Buying the Dip? A smart technique to identify dropping security before they rally!
In general, humans have a tendency to buy things that are offered at a discounted price. The heavy rush or the queue outside shops offering products on sale is an example of this!
This human trait is also visible in the stock markets, where every individual wants to buy a security at the lowest possible rate but sell at a higher rate. Remember the popular saying ‘buy low and sell higher’? While the mantra of ‘buy low and sell higher’ works well in trading or investing, many traders & investors face quite a difficult time following this strategy as they keep on averaging losers on the way down in anticipation that the stock or the security would change its course. However, to their misery, the security they had bought on the way down continues to plunge and instead of creating wealth, they begin to lose their hard-earned money.
So, is buying the dip a wrong strategy? Not at all, but this strategy needs to be followed with a slightly more targetted approach. Last Friday, we witnessed a sharp turnaround in Nifty as it jumped more than 1 per cent after registering a series of negative close. Many claimed that it was gap area support, which triggered a sharp bounce back while some said that it was due to the oversold condition of the markets. We don’t deny that these may well have been the reason for a pullback, but don’t you think markets looked oversold a day before Friday as well?! And more importantly, how many of us were able to take advantage of this stunning and surprising rally? While the answer to this question is quite difficult to know but in order to help our readers take advantage of such kinds of moves in the future, we will share a methodology, which is quite objective and can also yield a good return.
As we know that in a single trading session, there can be both, buying as well as selling pressure, in the market. During the day, both the parties i.e., buyers and sellers put in their efforts to establish their authority. However, by the end of the day, only one camp would emerge as a conqueror. Now, in this up & downswing, which we witnessed, how can one determine the amount of buying & selling that took place during the day?!
American author Larry Williams has defined a simplified process that can help us to differentiate between the buying and selling swing. He remarked, “Each day markets open for trading at a price established by an open outcry based on the buy & sell order that has been built up overnight. And once the open is established, the price moves up or goes down from the opening level”.
As step one, while the amount of price moving up from the opening price is categorised as ‘buy swing’, the downmove from the opening level is categorised as ‘sell swing’.
So, on a daily basis, we will have buy & sell swing if the price has moved above and below the opening price.
After getting the swing values, the second point to be considered for this system is to check the close of the day that will help us to determine which side has won the battle for the day. If the candle is green, it signals that it was dominated by bulls as the close is greater than open & vice versa.
Moving ahead, the third step of this system will be to consider buy swing values (the amount of price increase from the opening price) for only those days where closing was below the opening (negative candle). If we take this a little further, we can consider an average of all the buy swings over a specific period as it will give us an idea about the amount of buying pressure in the market over a considerable number of days.
And, if the price in the subsequent trading session is able to move above its open by an amount that exceeds the average of buy swings considered for X period, then it would be safe to assume that things are taking a turnaround.
The last and the most important step of this system methodology is adding a multiplier of 1.4 to the average in order to avoid noise or false move.
To demonstrate this, we would now take into consideration the example of last Friday’s move on Nifty:
1. Nifty had formed multiple red candles from March 10 onwards. So, whenever, there is a formation of four or more red candles, we will calculate the buy swing average.
2. How to calculate buy swing? Difference between open and high:
March 10: Open=15202.15 High=15218.45. Buy Swing: O-H: 15218.45-15202.15: 16.3
March 12: Buy swing: 15.15
March 15: Buy swing: 0 (because open & high were equal)
March 16: Buy swing: 55.5
March 17: Buy swing was 10
March 18: Buy swing was 19.7
If you notice, we have considered buy swings of down close (red candle). We will add all the buy swings 16.3+15.15+0+55.5+10+19.7= 116.65. Now, if we divide 116.65 by 6, we will get a value of 19.44. If this is multiplied by 1.4 (multiplier factor), we will get a value of 27.21, a value rounded to 27. Let’s call it turning swing value.
3. On the seventh day i.e., March 19, Nifty opened at 14471.15. Now, we will add 27 points into this and whenever the price moves above 14498.15, that’s our Entry Price our buy would be triggered as per the system. Things are about to turn around as we have exceeded the average buy swings of the last six days. (Option buyers can also benefit from this as usually if the buy is triggered, then there is a high probability that a strong move is likely to come).
4. However, one needs to consider trades only in the direction of the primary trend. Like in Nifty, the primary trend is in an uptrend and is interrupted by several counter-cyclical trends. During these counter-cyclical trends, if we get more than four red days or down close, we can apply this system for long trades and vice-versa for short trades.
Note: This system is originally designed by Larry Williams.