To make money in the stock market, avoid these three buying mistakes

Stock markets have trading days or holidays. Using stock market jargon, trading days can be either ‘bullish’ or ‘bearish’. But if you follow the so-called experts on business channels or the pink papers, stock markets have ‘good’ days or ‘bad’ days. On ‘good’ days, the Sensex gains. On ‘bad’ days, the Nifty falls.

What happens when both the Nifty and the Sensex drop by 4% – like they did today? It is a ‘terrible’ day! For whom? Obviously for the brokers and the business channels, because their business thrives on ‘good’ days. When the market moves up, more viewers tune in, and more investors place ‘buy’ orders. For investors, who were lucky or prudent to sell at higher levels, ‘panic’ days offer a great opportunity to cover back the stocks sold earlier.

So, are ‘panic’ days great opportunities to buy? The short answer is: No. In an earlier post, ‘How to tackle a ‘panic bottom’, I had explained that panic bottoms seldom hold. Technically, today’s heavy FII selling didn’t create a bottom in the Sensex or the Nifty. But it is a sign that the lower level of the last six weeks’ trading range may get tested, and possibly broken.

If you ever watch a tennis match between a top 10 player and a player ranked much lower, you will notice that there may not be much difference in their respective skill levels. The big difference lies in their ‘unforced errors’ stats. The better player makes fewer ‘unforced errors’.

In stock market investments, there are three such ‘unforced errors’ that you must learn to eliminate to enjoy greater success. These are common buying mistakes that many investors make:-

1. Buying near a top
2. Buying during a down trend
3. Buying before a bottom is formed

The buying mistakes in 1 and 3 are caused mainly due to inexperience with technical analysis. In the majority of bull and bear markets, a top or a bottom just do not happen out of the blue. There is a process, usually accompanied by a clearly identifiable reversal pattern, through which a top or a bottom gets formed. Such reversal patterns may take a few weeks, or a few months to form.

In both the Sensex and the Nifty, the Nov ‘10 peaks were part of ‘diamond’ reversal patterns, which transformed into large ‘descending triangle’ reversal patterns. So, we actually had two reversal patterns to indicate a change of trend from bull to bear.

The 2008 bear market ended with a 5 months long rectangular reversal pattern. It is expected that the current bear market will also form an identifiable pattern before the next bull phase can start. No such pattern is visible yet.

It is easier to identify reversal patterns after the pattern is fully formed. But there are prior signals given by various technical indicators that help to ascertain whether a reversal pattern is in progress. It is better to err on the side of caution when stock markets are rising or falling fast.

Buying during a down trend is acceptable only if you are covering up an earlier sale at a higher price. Not otherwise. Unlike tops and bottoms, which are tougher to identify, a simple trend line or the 200 day EMA can show whether a stock or an index is in a down trend. The biggest mistake you can make is to think that ‘it can’t fall any lower’. Learn to be patient and stay away during down trends. Buy only after an up trend is re-established.