Four key Shanghai market features that fuel volatility

Shanghai Stock Exchange
Carlos Barria | Reuters

The Shanghai Index has retreated dramatically and is moving toward the longer-term consolidation area between 3000 and 3400. The sell-off has been faster and more severe than expected.

These falls are exacerbated by four features of the Shanghai market that increase the volatility, severity and momentum of trends – both uptrend and downtrend.

1) The first feature is the application of limit-up and limit-down conditions. In big market moves stocks can be locked into limit-down just a few minutes after the opening of trade. The result is pent-up demand to sell. When the market opens the next day frustrated sellers flood it with lower prices in desperation to get out. The inability to exit the market feeds panic.

2) The second feature is the ban on short selling. A very limited number of stocks are available for short selling. The vast majority cannot be short sold. This means that the only way to make money is on the long side – buy low and sell high. Profits only come from rising prices so it makes sense to sell and sell quickly when the market begins to fall. It makes sense to sell and sell even more desperately when losses start to mount. This increases the volatility of the market and the speed of market falls.

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3) The third feature is the limited trading hours in the Shanghai market. Demand is confined to these four hours in total. When trading time is limited it easy for desperation to set in. It propels bull markets but it also propels falling markets. Longer trading hours remove the need to act quickly and emotionally.

4) The fourth feature is the suspension of thousands of stocks from trading. Nothing is guaranteed to induce panic selling more quickly. Investors fear that they will be locked out of the market so they rush to sell at any price. It becomes the same psychology as a run on the banks.

These four features all combine to distort the smooth operation of buyer and seller supply and demand. The result is very fast uptrends and very fast downtrends.

Of course these discussions beg the questions: where will the fall stop and when to re-enter the market? From a technical perspective we look for consolidation between 3000 and 3400.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – www.guppytraders.com. He is a regular guest on CNBC Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.