Stock Market

Bank Nifty overbought? Traders know just when to exit trades

Shishir Asthana
Chillicious Research

Banking stocks have recently shot up in the market even as the government has been making the right noises about restructuring them. But Bank Nifty often invites comparisons with its bigger cousin Nifty. Traders who are actively betting on the equity market, mine this relationship between the two indices to maximise their profits or, alternatively, to cut their losses.

Of the two indices, Bank Nifty is the more volatile one. Bank Nifty is fundamentally a subset of Nifty though there are more banking stocks in Bank Nifty.

The ratio essentially gives an idea of whether banking stocks have moved far ahead of the remaining stocks or conversely have fallen much more than the remaining market.

The ratio over the years keep on changing because of the shifting composition of stocks in the Nifty index. As weightage of financial stock increases, the ration between Bank Nifty and Nifty tends to move in a higher range. But once the weightages have been altered they tend to move in a well-established range.

Traders’ Cues

Equity market traders search for cues in various data points to enter or exit a trade with the best risk reward ratio. In order to get a clear signal many traders have been using data points to generate trading signal. Relationship between two different stocks or indices or even markets are used to come up with trade signals.
Traders track the Gold-Silver market, Oil-Dow Jones or Oil S&P market, Dollex and equity markets to come up with over-bought and over-sold signals. The ratio between two markets is tracked to highlight the turning point which offers the lowest risk for a trader.

Technical analysis offers many such opportunities for trading, however its critics say it is not an exact science. And there could be different results.

Traders in India too look at two or more stocks or indices. For example, the long-short trader, who bets on both sides of the market, buy the strongest stock in the sector and short-sells the weakest one.

Thus, when the market moves higher he is riding the strongest counter, while the losses on account of the short position may be small. Similarly, when the market is weak the trader is sitting comfortably on the weakest stock but his losses on account of the long position may yield a small loss.

Overbought Zone

Since 2014 the Bank Nifty to Nifty ratio has been moving in a band of 1.93 to 2.30. Traders look for going long on Bank Nifty when the ratio falls to 1.93 region and are ready to create a short position when the ratio moves near the 2.30 mark. As can be seen from the chart, these regions offer the best risk-reward ratio.

It may be noted that 1.93 and 2.30 are not exact points but regions. Thus, Bank Nifty is in an overbought zone when the ratio approaches 2.30 mark; it can move back from 2.28 or 2.32. Traders get ready to create a short position in Bank Nifty when the ratio approaches the region. Any weakness in the financial counters is used to short the Bank Nifty index. The same is true in reverse when it approaches the 1.93 mark.

Presently Bank Nifty at just above the 2.30 mark is in an over-bought zone. How the ratio plays out will be known in the next few days. But if history and data traders are to be believed, banks will continued to be priced high, until a pushback takes place.