As featured in the Herald Sun – Friday 30th September 2016.
By David McCulloch – Market educator and consultant to Share Wealth Systems
The significant key to longer term out performance is to simply avoid participating in large bear markets. It’s not a difficult concept and there are a number of fairly simple methods that can be used to indicate high and low levels of market risk.
Measuring Market Risk.
To help determine a level of market risk, we can use a variety of technical indicators. In this example we’ll discuss the use of the stochastic oscillator. As the name suggests, this indicator oscillates (moves) up and down between 0-100. The parameters that could be used for this indicator when it is used as a market risk model could be 25/8/1 and applied to a Weekly Chart. A benchmark index is normally chosen on the basis of how well it represents the stocks in your preferred market. For example, if your preferred market is the Australian market, then a suitable benchmark index might be the ASX200 or even the All Ordinaries index. If your preferred market was the USA market, then a relevant benchmark might be the SP500 or perhaps even the SP1500.
The market risk indicator assists in defining the direction, strength and sustainability of the benchmark index’s trend. The nature of the benchmark index’s trend will influence the stochastic oscillator line. The position of the stochastic oscillator line can then be used to help determine the level of market risk.
As an example, if the stochastic was at a level between 80-100 it would suggest that the benchmark index is at a lower level of risk compared to a reading of 0-20. How might you use that information to assist with your decisions on entering new positions? One way might be to not open any new positions unless the indicator was above 60 for example.
From observations on a Chart of the benchmark indices, when the indicator goes below 60, there is an increasing chance that the market can quickly slip further to the down side and so it makes sense to exercise caution at those levels. Continued management of all open positions in accordance with your plan and waiting until conditions improve before adding might be prudent. As with any technical indicator there is a degree of lag, and nothing is as current as real price action. A clear understanding of both can be used to create your own market risk models, and whilst it might not sound that exciting, it does provide a solid context from which to make your investing decisions.
A regular habit of individuals in Melbourne is to check the weather report on the evening or morning news in preparation for the day ahead. Being fore-warned is to be fore-armed, and so it goes in the markets. Just because the forecast this week has been for rain, doesn’t always mean that we get wet. Creating your own market risk model allows you to plan ahead and take the necessary action in alignment with your investing strategy.
David McCulloch is a market educator and consultant to Share Wealth Systems.