Will the market crash if Nifty falls below 5200?

What is the point of asking this question when the Nifty closed above the 5400 level today? Regular readers may have the answer to the second question: Because the Nifty has formed a large ‘descending triangle’ pattern from which the likely break is downwards through the horizontal support level of 5200.

The one year bar chart pattern of the Nifty clearly shows the large descending triangle:

  

To try and attempt an answer to the first question, we need to look at some of the technical ‘rules’ associated with triangles. If you are new to technical analysis, it may be worth mentioning that there is nothing technical about ‘technical analysis’. It is just a name. A better name would be ‘sentiment analysis’ or, better still, ‘supply and demand analysis’.

Price charts tend to form certain patterns based on the supply and demand for individual stocks. In the case of an index, the patterns are formed by the combined supply and demand for stocks that are included in an index. The ‘rules’ for certain patterns are based on observations made over many many years of stock and index charts.

What are the rules associated with a ‘triangle’ pattern?

1. A triangle is a ‘consolidation’ or a ‘continuation’ pattern. That means, the previous price trend consolidates within the triangle before continuing in the same direction as its earlier price trend. Sometimes, a triangle can be a ‘reversal’ pattern; i.e. a previous up trend becomes a down trend (and vice versa).
2. An upward price break out from a triangle should be accompanied by an increase in transaction volumes. But a downward break out need not be accompanied by higher volumes. If an upward break out happens on weak volumes, it may lead to an ‘end run’ or a ‘false’ break out. If a downward break out is accompanied by high volumes, it may be a ‘shake out’ or a ‘bear trap’.
3. A break out – in either direction – should happen within two-thirds or three-fourths of the perpendicular distance between the base and the apex of the triangle.
4. In the case of right-angled triangles, price break out occurs through the flat side; i.e. upward from an ‘ascending triangle’ (flat top and rising bottoms), and downward from a ‘descending triangle’ (flat bottom and falling tops).
5. Triangles seem to lose their ‘power’, the closer the prices get towards the apex. Some times prices move right through the apex without a clear break out in any direction.
6. Triangles have measuring implications. On an upward break out, an upward sloping line is drawn parallel to the lower side; on a downward break out, a downward sloping line is drawn parallel to the upper side. The height of the triangle will be equal to the extend of the upward or downward move following the break out.

Since we have a clear descending triangle pattern on the Nifty, let us evaluate the rules to arrive at the most likely occurrence.

If we extend the downward sloping trend line and the flat bottom of the descending triangle to the right of the chart above, the apex will be formed around 5 months from now; i.e. in early Jan ‘12. The triangle started forming from the peak of Nov 5 ‘10, so the distance to the apex of the triangle in terms of time will be about 14 months.

A break out should happen within two-thirds (9 months 10 days) and three-fourths (10 months 15 days) of the distance to the apex from Nov 5 ‘11. That gives the period between Aug 15 and Sep 20 ‘11 within which a downward break out should occur. A break out may occur even earlier. The measuring implication will be the height of the triangle, which is 6340 (Nov 5 peak) – 5180 (Feb 11 trough) = 1160 points. So, the Nifty can drop to (5180 – 1160 =) 4020. That will be the worst case scenario.

If the downward break out is accompanied by high volumes, then the Nifty can turn around and resume its up trend by shaking out the bears. There is a possibility that the Nifty consolidates within the triangle beyond Sep 20 ‘11 and breaks out closer to the apex. In that case, it may fall only till 4840 (its May ‘10 low). A break out above the triangle is also a possibility – but should be accompanied by high volumes. The other possibility is that the Nifty continues to drift sideways and fizzles out through the apex of the descending triangle.

The answer to the original question is: It may do so. In technical analysis, there are no certainties – only possibilities and probabilities. A downward break out with a drop to 4840 is the most probable outcome. But a drop to 4020 can not be ruled out by any means.

What should small investors do? Keep a close watch on portfolio stocks and the 5200 level in the Nifty. The technical indicators are looking bearish – signalling a downward break below 5200.