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The concept behind trend-following trading systems is simple. If the system gives a buy signal, the trader will set a stop loss below entry price and go long. If the price does go up, the position will be held and the stop loss moved up. Inversely, if the system gives a sell signal, the trader will set a stop loss above the entry price and go short. If the price falls, the position will be held and the stop loss moves down.
This combination of a long/short position and a trailing stop loss aims to minimise leveraged losses (if a stop is hit) and maximise leveraged gains if the trend holds. It works best if the price trends steadily in one direction. The trading system must set a stop loss that won't be hit on a random fluctuation. It’s also important to find markets that trend long enough to make this worthwhile.
The entry signal could be many different things. Traders have their own preferred timeframes and different levels of holding power. The big guns can roll over positions across settlements while the day trader enters and exits every day.
Some systems use simple signals like 20-day highs or lows. Other systems use moving average breakouts - a rise above say, the 55-day moving average, could be a signal. Similarly, stops can be calculated in different ways.
The last two years have been terrific for trend-traders of the Indian stock market. The market shot up from the 2016 Budget, until the Demonetisation announcement. Then it crashed until mid-December 2016, after which it shot up again.
That’s a long signal that lasted from February 2016-mid November 2016, a sell signal that lasted about a month, and a long signal that then lasted 14 months. Each of those signals saw a big move in one direction, without much in the way of corrective moves in the opposite direction. The February 2018 has triggered a sell signal. That's less than a week old but the market has fallen over six per cent in four sessions.
Since trend-following systems are quite popular, they create clusters of entry and exit points, where volumes spike up. Different trend-following systems would have triggered a sell signal at different levels. As every sell-signal came in, there would be new volume.
The details of where stop losses are placed, is interesting for similar reasons. If there's a rebound, stops will get triggered and short-covering will close out positions. Some trend-following systems follow up stops with "double-plus" long signals, leading to buys and causing momentum in the opposite direction.
Clearly, there was both short-covering and buying after the Nifty hit 10,300 levels yesterday. It triggered an uptrend of 200 points - almost two per cent. At least part of that rebound was driven by successive stops being triggered as the Nifty started its recovery.
Stops will vary from about 60 points (roughly 0.5 per cent) for day-traders to about two per cent (200-odd points) for position-traders. That implies the Nifty could see buying accelerate between 10,550-10,700 assuming that the market does continue a recovery.
Resistance caused by new selling would also start kicking in at higher levels. Investors and traders who bought the index on the way up, would be looking to cut their losses if the index hits their entry levels again. A lot of volume came in at the 10,700-mark and above in pre-Budget trading.
My best guess based on volume analysis and popular trading systems would be that the Nifty could bounce somewhere between 10,750-10,900. That would still mean a long-term downtrend since the pattern would be a bearish set of lower peaks.