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Nifty has just broken the day’s low. It had fallen steeply on the day before, after successive days of gains, making the day’s fall even more ominous. Collapse theories do not dominate the whatsapp groups yet, but some have started to wield the “I told you so” sword. And then it happened…just as it did, several times over, in the last many months earlier. The Nifty swung back swiftly, wiping out almost all of the day’s losses and it wasn’t long before traders started humming the “new peak soon” tune.
Again. We have seen this drama unfold several times over in the last couple of months. Has it made believers out of the circumspect? Or are the whatsapp groups teeming with those who began their stock market journey only post March 2020? Or has the relentless and seemingly endless rallies of the last 1.5 years made the seasoned traders forget all the bitterness of the past? Data released by the Bombay Stock Exchange (BSE) show that the number of stock investors (Unique Client Codes) rose by 10 million over the three months from June 6 to September 21.
This is the fastest pace of addition in its history, reports mint. This rapid entry of new investors has meant that FIIs sales or purchase have ceased to be the number one reason for influencing market sentiments. According to data from the Association of Mutual Funds in India, inflows into mutual funds from regular contributions through systematic investment plans, or SIPs, hit an all-time high of 103.5 billion rupees ($ 1.4 billion) in September.
For the sake of understanding the phenomenon that is unfolding in front of our eyes, stock market investment activity can be considered as a game of skill, probabilities and as well as the participant’s patience and their ability to withstand pressures of greed and fear. This, however, is a game of imperfect information. But therein lies the charm of the game and its intrigue; the winnings are just an incentive to keep playing. For a game with perfect information and set rules, like Tic-Tac-Toe, strategies work all the time. If you have played Tic-Tac-Toe enough times, you would know that an approach can be used to ensure that you do not lose, while positioning yourself to win, if the opponent makes a mistake.
Extending this logic, can we have a strategy that ensures that you do not face a loss in stock market investment? Sticking to a set of stock picking or exit strategies using fundamentals, technical, macros or a combination of all may not ensure a loss free game. If this were a pure strategy game with perfect information, it would be zero sum, as the money made by one player would be exactly the same as the money lost by the other, assuming it to be a two player set up.
But, in stock markets, the bears and bulls do not complete the set up. The government, exchange as well as intermediaries also keep taking money off the winnings of the two player set up. Seasoned day traders or algo traders approach the market in such a way that they do not lose beyond a certain value as long as they stick to a set of strategies, irrespective of what the other set of players employ as strategies. In the real world, sticking to the pre-defined strategies may not be always possible, as changes in personal circumstances or regulatory environment, may force a deviation or complete abandonment of strategies. But, can this concept, at least loosely, explain how stock markets have continued to remain on an uptrend?
In “Nash equilibrium”, each player is assumed to know the equilibrium strategies of the other players and no player has anything to gain by changing only their own strategy. If the stock market had only two set of players, with one set who bought and held on to stocks only, and the other who only sold strangles on index options, then it is possible for the continued rise in stock market may ensure that profits continue to flow in for the first set of traders by way of consistent stock gains, while time decay consistently delivered money on the strangles. Ideally this is an equilibrium state. Is it possible to go on, allowing markets to keep expanding, like it has been, lately?
These two sets of players, (while continuing to assume that the game of stock market investment had only these two set of players), are not in pure disconnect just because they play different assets. Infact, the stock traders’ bullish stance fetches a higher premium for options, which in turn makes the time decay a worthwhile play for the seller of strangles, without in turn affecting the stock traders’ ability to keep expecting higher price for his stocks. In other words, one set of player’s strategy is the best response to that of the other. This is Nash Equilibrium. So where is the catch?
The catch is when players are unable to find the best strategy, or in this case, the best investment advice. Or less than ideal advice. When that happens, players keep on adjusting their game, and may also change their strategy in response to the decisions taken by the others. And it will not be long before odds / gains shift significantly away from one player, so much so that the equilibrium is shaken. Not collapsed, though. The equilibrium may also be tested if the pace of price rise is too quick. When that happens, it deprives the players of the learning opportunities and may prompt them to employ less-than-ideal strategies, i.e. incorrect stock valuation.
Either way, an equilibrium with consistently expanding prices is theoretically possible, if the buyer continues to see the opportunities of a higher price to sell. It only needs a consistent flow of liquidity. With more than 95 percent of the population yet to tap into Indian stock markets, and a structural shift in savings happening, the stock market game may continue playing out the equilibrium that we have enjoyed seeing in the past 19 months.
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