The Flat Earth

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In 2008, when Indian stock markets wilted under the pressure of global financial turmoil, the fall in Nifty wiped off the gains that had been built over the previous 26 months. And all it took was just 9 months, about one third the time required to build those gains. Interestingly, market re built again, and recouped all of the lost amount, at least in index terms, in another 25 months, which was almost the same time it took to build, prior to the 2008 crash. Why would it take more time to rise than fall? Posed from an investor perspective, why would the prices fall faster than their rise? The answer to this question lies in understanding how we respond to fear and greed.

You may have noticed that the pain that you feel on losing something is more than the happiness that you experience on gaining the same. One possible explanation is that the part of the brain responsible for pain could be much more evolved through the generations of human evolution, which had gone through excruciating phases of resources’ deprivation, which would have meant that our brains were wired in such a manner to ensure preservation of such resources. And hence the higher impact that you “feel” on losing. And when it comes to communication, we tend to pass on negative news faster than positive ones, which we try and savour more. And this is how stock market signals gets passed around too. When there are signs that a downtrend is in motion, the fear of losing prompts A swift exits, in an effort to cut further losses. More investors duly follow the same path, to reduce further pain and such selling pressure en mass creates a cascading effect accelerating the pace of the falls. In stark contrast, an uptrend is usually a hope filled move; hope of more, with no immediate threats on you. Hence there is no urgency, and word gets passed around at its own pace. And, the sense of hope varies vastly from person to person. All of this ensures that the consequent action on the markets is a long drawn one and not sudden. Investors who understands this, do not burden themselves with the urge to rationalize every sizeable move with news. Since it is in the human nature to swing between despair and hope, prices too follow the same, bringing in a certain element of predictability. This is why analysts have constructed numerous indicators to pick profitable price moves. Let us look at one such indicator.

The spherical earth idea is the truth, but the flat earth idea is more real to most of us, and hence can’t be much farther from truth. For 99 percent of the time, we do not require to be burdened by such ideas, as our size in proportion to that of earth is too small to make it a point of consequence for every day decisions, unlike gravity, which we have to deal with in every wake of our life.

Similarly, the idea of a stock or index being in uptrend or downtrend, may not be as significant as it is made out to be. This is because, price moves from one point to another is not in straight lines, because there is always tussle between views, allowing prices to push higher, pull back, move forward again, and so on. These swings or oscillations can be considered to be occurring in a horizontal plane, while the directional move can be considered to be proceeding along the vertical plane. If one can pick a few of such moves that generates reasonable returns, should he be worried about which plane it is moving, or whether the stock is directional or moving in ranges?

Let us take the example of oscillators, as they are called in technical analysis, to understand this. Relative Strength Index (RSI), Williams % R, Rate-of-Change (ROC), Stochastics, Average Directional Movement Index (ADX ) are all common oscillators, but we will look at Moving Average Convergence Divergence (MACD), because it has an edge over them. Let us first look at how MACD is constructed. MACD is the acronym for Moving Average Convergence Divergence. The whole idea of MACD lies in its name itself; two lines are constructed using moving averages and their crossovers, convergences or divergences are used to signal price moves. The first line is the MACD line which is constructed by subtracting the 26 day exponential moving average of the stock price from the 12 day exponential moving average. The other line is called signal line, which is the 9 day exponential moving average of the MACD line. The edge that we spoke about earlier is that, with the use of a longer and short moving averages, the MACD technical indicator is both a trend follower as well as a momentum oscillator. Traders use the cross overs between signal line and MACD or divergences between price and MACD to obtain buy/sell ideas. And of course several other interpretations.

Price is the most visible indicator to your fortunes but more often than not, it triggers your despair/hope button interfering with your decision making process and thereby lowering your chances of profit. The role of a proxy, hence, is to keep your involvement with price at an optimal level. Not so much that it interferes with your emotions, but just as much that will strengthen the signals obtained from the proxy, like a technical indicator.

 

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Chief Market Strategist, Geojit Anand James extensive expertise in financial markets including equities, derivatives and commodities. A Certified Financial Technician (CFTe), Anand James holds an MBA as well as B.Tech degrees. Anand James heads a research team that provides Investment/Trading advice in Equities, Equity derivatives, Index Futures & Options and Currency Derivatives to clients, applying advanced technical and derivative analysis.He provides Technical outlook of Nifty-Sensex Outlook and writes on equity markets in India and market outlook.

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