Why does the Shanghai market rise and fall so rapidly? It's a question I have been asked many times in the past week in the face of the rapid fall in the Shanghai index.
The standard explanation is that the Chinese market is dominated by retail traders and they cannot be trusted. Its they who are responsible for the rapid falls.
This idea is patent nonsense.
The average holding period for stocks on the New York Stock Exchange is less than 1 second and this is an exchange dominated by institutional and fund managers, not excitable retail traders.
In 2008 these same fund managers were the ones busy selling their investments while, at the same time, telling their clients not to panic and not to sell. This is clear from the composition of the volume sales on the first days of the 2008 falls.
The explanation for Shanghai market volatility lies elsewhere. There are four structural factors which contribute to the accelerated rises and galls in the Shanghai market.
The first is the limit up limit down restrictions. When the price move reaches 10%, trading is halted until the next day. Image you are a seller. You want to get out at 100, but the stock is locked limit down at 100 and your order is not filled. The rational reaction is on the next day to offer to sell at a lower price, say 98, to make sure you get out before price locks limit down again.
The reverse applies in a rising market as buyers bid higher to get stock before it locks limit up. The result is both up and down trends accelerated unnecessarily.
The second explanation is the ban on short sales. This means the market can only be traded form the long side. In a falling market the options are to sell quickly – adding to the cascade effect of selling. Or to simply sit on a loss. There is only one rational course of action, and this contributes to an acceleration in the wave of selling.
The third explanation is the ban on intraday trading. Stock you buy today cannot be sold until tomorrow. This has the effect of widening the stops so the move downwards is not slowed by incremental selling. Instead the selling on stop is concentrated on the day following the initial fall. Again this accelerates the downtrend.
The final factor is the lack of derivative markets which can be sued to hedge a falling market. This leaves investors with few alternatives in a falling market. Selling is the rational thing to do and when everybody has only this choice then naturally the market fall is amplified. This is not a sign of irrationality, but a sign of extreme rational thinking.
These are structural factors that impact the Shanghai market. In this environment the key focus is on the strength of support levels in the Shanghai Index. Traders watch for consolidation support to develop near 3,070. Once support is confirmed then they will enter the market as buyers.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders, which can be found at 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. He is a special consultant to AxiCorp.
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