The 200-day moving average is the last defence for the bulls. Once prices close below the 200-day EMA, it triggers institutional selling and establishes a bearish bias in the markets. From the recent top to the most recent bottom, the Sensex has shed 2,300 points, a loss of more than 10 per cent. Officially, the markets are declared bearish only after they have lost 20 per cent.
We had written on November 8 ( http://www.smartinvestor.in/market/technicals-48112-technicalsdet-Markets_at_final_frontier_of_resistance.htm) that it was time for aggressive traders to go short and recommended against going long. That observation proved prescient as the markets have corrected substantially. We think the Sensex can go down to 18,000, if the 200-day EMA is broken. We are focusing on the Sensex, but the Nifty, too, has similar price action.
There are two reasons for the current bounce. One is obvious to most traders, it’s the fact that the Sensex touched its 200-day EMA. There is another reason. Look at the horizontal lines on the chart from where the Sensex bounced. Now, look to the left from where the lines originate and notice the gap.
On September 13, the demand for stocks far exceeded the supply and prices gapped up and continued their rally. The index was also breaking out of a previous high, which resulted in a lot of break-out traders going long. When prices came back to the level where demand exceeded supply, the markets caught another bounce. So, the bulls had a confluence of two factors, the 200-day EMA and the gap in their favour, which resulted in a bounce.
It remains to be seen if the bounce is sustainable. For one, the market made its third lower low last week and a lower high on January 3, the most recent high before the sell-off. A market beginning to make lower lows and lower highs is the early sign of an emerging bear. Unless the markets close above the January 3 high, we would stay on the bearish side.
However, now is not the time to short the markets as they have sold off substantially. The areas to take short position will be at the 19,550 level with a stop above 19,650, and at the 20,650 level with stops above 20,750. Remember to take your stops to avoid huge losses. Also, note that markets often bounce strongly from their 200-day EMAs.
The author is based in Chicago and is the editor of www.capturetrends.com