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Back to Basics
  • : January 22, 2021
  • : B. Krishnakumar

Back to Basics

I wanted to focus on certain aspects which are considered absolute basics, but we tend to forget them or lose focus on these basics as we try to learn more advanced concepts. The post last week was an attempt to bring our focus back on something as simple as relative strength concept.

I consider these posts as a reminder or notes to self. Putting my thoughts in writing makes me focus on these concepts and helps me bring the focus back to basics. In any field of activity, it is essential that one focuses on the basics.

In this context, I strongly recommend you guys to read this book “The 5 Elements of Effective Thinking” written by Edward B. Burger & Michael Starbird. In this book, they talk about the importance of focusing on the basics.

Here is a quote from that book:

Four things

As mentioned earlier, I consider these posts as a self-talk and to reinforce or get my focus back on fundamentals. I hope it rings a bell amongst you readers as well. The idea for this post was triggered by one of the questions someone asked me (apologies I forgot the name of the person). The question was “How do we anticipate and /or deal with the volatility witnessed in Nifty on Friday (Dec. 11, 2020).

The answer to the above question is not so straightforward, but it is not complicated either. Remember price follows basically the same pattern across multiple time frames. This aspect is called as fractal behavior. The problem or the complication happens when different patterns play across different time frames.

In a strong trending market, you will notice that price rises or falls smoothly across almost all-time frames. It is extremely easy to deal with this scenario. Any breakout approach will yield significant profits in such a scenario. There can however be instances where price is in a smooth uptrend in bigger time frame while it is in a volatile counter trend pull back in a smaller time frame.

The higher the time frame you trade, the lesser the number of trades and the bigger the chances of riding a big move. As always, there is another side to whatever we do. Trading in higher time frames requires a lot of patience, it requires the usage of wider stop loss & wider trailing stop loss and relatively bigger drawdowns.

As you go lower down the time-frame hierarchy, you have the benefit of trading with smaller risk, but you may end up taking more trades. The number of whipsaws could also potentially increase. So, there is always a trade-off in whatever decision we take. It is essential to understand what we prefer doing and choose the time frame and the tools accordingly.

Getting back to the question of avoiding or dealing with Friday kind of scenario, the simple answer is, it cannot be avoided or anticipated. If you are dealing in a relatively smaller time frame, you can end up with more such shakeouts or volatility spikes.

And these volatility spikes do happen across all time frames. Remember, what comes across as volatility in one-time frame will manifest itself as a trending move in another time frame.

If the above explanation sounds a bit confusing, let me explain it using Nifty Futures 1-minute chart. Let us define a few things upfront for the sake of clarity.
  • Price is in an uptrend if the short-term moving average (20-EMA) is above the longer-term moving average (40-EMA)
  • Price closing below the MAs is not considered as trend reversals.
You can choose any other trend identification or trend filter tool and you will see the same scenario playing out. Here is the Nifty Futures 1-minute chart in 0.25% brick size. This is the higher time for my reference. I trade Nifty Futures on a positional basis and I prefer to hold on to my trades for several weeks.

I will not take short trades as long as the trend (as defined above) is bullish in 0.25% brick size. Notice the circled areas on the chart above where price witnessed pull back to the MA. These appear harmless in this chart. But these moves can offer wonderful trend trading opportunity in a lower time frame. But I am not bothered about participating in them as my time frame and objective is different.

Let us switch to a smaller time frame and look at the same price action. Here is the Nifty Futures 1-minute
chart in 0.1% brick size.

You will notice more noise being accommodated here because we have gone to a lower timeframe by reducing the brick size. You will notice that the trend flip-flopped between bullish & bearish modes on quite a few occasions. Again, remember, the trend is determined by the positioning of MAs. We are not changing the trend definition mentioned earlier.

Here is the same Nifty Futures 1-minute chart in 0.1% brick size, but with Super Trend indicator added. I prefer using Super Trend indicator as my stop loss / trailing stop loss mechanism. I find this brick size suited for my style of trading. It can be different for you based on your time frame and risk profile.

Notice how my long position was never under threat during Friday’s shakeout or volatility. Price came close to my stop loss (super trend indicator) and bounced back. If I were not looking at the live price action, I would not even realize what happened on Friday.

But, if you go a lower time frame, you would have been affected by this volatility. Just cannot help it or avoid it. Have a look at the Nifty Futures 0.05% brick size chart now.

If you are someone who trades on smaller time frame (0.05% brick size), then your long position would have been stopped out when price fell below the Super Trend indicator on Thursday. A long trade would have been triggered again on the breakout above Super Trend indicator (check the chart above). This long position would have been stopped out again during the volatility spike on Friday. And long would have been triggered again towards the close of Friday.

To summarize, volatility spikes and its impact cannot be avoided or anticipated. And what comes across as a violent move might be captured as a harmless pull back in a bigger time frame. Understand the interplay of time frames and use this to your advantage. Try moving to slightly higher time frames or have higher time frame context to tackle such volatility spikes.