Charts: Exploiting Market Dips with Warrants

"Exploiting Market Dips with Warrants" by Cat Davey (independent journalist) - November 2005

In a strong bull market such as the one currently occurring on ASX, the cheapest place for traders to buy is on dips. In the world of technical analysis where breakout trading is king, the idea of buying on dips goes with the concept of averaging down and is generally considered risky and amateurish. However there are occasions when it is possible to enter on a correction prudently and profitably. The smart approach to buying on dips is to wait for the correction to show signs of fatigue and then be ready to jump on board when the earliest technical buy signal is given. When analysing a stock or market for this strategy you would usually look at past corrections. No two corrections are ever the same, but often they will show similar features. The following highlights this analysis process using the prior two corrections for the S&P/ASX200 index, more specifically highlighting a reverse head and shoulder pattern. The analysis is then converted into a simple warrant strategy to exploit this early buy signal. 

Common Features of S&P/ASX200 Corrections

1. Large Initial Drop
The first common feature of the two charts was a fast and large initial drop. In March it was a fall of over 209 points in five trading days. In early October it was a drop of 197 points in just two days. This was panic selling and will often happen when a market has travelled very quickly higher and especially if those gains start to accelerate. The first correction included a second round of dramatic selling with the index losing another 177 points in three days in April. These moves have been highlighted in the chart below.

2. Congestion
A correction shows it has the potential to end when the price action starts to consolidate or congest. This may lead to more losses, as in the continuation of falls in the fist correction, or it may yield a definitive reversal pattern. The first clues of a potential reversal therefore are a narrowing in the daily ranges. From 50 or more point falls, the price action might initially show slightly narrower ranges where there is at least some rebound on the previous day’s lows. More retracement of previous ranges shows steady probing of previous range highs and lows. This congestion pattern may show a slight upward or downwards bias and even include a more volatile ultimate low point.

3. The First Higher High and Higher Low
In technical analysis terms the basic definition of an uptrend is the instance of a wave with a higher high and a higher low than the last. The end of both corrections in the past came when the index made a higher wave high after rejecting the previous low. In a strong bull market such as the one the index is currently in the midst of, investors and traders need little encouragement to jump back in. Something as simple as a new wave high in the correction has been enough to trigger a strong round of new buying. In the case of the index both these new waves higher were part of a reverse head and shoulders pattern.

Daily bar chart with higher high and higher low

Reverse Head and Shoulders Pattern

Many corrections follow the basic pattern of (1) sharp falls, (2) consolidation, (3) new wave of higher high and higher low. However something more specific happened in both circumstances on the S&P/ASX200 - a reverse head and shoulder pattern formed. This term is bandied about by plenty of amateur chartists but there is a specific procedure for this pattern. A reverse head and shoulders pattern happens at the end of a downward correction where the first shoulder forms a low and is followed by a rally and new drop in price to a point lower than the first or left shoulder low. This is then followed by a rally that does not go higher than the first shoulder rebound. The next leg is the right shoulder which does not go lower than the extreme low of the head. Thus the appearance is an upside down head and shoulders pattern. The critical point of the pattern is the breaking of the neckline. The neckline is drawn across the chart from the first shoulder rebound high to the high point of the rebound following the head formation and beyond. Therefore the angle of the neckline for a reverse head and shoulders will usually point downwards. The pattern is confirmed and the buy signal given when the neckline is breached. 

Inverse head and shoulders pattern

Buying ETFs and Instalments on Confirmation of the Inverse Head and Shoulders

The first correction confirmed the inverse head and shoulders pattern on 19 May 2005. Buying an indexed ETF the following day at the opening would have allowed you to take a position on the index at $41.40. To demonstrate the leveraged effect of the instrument consider the September highs of the index at 4,679. If the underlying index opened on 20 May at 4,041 and travelled as high as 4,679 (Sept 2005) the return would be approximately 15.8%.

In order to benefit from this movement you would need to translate this into a tradeable instrument on ASX.  Two examples of tradeable instruments are indexed ETFs and indexed ETF instalments.  The indexed ETF is an ASX listed managed fund that tracks the underlying index.  It is the closest tradeable instrument over the index available on ASX.  Alternatively you could take a leveraged view by investing in an instalment over the indexed ETF.  The instalment will track the performance of the ETF, while providing a leveraged return and passing on all the distribution benefits to the holder.  

To illustrate how an ETF and ETF instalment can allow you to benefit from this technical analysis opportunity we look at the following example.

If you purchased an indexed ETF (ASX code: STW) in May at $41.40, then once the index reached 4,679 you could have sold it for $46.88, reflecting a return of 13.2% over a 5 month period.  For a more aggressive play on this strategy, purchasing STW instalments could further enhance your return over the same duration.  In this instance, the STW instalment would be purchased at $17.88 and subsequently sold at $22.42, illustrated in the following table:

Indexed ETF (STW)  Instalment over STW
Buy price (May) $41.40 $17.18
Sell price (September) $46.88 $22.42
Return on Investment (%) 13.2% 29.3%

In both cases you were able to convert the technical analysis signal into a trade on ASX.  On one hand achieving an un-leveraged position while on the other, magnifying your return through the instalment over the underlying.

The key to any such trade is the risk/benefit trade-off and whether your timing was correct.  In this instance both positions were able to generate postive returns, ETF 13.2% and instalment 29.3%.  However, you must consider whether this strategy and the instruments you are using are inline with your financial objectives and risk profile.

About the author

Catherine Davey Bio – December 2005

Since 1999, Catherine has worked as a qualified technical analyst with InvestorWeb, one of Australia's leading online stock-market research organisations.  Additionally, she is a freelance analyst and finance journalist with regular contributions to Your Trading Edge (YTE) - The definitive bi-monthly publication for traders in futures, options, forex, stocks and commodities.  She completed a Master of Business (Applied Finance) in 1990 and is a former futures broker.

More recently she is the author of Contracts for Difference Master the Trading Revolution and recently completed a new book, a trading diary due for publication in February 2006.

Catherine lives in Sydney and is an independent trader and investor.

Disclaimer
The information is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.