Market Tops & Glad Tidings in Cloud Cuckoo Land

There are two basic strategies to make money in the stock market — either buy at a lower price and sell at a higher price or sell at a higher price and then buy (cover) at a lower price (called short selling). Sadly, most of the retail participants in the market have been doing the opposite. In this article I would try to illustrate why over-optimism at market top on a good news could be painful.

Majority Loses – Minority wins

In the stock market, someone’s gain is someone else’s loss and vice versa. It might be an astonishing fact for some traders that stock markets have been designed so that majority of the traders lose money and a very few gain from their losses. Unfortunately, the majority here means more than 90% (retail) traders which have been losing money and their losses are making the remaining less than 10% (professionals) richer day by day. There are many reasons why 90% of people have been losing but one of the major reasons behind their losses is trading on the basis of news and follow the herd.

Herd Follows the News

News trading is one of the major mistakes that retail traders make in the stock market. They would simply read or watch the news on television to decide what they are going to trade or invest in. They ignore the fact that most of the financial news on television or the web is either paid or spread rumors. There would be very few genuine newsletters or web services but it’s difficult to find and experiment with them.

One should always keep in mind that financial news can never help you fulfill your trading/investment goals unless you use them the right way. In this article, I will try to discuss how good news about stocks mislead retail traders to buy at or near the market top.

Bitter Psychology of Tops

Believe it or not, at the market top all news will be good. Economic stories in newspapers and television would tell you that economy is recovering and growing at a faster pace. Industrial numbers would be improving. Some poor figures like high inflation would not affect the market. In all this hullaballoo, you have been observing a stock that you missed buying near its bottom. You have spared money to buy this stock at a fair price. The stock drifts to its all-time highs but you are looking for a better bargain and setup. The stock forms a breakout pattern on the charts and at the same time, good news about some big order or reward to the company is shared over the media. You have already suffered a huge loss on papers missing an opportunity at the bottom and now you don’t want to let go of this one. You are eager to grab the stock this time, even at a higher price. And why not, for you, it’s a picture-perfect trade where everything is falling in line – the setup and the good news. It’s like nature wants you to make money in this trade.

You take an off from your business or shop and drive with full excitement to the broker’s office. At the market open, the first thing you do is to buy your stock at market price. The stock moves up and you are happy. The stock has a very high volume on this day. You would not have observed this much volume for the last so many weeks or even months. This simply means that it’s not only you but a retail herd who are involved in this buy trade setup. The stock is closing strong so you want to hold it. The next day the stock opens the gap-up; trading volumes are still high but the stock does not move much. You still expect higher prices and decide to keep the stock. Unfortunately, the stock hesitates to go higher, reverses, and never retests the highs in the near future.

So what went wrong? When everything was good and picture-perfect, why are you sitting in a loss? Because you are in that 90% lot. You are buying the news near a top. The second mistake you did is that you hold it forever. This could have been taken as a short-term opportunity.

Professionals’ Edge

Another question that comes to mind is that what the heck do the top 10% do to make money? And why they don’t lose? The answer is simple; they simply buy the bad news so that they can sell the good news. Just ask yourself, who would sell near the top when a large number of traders are involved in buying the breakout? The answer is that only those traders would sell at higher prices who had accumulated at the bottom when the news was bad. They accumulated from the herd in panic at the bottom and then distributed to the herd in euphoria at the top.

Recent Real-World Case Studies

Let us understand how professionals distribute to the herd when the stock is in a strong uptrend and news is good.

First, take the case of Larsen and Toubro which is a great company but faced distribution in February 2021 and made an intermediate top.

Jan 29th The stock was in a strong uptrend for the last four months when news came on Jan 29th (highlighted in the yellow rectangle on left) that LTHC Engineering wins ‘Engineering Procurement Construction-Company of the Year Award’.

Feb 1st The stock gapped up the next session; broke out to new highs and closed 8.5% higher.

Feb 2nd the stock again gapped up by 1.7%. Now everybody wants to buy it for a ride to the Moon. The stock is up 19% in two days and here the professionals who accumulated in Mar-Sep 2020 period, started distribution. Professionals generally have millions of shares, so if they trigger ‘sell’ at random prices, they won’t get better fills. Also, retail traders would start following and sell with them, which would be a bad business for them. Professionals wait for a place where a large group of traders would be involved in buying so that they can sell into retail buy orders. Just notice a very high volume at candle ‘A’ with the long wick at the top, an indication of the above scenario.

Mar 10th The stock never attempted to hit the highs again until another news came on Mar 10th (highlighted on the right edge), that LT wins the HR Excellence Award. The stock tried to break out the next session but professionals hit the sell button once again, which failed the breakout and trapped the traders once again on the wrong side.

On this chart, the stock is down 18% from the highs (point A). If someone bought at A he would be definitely sitting at a loss. The stock again attempted to hit the highs near A in June but could not hold and faced an 8.5% reaction.

From this example, it is evident that good news at higher prices is good for short-term trading but not for the longer or medium-term.

Now let us take another example of Adani Ports & SEZ.

Apr 5th The stock was in a strong uptrend and on this day news of APSEZ acquiring a 25% stake in Vishwa Samudra Holding Pvt Ltd came out (the day highlighted in yellow).

Apr 6th Next day the stock gapped up, broke out of a technical pattern, and gained almost 15% in a day

Apr 7th The stock gapped up the next day and people want to buy APSEZ at any price. It made a high 6% above the prior close but closed 2.5% down by the end of day. Just notice that volume at ‘A’ was higher than the previous day yet stock closed lower. Only one thing can do it and that is professional selling. Their huge sell orders distributed the stock to the euphoric herd.

The stock was hit by -22% in the next 10 sessions. It again made a marginal new high in June where many breakout traders would have trapped themselves. Later on Jun 14th the stock broke down in a panic sell-off due to some rumors and could not gain much strength thereafter.

Final Thoughts

From the above discussion, it is clear that the combination of higher prices and good news is not the best buying opportunity for longer term. Always remember that someone is selling heavily into your buy orders at higher levels. However, such setups can be traded for the short term. A quick gain of 10-20% after a news/event breakout at all-time highs is an exit opportunity rather than fresh buying and holding forever.

The scenario discussed in this article does not always mean reversal. But it indicates that weakness has emerged and the stock may linger below the distribution levels for longer than expected. It may also lead to an intermediate top. The price may sometimes go a little higher where further distribution takes place and the stock slowly starts wriggling down making lower lows.

In order to be a profitable investor/trader in the stock market, one needs to follow the professionals. One will have to patiently wait for better opportunities. There might only be a couple of opportunities in a 3-5year time horizon. An investor should always take the larger picture into account rather than short-term news or patterns. Only then he will be able to buy the lows and sell the highs.

I hope this article helped you to understand the market behavior in a better way.

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Author: JJ Singh