Insights

For every action, there is an equal and opposite reaction

June 7, 2012 . FundsIndia Desk

Most of you would have realised that the title is Newton’s Third Law of Motion. Many might wonder that this meant to be a financial services related blog and what has Newton’s third law of motion got to do with it.

Be my guest.

The Newton’s Third Law of Motion can be used in analysing stock price movement. Price of any actively traded asset tends to fluctuate around the mean or the fair value. Where most people lose track is that the mean value is a dynamic concept but lots of people work on the premise that it is a static number.

The best trades happen at extremes from the mean. Once price hits an extreme, it tends to revert to the mean. After reaching the mean or the centre or the fair value, price may then reverse or continue its journey to the other extreme. Multi-bagger trades occur when you enter at one extreme and exit at the other.

Does this sound esoteric? Let’s talk about this with an example. Featured below is the daily chart of Infosys Technologies. Everyone tracking the markets would be aware of the sharp crack in the price after the company announced its fourth quarter results last month.

The green line in the chart is the centreline which is used as a reference point. The prior swing high is used as an “Action” point to measure the distance from that high to the centreline. The same distance is flipped over below the Centreline to arrive at the reaction line.

Note how the fall post the disappointing results was halted right at the reaction line. The entire world turned bearish on Infosys and price cracked 11% thereafter, But the reaction line came into play and arrested the fall.

It is also interesting to note that the reaction line has acted as a strong support even amidst the sharp crack witnessed in the last few weeks.

This is just a simple demonstration of very complex subject. How to frame trades with this tool is a different subject and a complex one at that. We would address this in subsequent posts.

The safest way to use this concept in trading, especially in the beginning stages of the learning curve, is to use the reaction line as a Target, rather than an entry mechanism.

Hope you found this interesting.

Cheers

B.Krishnakumar

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