that has shown that over the long term, the best growth is delivered only by equities. While in India, Real Estate has also proven to be a bonafide wealth generator, I strongly believe that growth over the next decade or two will more likely come in Equity with Real Estate more or less providing sub-optimal returns.

So, how does one go about in investing into the markets. For a lay man, there lies there options of investing his savings into the markets

1. Investing via a Mutual Fund

Theoretically speaking, this is the easiest way to gain exposure to the markets. But then again, not all Mutual Funds are the same and hence some amount of research is necessary to ensure that we invest in the funds that have showcased long term growth vs chasing funds that have made a mark in the very near past.

While most mutual funds in United States haven’t been able to beat the benchmark consistently, in India, we have hordes of fund managers who have beaten the benchmark returns year after year. Whether this is due to they being Genuis or whether its because of the fact that the benchmarks are not really that good a criteria to compare against is a story for another time.

But having said that, its a fact that top funds keep changing over time. Prashant Jain is a much acclaimed fund manager, but lets face the facts – his top fund, HDFC Top 200 has generated a CAGR return of 13.36% DSP BlackRock Micro Cap Fund which over the same period has seen a CAGR return of 24.5%.

What I have done above is known as Selection bias. I have selected the DSP fund not by foresight but by using  current returns. In 2008 and 2009, the best large cap fund (5 year returns) was Reliance Growth Fund. Over the last 5 years, this fund has provided a CAGR return of 12.8%.

Over a similar period Nifty Total Return Index has shown a CAGR growth of 11.68%. While one can still argue about there being a alpha out there in funds such as HDFC Top 200 and Reliance Growth, we need to also consider the fact that they hold stocks outside of Nifty constituents and in essence, comparing the performance to Nifty is erroneous.

Personally my family is invested into multiple funds across the spectrum and overall, returns have been decent enough. As Warren Buffet once said, diversification is the only free lunch and this applies to Mutual funds as well.

A step above Mutual Funds comes a more personalized investment vehicle.

Portfolio Management Scheme (PMS for short):

Those who follow me on Twitter know that I am a very strong skeptic of PMS as a investment vehicle. My main objection comes from the fact that for most brokerage led PMS, this is not something where the objective is to generate above market returns for the client but is a nice way to churn the portfolio as much as possible in an attempt to garner as much brokerage as can be culled from the account.

In fact, it is a surprise that Assets under Management of PMS has growth substantially over the years despite most of them not even providing decent returns (let alone market beating) and worse of all, hiding the facts from the potential investors.

AUM

I do not have the break-down as which firm manages what amount, but just as a simple exercise, lets review the performances of top names in this business

Coming up first would be Sharekhan (Link)

AUM: Around 32 Crores

Sharekhan

What surprises me is not the under-performance but the fact that NSE Nifty returns are shown as having given different returns when compared with different products.

India Infoline (Link)

AUM: 4600 Crores

India Infoline runs a multitude of funds

IIFL-1

IIFL-2

Motilal Oswal (Link)

AUM: 1400 Crores

Moti

One of the few which has beaten their benchmarks. But then again, these are 1. Weighted Returns (and not everyone would get the same) and 2. Am not sure if these are after fees or before fees (Fees are substantial in nature, refer to page 14 of the document).

There are at least another 25 – 30 firms offering PMS, but I do hope you get the idea. PMS is not a ideal vehicle to ride the markets. In fact, one PMS firm actually managed to lose money when the markets were going up and lost money when the markets were coming down. The fund manager is now a star investment advisor 🙂

Last but not the least

Direct Investments into Equity:

Directly investing into equities is one of the most risky ways to put savings to work if you are neither willing to work hard nor have a clue about how markets work. Too many folks have burnt their hands in equity investing to swear off anything related to equity (Direct or not). But having said that, the only way to beat the returns generated elsewhere can be found here.

But if you are willing to put in the hours required to learn and understand the various way to analyze the markets, its a effort that can provide for worthwhile returns with total control in your hand.

But a caveat first – International evidence has shown that the average equity investor under-performs the markets very badly. In fact, many would have been better off just putting the cash under their pillow than investing into markets

InvestorReturns

While the above data comes from Mutual Fund investments and redemption by individual investors, with human psyche being the same, direct returns by investors would not be too different.

Investing (no matter how large or small your investments is) is a full time endeavor. Unless you are willing to devote a substantial amount of time, this is definitely not a area to dabble in since not only would the returns be below par, but the time spent could have been better utilized elsewhere.

To fill this gap, we have many a person offering to advise (Newsletter based generally) for a small fee. But with the vast majority of them being pure snake oil sellers, I would generally avoid all such stuff unless they have proof of their pudding (Audited returns of their own funds which in turn should be substantial portion of their net worth)

To conclude, while its true that some funds have shown ability to beat the markets, I recommend novice investors to distribute between a few select funds and a few ETF’s that track the index (Index funds). Invest regularly and you would turn out fine regardless of the gyrations we see in markets.

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Of Helmets & Stop Losses

Bangalore (like many other cities) has had a rule for compulsory wearing of helmets by those riding a two wheeler. But what I observe is that many a helmet are worn to protect not the head but the risk of getting caught by the police constable. At the first instance of a risk to the head, the helmet would be sure to bail itself out leaving the head to take care of the mess by itself. And since the wearer of the helmet in a way thinks that his head is protected, he may actually take more risks than what he would have when he was not wearing one (before it was made compulsory).

So, what is the relationship between the helmet and the stop loss you may ask. Well, there is one. A wrong stop loss like a wrong helmet may cause more grief to the user than to a trader who trades without one.

A stop loss is said to protect one from the loss while allowing the winners to remain in the system. But the thing about stops is that if not placed right, it has a ability to cause more damage than one where it was not used in the first instance.

So, what is the ideal stop you may wonder. Is placing a stop above a resistance / below a support a good idea? Or should one just stick to one’s risk profile and say that if a stock loses more than X% of my capital, I am out?

With the increase in algorithmic trading, stops below support / resistance are the easiest to take out since everyone sees more or less the same chart and comes more or less to the the same conclusions.

As to those using X% of risk per trade, the problem comes by the way of the fact that the stock may not necessarily fit that profile. Some stocks have very high volatility while some remain bland for most of the time but then spurt up in one swing what would be a multi X deviation from the mean.

So, when is that one should sell or buy (based on one’s existing long or short position). To me, the best way is the way described by Jesse Livermore (which I shall paraphrase) where he says that if a stock is good enough to sell, it should be good enough to short as well. So, if you are placing a stop at level X, not only should you be happy to sell your longs there, but also be willing to go short.

That does not mean that one has to go short every time one wants to exit a long, but its the conviction that matters.

On the other hand, if you are using a portfolio / ranking based model, the above assumption may not be required since you will be exiting one stock in favor of other which your model is showcasing as one with a better opportunity.

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How often does the Sensex double

Recently when Sensex breached (for a few moments) the 30000 mark on Sensex, Anchors on CNBC-TV18 dressed up with T-Shirts with 30000 printed in bold numbers (and in Red for added effect).

Way back in 2007, with Sensex breaching one round number after another, it was a series of parties in the studios of business channels. But I wonder if television anchors celebrated when Sensex crossed above the 25600 mark.

Whats so important you may ask about the 25.6K mark. Well, it signified the 8th instance of Sensex doubling in price. Below is the table as to when we crossed the mark and how many days it took to achieve it.

The fastest double for the Sensex came in 1990 when it doubled in just 188 days (all calculations are on calendar days and not trading days). The slowest on the other hand took all of 4656 days (translating into 12.75 years).

Average time taken by Sensex to double is around 4.5 years. 51200 is the next double number & I do wonder if we shall scale that peak by 2020

Sensex

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Comparing PE Ratio of Sensex & Nifty

For a long time, we looked at only one Index when it came to the Indian Markets and that was the Sensex. Even years after Nifty had come into the picture, Sensex reigned supreme. While Bombay Stock Exchange is the oldest exchange in Asia, when it came to the Sensex, the whole concept is fairly recent  having been first compiled in 1986, more than 110 years after it was founded.

But with derivative trading in Nifty taking precedence, Nifty is the key Index most participants look at. While we have seen Sensex too becoming available for trade, the first mover advantage has meant that Nifty has virtually steam rolled over it.

When it comes to analyzing how expensive or cheap the markets have been, I have most of the time stuck to Nifty since NSE has made the download free and easy. But today I decided to update my Sensex PE and the variation was very interesting to say the least.

First out, here is the updated Nifty Price Earnings (trailing 4 Quarters, Standalone) chart with long term average and standard deviations

Nifty

NSE provides data from 1999 and the calculation suggests that we are closing on to the peak valuation of 2010.

Theoretically speaking, the Sensex PE should show a similar number despite the fact that it has lower number of stocks compared to Nifty. But Sensex Price Earnings number seems to suggest that the market is not all that expensive. A caveat here, While I downloaded the Sensex Price Earnings number from its website, I could not gather as to whether the same is based on Consolidated numbers or Standalone and that in itself can make a difference.

Sensex

What is interesting is that sector weights aren’t too different from each other. Below is the sector weight charts for both Nifty and Sensex.

Nifty Sensex

As you can see, the difference in weights is not so much as to impact the net valuation on a big time.

To better understand the moves of Sensex PE Ratio and Nifty PE Ratio, here is the chart of them combined (Relative Comparison)

Nifty

One of the things that is straight away visible is that while they have more or less moved in sync in the past, this time around, Nifty PE Ratio has shot up more substantially than that of Sensex.

And here is a Relative Comparison chart of Nifty & Sensex

Nifyt

And finally, a ratio chart where I divide Sensex with CNX Nifty

Nifty

What the above chart shows is the points Sensex moves for every point on Nifty. Since 2001, this has been in a broad range.

Personally, I would stick with the NSE Price Earnings Ratio but it would be interesting to know why we are seeing this sudden difference in the Price Earnings of Sensex vs Nifty. The difference lies in a few company results, but it would be interesting to know which of them have actually caused this action.

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Traders biggest Worry

What is the biggest worry for a systematic trader?

If you said, Loss, you are wrong. Yes, a loss does hurt a trader, but unless he has no clue as to what he is doing, he knows that losses are inevitable, even big losses. What he worries more is the risk of his system going into a losing steak.

Lets assume your system is doing fine and you suddenly find markets moving against you and by the time your system comes with its signal, you are on a non leveraged basis looking at a loss of 8%. A loss that big hurts and for some one who is leveraged say 3 times, he would have just seen 24% of his capital vanish into thin air.

But what if the same trader sees a draw-down of say 4.75% but not in one big swoop but one that comes as a streak of 9 consecutive losses and one that lasts over 44 calendar days. Which one do you think shall be more painful?

In case of the 1 big negative trade, While the pain will be immense, it will quickly pass as the trader moves to his next trade (with a much lower position size) and hopes that he can at some point of time recover from the hole he has fallen into.

In case of the 9 small but consecutive trades, the pain is much more dragged on as the trader spends nearly 1.5 months with every trade he has taken going for a toss. Its very tough for even those with strong hearts (not to mention a nice bank balance) losing their sanity and deciding that pulling the plug from the system may be the only way out.

But losing streaks are fairly common and as I shall showcase later, something that you shall have unless your system has a win rate of 100%. When you run a back-test, most reports do provide you with the number of losses that have come in a streak.

But what if your system is more mechanical driven and hence cannot get such a number. The easy way out is to just measure the win or loss % of trades and then check the following table.

Streak

The above table lists the probability of you seeing a draw-down of X number of trades based upon your systems winning / losing percentage.

Most trend following systems have a win percentage that ranges between 35 and 45 and if you can check out the same in the above table, you can see that there is a very strong probability that your system at some point of time shall witness a streak of losses ranging from 6  – 9 and that can be said with near 100% confidence.

So, what can be done about that you may like to ask. Unfortunately, there is nothing much you can do other than to keep trading while reducing your position size at every drop of equity. This way, by the time you hit your 8th or 9th losing trade, your position size will be considerably smaller and hence the account will still be able to trade without having to witness fresh capital deployment from outside.

What is interesting though is the fact that even if you have a streak of 9 losing trades, the loss in money terms is generally lower than the biggest losing trade. For example, I was just testing the same for a simple Moving Average Cross over system (3 by 5).

The biggest loss (period being 1st June 2009 to today with trades taken on Close) was a loss of 346 points (8.07%) which took just one day (Entry on 30-07-2009 & exit on 31-07-2009). On the other hand, the streak of 9 losses (loss in point terms being – -40, -9.4, -39.95, -22.45, -44.55, -39, -65.6, -13.2, -20) stretched from 20-07-2010 to 02-09-2010).

While the system may still be positive, that 45 days of bleeding is something that will not pass off in a hurry and like a deep wound would remind the trader every time he encounters a loss.

What is also noteworthy is that a longer streak may not actually be the most painful (in terms of loss). While the 9 trades in total lost around 4.75%, the same back-test data provides evidence of smaller streaks having a bigger impact (in terms of losses).

While there is no escape from such streaks, having a good position sizing algorithm would ensure that the pain in terms of loss of capital would be lower than what it would be if a single position size was maintained throughout.

Use a position size that is neither too aggressive or one that is too meek. In case of the former, you risk blowing up your account while in terms of the later, you never can take advantage of the good runs. But whatever you do, remember that unless the system is faulty, streaks do not stretch to infinity and hence one needs to keep his cool and take all the trades as and when they are signaled.

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Getting carried away

Way back in 2007, a good friend of mine called me to ask me to check out a company by name Jindal SouthWest Holdings Ltd. He said that he had heard from some one that it had quite a nice value  and was currently trading at pretty discounted rates.

Checking on what I could, I saw that the Intrinsic value of the company (based purely on what it held) came to around 2500 – 3000 per share and the company was trading around 500 bucks (though a couple of years ago, one could have had it much cheaper). While in US, most holding companies are valued at pretty low discount rates, in India due to the fact that most of these holdings will never be sold, holding company valuations have never been aggressive to begin with.

Yet, the deep discount did entice me to invest into the same. The timing of my entry in hindsight proved to be one of great acumen as the stock straight away started to move substantially higher. At 2000, I decided to get rid of half my quantity but the stock showed no signs of weakness. At 3000, I got rid of the rest of it as well (to fund some other idea which ultimately ended up eating both my capital & profits :P).

But before I sold, I did a revaluation of the holdings and voila, instead of the 2500-3000 which was there before this rally started, the valuation had now changed to 5000-6000 🙂

This is not a story to boast my stock picking ability (which I have none anyways) but to remind one not to get carried away with the momentum. Some months back, I got into another stock – a very small quantity but one that has been moving pretty strongly on the back of a report of a small cap fund manager initiating a position in the said stock. While there has been no change in the fundamentals of the stock, the hype given the story and the person who picked it up has meant that the stock is now 300% above my purchase price.

But this cannot really last unless there is really a pot of gold at the end. I do not know when this will end, but the ending generally is not good either. A stock that moves up in Buying freeze generally comes back in selling freeze making it tough if not impossible to exit such stocks.

While not everyone can have a deep understanding of the DCF / SOTP), as a investor, its essential that you know what you are paying for. There is no point in paying 5 times the price just because of some hidden quality which may or may not materialize in the future.

Even in this bull market, there are plenty of stocks that are moving down and hence its always pays to be cautious and fearful than let the greed of easy money carry us away. I am a guy who can be called  a perma-bull, but just because the long term is good and the road ahead is a path of roses, there will always be thorns that can cause significant damage to those who are unprepared.

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Budget & its implications on Markets

Since long Budget day has been seen as one the The most important trading days in the history of the stock markets. So much so that regardless of whether its been a week day or not (Saturday as Budget day falls this year for instance), markets have remained opened during the time.

Budget day trading is a Speculator’s delight. Huge swings can be seen in stocks based on how the market perceives what the finance minister just spoke. The reactions are instantaneous when one perceives the huge benefit for the huge disadvantage that comes up due to the addition or removal of some duty.

It used to be a Carnival like atmosphere in most brokerage houses until recently  as the wild movements accompanied by ecstatic trading meant that regardless of whether you made money or lost or were just a bystander who had come to witness the event.

Before 2000, Budgets used to be presented in the evening based on the legacy we carried from the time of the British (a subsidary company cannot present its accounts before the holding company na:) ), Budgets used to be presented at 5 in the evening and while markets closed once the Budget got over, the next day was open regardless of the fact as to whether it was a Weekday or a Weekend (Sundays including).

Since Sensex data goes back only so much, I have been able to Analyze the Budget day movements from 1981 onwards. The data provides for some interesting insights.

There are basically two types of Budgets. The full budget (like this time) which is generally presented on the last day of February and has the accounts for the whole upcoming year. We also have what is known as the Interim Budget in years where there is a scheduled election. Dates of those are not the same and as can be seen in the data below, is pretty varied. While the first Interim Budget is really Interim in nature, I have treated even the full budget that follows that as Interim since it comes generally in the mid of the year and hence not exactly comparable to the full budget that is presented in Feb.

So, lets first look at the data of how markets moved in the day prior to the Budget, the day of the Budget and the days following that (click on the pic to expand)

Budget 2 Budget 1

The YoY percentage number refers to the return generated by Sensex from the date of the Budget to the next and its here that I notice something interesting. The full budgets are better off for the markets (in a positive way) compared to the Interim.

Budget 1

Of course, the whole variation maybe just because of sample size, but something for the bulls 🙂

But even more interesting is the impact of Budget day on the future.

Scenario 1 deals with Impact on markets if markets closed positive or negative on the day of the Budget.

Budget 1

If markets end the day of the Budget in positive territory, there is a very high probability that the trend shall continue to dominate for the upcoming week as well and if they end in negative, again high probability of the trend continuing. Also included in above data is how markets had behaved going into such days. Not much of a difference can be seen which leads one to believe that budget numbers were sacrosanct and markets were genuinely surprised or disappointed.

How about for the year ahead you may ask and here is the data for the same

Budget 1

As you can see, the probability of markets continuing to move in the same direction as one based on just what it did on Budget day extends to the forthcoming year as well.

As much as we would like to believe that Budget day plays a huge role based on above evidence, there is one thing we are missing and that is how the impact is based on how expensive or cheap the markets were at that point of time. Unlike Sensex data, I have data for Sensex Price Earnings going back to only 1991 and that is the time from which this analysis prepared. Additionally since Sensex Price Earnings ratio has been stopped been given free,, I have shifted to Nifty Price Earnings Ratio from December 2012.

Readers of this blog will remember that I post Nifty Price Earnings ratio with a Mean calculated from the 1st data point to the last. I also compute the standard devation of the said data to provide us with something to compare and constrast current data with. In this case, for the early years, the average is not exactly something that is sacrosanct since it uses very little data but as the years go by, the average really starts to become closer to what we see in recent years. So, without further ado, here is the data split into two pics – one for those years where markets went up and one where the markets went down post budget till the next budget.

Budget 2 Budget 1

The Ends column refers to whether Price Earnings was below the Average on the day of the Budget or above it. In 11 out of the 18 instances that markets had a positive return, PE was below the average. In case of years where markets went down, only in 4 out of the 11 instances were PE below the average.

Currently Nifty Price Earnings Ratio is well above the 1st Standard Deviation on the positive side and that is not a good sign for the forthcoming year  if history is any guide.

The first full budget presented by the last NDA government had the markets all happy as Sensex zoomed up 5.13%. Will this budget create a similar euporia?

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The Wake up Call for Technical Analysis

Technical Analysis has never been seen as a viable tool for generating income / wealth from the markets and the number of jokes surrounding that are legion to say the least. The Oracle of Omaha once said and I quote ”

“I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.”

While I have no clue as to what chart he saw before making such a comment, I am very sure that if he saw any trending  chart, there has to be a different answer if you were to invert the chart.

Today, Technical Analysis made its mark in Dilbert and once again seemed to suggest that technical analysis is no more than Sorcery mixed with Astrology. Before I continue on my tirade, here is the cartoon strip that will remain famous for years to come

Dil

One may recall that when Gold saw a steep fall, some one created a chart and aptly named it “Vomiting Camel” pattern. While no technical analysis books carry any details of any such pattern, with one hearing about all kinds of animal patterns, this was not entirely surprising to say the least.

While every strategy, be it quantitative or value investing has its faults, when it comes to technical analysis, one feels that maybe we are beyond reproach. Most doctors consider Homeopathy to be equal to quack medicine though I can line up persons who have been treated successfully, critics are happy to point out that its nothing more than sugar pills that are seemingly disguised as medicine. The act of curing is purely based on our mental strength and this serves only as a Placebo and in a way acts as a catalyst to cure the problem being faced.

The reason Allopathic medicine is not only widespread but also widely used is due to the fact that to qualify as medicine, it has to go through several tests (including blind tests) which try to ensure that the medicine is really effective without the healing happening due to other factors. How many of our Ayurvedic / Homeopathic / Unani based medicine can claim to have such strong test requirements?

Just today, I read that the Government of Telangana Chief Minister saying that it will construct a new secretariat building in Hyderabad since the existing one suffers from Vastu defect. Before you laugh at the ridiculousness of the thought process, do give a thought to the many who claim to have seen changes in their life owning to they shifting the door / window / bathroom / pooja room. You name it and you can find plenty of people whose lives have changed. So, should we start teaching Vastu along with Architecture?

On Google, a search for Technical Analysis is provides one with the following options

TA

Think about it for a second. A way of investing / trading is seen more as something that does not work than something which is a way to investing. Even the second option has reared its head only recently.

I am a strong believer that technical analysis works. Even though Quantitative Analysts would want you to believe that the difference between Quantitative Analysis and Technical Analysis is similar to the difference between Astronomy and Astrology, I strongly differ for the simple reason that not only are a lot of concepts have its foundation in mathematics, a lot can actually be proved much to the dismay of its opponents. Its only recently that researchers have agreed that Momentum in markets are sustainable and can be used to generate returns above what Beta says they would.

While Fundamental Analysts strongly believe in valuing the business, we Technical Analysts strongly believe that human psychology has not changed and hence patterns keep repeating the way it has done for hundreds of years now. We believe that finally, Price is King since there is no point in disagreeing with a price that the market believes to be the true value of a stock / index.

That said, the bane of technical analysis lies in patterns / strategies that seemingly cannot be expressed in mathematical terms and hard coded so as to be able to apply it without the need for a chart.

If you look at the sky, its easy to see patterns in clouds though they are nothing more than random elements coming together to play a trick on our minds. Why is it so difficult to accept then that many a pattern that appears on charts are no more than the coming together of random elements.

A lot of patterns can be hard coded and tested for efficiency and these to me are worth pursuing (if the results when tested blindly on multiple markets yield similar kind of results). In fact, a lot of hedge funds are rumored to use pattern search algorithms in order to squeeze out gains from seemingly random movements in markets.

But not all patterns / strategies are the same and if you believe that the strategy you pursue can never be coded & automated fully, you are failing to distinguish between the real and dream.

The Church for a long time held steadfast to its belief that the Earth was the center of the Universe before finally acknowledging the universally known and acknowledged truth. Similarly, Technical Analysis if it wants recognition and respect needs to accept that there are strategies that can be tested and proven as viable and there are those that are good for selling newsletters and does not actually fulfill the promises it makes about its ability to predict into the future.

Technical Analysis is to me is more than just a way to get probabilities better than what can be achieved using a simple coin toss. We may never get a Technical Analyst  with the stature of Warren Buffett but we do have folks like Dunn Capital who have shown strong performance for a very long period of time. I strongly believe it makes sense to learn what CTA’s use for developing their trading models since many of them have shown handsome market beating returns without having to buy stocks / companies.

I strongly believe that long term wealth can be generated using strategies based on the concept of technical analysis. But always have a skeptical mind since its better to be seen as stupid for asking a question than seen as a stupid for having lost money using a strategy that can hold no water.

Let me end here by quoting David Hume from his book, An Enquiry Concerning Human Understanding

“In our reasonings concerning matter of fact, there are all imaginable degrees of assurance, from the highest certainty to the lowest species of moral evidence. A wise man, therefore, proportions his belief to the evidence.”

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Support, Resistances and Trend Following

Support and Resistances are the key tools of technical analysts who rely on the chart for making their assumptions. The key concept here is that of human psychology. A support is a place where the markets have made a bullish reversal earlier and one where one can expect fresh buying to come in and a resistance is a point where the price had taken a bearish reversal and hence when the markets came back to the same point next time around, you should see some amount of selling.

Rather than re-write what has been written in multiple books, I shall instead reproduce here what Jeremy Du Plessis writes in his authoratitive book on Point and Figure.

<Book Quote starts here>

RS

The price is in a downtrend. It pauses, reacts back up to point A, and then falls to point B.Technical Analysts do not reason why it did this; it is simply understood that supply and demand caused the price to move in this way. At point A, buyers were not prepared to pay any more and so the price declined to B, where the buyers were prepared to start buying again.

You have to remember that the market is made up of lots of participants with differing views and obj ectives. Buyers who bought at point B may take profits at point C. However, there is another group who bought at point A, are pleased that the price has risen back to the same level at point C, and are pleased to get out of their position. This collective view causes a resistance level at point C and causes the price to move down from point C.

Remember, buyers at point B made a good gain when they sold at point C, and so when itgets down to point D they start buying again. This creates a support level, where buyers are prepared to take an interest again. This demand pushes the price back up again. Once again, at point E, they start selling, reinforcing the resistance level at that level. This causes the priceto decline again until it reaches support at point F, where the same short-term traders, who have bought at B and D before, start buying again.

Point G is as far as the price gets again because the short-term traders have become confident that it will not go higher, and so the resistance at that level gets stronger. It declines again to point H and, once again, the buyers come back again, creating support for the price. The price bounces to point I and then falls back to point J. The same buyers who bought at point H are pleased that they now have a second chance to buy at the same price at point J, but this time, the sellers are in charge and force the price below point J. It is important to consider how the participants feel about this. Buyers had become confident buying at the same level and
making a profit, so much so, that they probably were buying increasingly more each time.

For the first time, they are in a losing position. Some will sell their positions immediately, creating a selling frenzy that pushes the price down. Others will, however, hope and pray that the price will rise back to the price they paid. Point K is the point where the price has become oversold. That is, it has fallen too far too quickly, and short-term traders looking for a quick profit start buying. This forces the price back up to point L briefly, where the new buyers take a quick profit and some of the B, D, F,H and J buyers sell to break even. The move to point L is short-lived as so many sellers appear. So, the level at point L, which was a support level, now becomes a resistance level.The price falls to point M.

There is no reason why the price stops at point M. It could be at any level. It is simply a point where demand exceeds supply and the price is driven back up again. It is important to pause and consider the psychological make-up of the participants. There will be a large group who bought at the B, D, F, H and J levels and are still holding their positions. What is going through their minds is ‘if only the price can reach the price I paid, I will sell out and never buy another thing again’ ! This creates even more resistance at the L level, which is the same level as the previous support. So, when the price does eventually rise back to that level, those who have been praying start selling at point N, reinforcing the resistance level and forcing the price down again to point or lower. The level at points L and N will remain a strong resistance until there are no sellers left at that level.

The important point about this scenario is to understand that levels of support and resistance do occur on charts and that they occur for psychological, not fundamental reasons. When support is broken, it is important to recognise and understand that support becomes resistance to any up movement and that this is also caused by psychological reasons. Although not shown in the diagram, resistance, once broken becomes support to any down movement. So support and resistance alternate.

<End of Book Quote>

Trend following on the other hand does not concern with Supports and Resistances as those defined in the chart above. What Trend following looks for is a reversal of the current trend. So, at none of the points mentioned does a trend follower get a signal to reverse his existing position.

Trend following is always a late comer since it first waits for evidence of the fact that the trend has really turned around to Bullish / Bearish. Only once the confirmation (based on whatever approach you have), does one get a signal to reverse the signals and bet on markets moving the other way.

When you assume markets to reverse from a support or resistance point, you are in affect claiming the power of prediction where none exists. At any resistance / support level, what is the probability of a reversal happening? I would say its 50-50. It may happen, It may not. But if the whole probability is just 50%, why are Support / Resistance lines looked upon with such flavor?

The reason in my view is that this happens due to the fact that we see what we want to see. Lets use a real example, the Daily chart of Nifty.

Nifty

I have marked all previous tops as they occurred. As you can seem only once or twice was the next low in line with the previous top. Most times, it made a low where there is theoretically no supports or made a high where there was no resistance (the Dotted line for instance).

Markets being a game of probabilities, do you really want to go with nothing but a theory that is seen as good just because we can find evidences of it working (Selection Bias anyone?).

Nowadays everyone calls himself a trend follower as trend following has become the faith to be seen in (just like all folks on the fundamental investing side want to be seen as Value Investing, even when they are investing in stocks like Bosch 😉 ), but true trend followers never trade based on rules that cannot be tested historically using a automated program.

After all, its well known that the mind has the ability to see patterns where none exist and similarly, we are adept at seeing support and resistances where they worked while if you were to codify it, you shall see that its a strategy that does not have a Edge.

Nowadays I am starting to agree with the philosophy of “Whatever Works”. If it works for you great, but do remember not to confuse strategies just because some one says they are one and the same.

The reason Asrtrology / Vastu and even Homeopathy is looked down upon is not because it has not been proven to be right ever. Search enough and you shall spot enough folks who shall swear by it. The reason why they are not accepted by the scientific community is due to the fact that they cannot pass tests designed to remove the human bias and behavior pattern for instance.

In Technical Analysis, unless you remove the bias of the self, any pattern / any strategy can be seen as one with excellent characters where none may exist. In a way, its amazing that while we understand the reason why lottery ticket buying is a waste of money given the low probabilities of it working for us, we fail to reason out similarly low probability strategies that are abound in the market.

Until you are able to sieve the wheat from the chaff, the results will always be sub-par – something that you could have got without having to go into all that trouble in the first instance. Food for though. eh? 🙂

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