To Trend or Not to Trend, ...
Buy low and sell high, or sell high and buy low -- that's the long and the short of it.
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Except for dividends, you only make money in the market if you catch a trend. It's like water surfing -- you only surf when you catch a wave, though you can enjoy just being in the water. To make money you have to be long and buy low and sell high, or be short and sell high and buy low. Another way to say this is to buy high and sell higher, or sell low and buy lower. It's relative, literally.
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A trend could be in a major direction and last several years, or even decades, or it could be just the difference between the high and the low of a trading range. If you buy something in the former category, you're an investor. If you buy on a short-term basis, you're a trader. But long-term or short-term, it's the same business.
Trouble is, markets go up and down even as they trend higher or lower. Whether long-term or short, the stock you buy may eventually go high enough for a handsome return. But in the meantime it could go lower and you could stand to lose a bundle if forced to sell. Either as a trader or investor, you have to have a strong stomach and a lot of faith, or make a quick exit before you get caught with a big loss. Either way, it's tricky; markets are highly nonlinear.
You need to understand that there are trends within trends -- or waves within waves. You have to choose your length of trend and watch the longer and shorter trends like a hawk. If you don't have the faith or endurance to suffer heavy downdrafts, you need to close the trade. If the trade causes you to lose sleep, you have to get out. The sooner the better!
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The moving average has always been a popular detector of trend. Among the many versions, one of the most popular is the 200-day moving average, a long-term trading tool. As indicators go, it's probably as good as any.
For example, if the price of the S&P 500 index is below its 200-day average, it is considered to be in a down trend. On the other hand, although the price of the index may have fallen, if the current price is still above its 200-day moving average, the index would still be considered to be in a bull market. As such, it would only have suffered a significant correction to the bull market.
The problem for you as a trader/investor is to establish whether such a drop in prices is of the bear variety or the bull correction variety. This is true whether you're a long-term player and watch the 200-day moving average, or a short-term trader and watch the 2-hour moving average. Either way, long-term or short -- or anything in between -- you need to be able to distinguish between a reversal of trend and a correction in an ongoing trend.
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You might find an equity to trade that has your trend length and buy into the equity but still not profit. One reason might be because you bought too late, after the gains had been squeezed out. You'd like to get an earlier start next time. You might then choose to look for bottoming or topping information. You can apply shorter moving averages or oscillators to detect the beginning of a new trend. Or you can look for topping or bottoming patterns in price charts. You might also apply divergence analysis to detect the end of either an up move or a down move. Another way is to apply duration analysis.
The Moving Average
As with the 200-day moving average, the plan is to buy an equity when the price of the equity rises above what you deem to be the relevant moving average. If you choose to operate with the long-term, 200-day trend, you will buy when the price breaks above the 200-day moving average and sell when the price goes below that moving average.
Sometimes, however, a security will dip below the moving average and almost immediately go back above it -- i.e., the price can overshoot the average line. The same thing can happen in reverse -- the price going above the moving average and falling back almost immediately. In either case you can get whipsawed.
To reduce the chance of getting stung in this way, you can use a short-term moving average of the price as a test vehicle, instead of the price itself. The short-term average smooths out the price ripples a bit and cuts away some of the "noise," as engineers say. Should the short-term moving average now dip below the long-term moving average, the event would be more definitive and would probably be a more nearly true trend-reversal indication.
Chart Patterns
To detect the reversal of trend of an equity using a price-history chart of the equity, you have to look for topping or bottoming patterns, like head and shoulders tops, double tops, and so on. The patterns are essentially turning patterns and reflect new money coming into the equity and old money (smart money) going out.
Smart money may also be selling the stock short. This is common practice among specialists.. The chart patterns reflect a redistribution of the stock. Stocks are going from strong hands to weak hands. The smart guys (or the pros, or whoever) are "distributing" the stock, and the unfortunate late buyers (or novices, or whoever) are buying.
The same thing happens at the bottom, in reverse. In this case the smart money is buying and stocks are moving from weak hands to strong hands. Floor specialists and savvy traders are now buying on the cheap, and late buyers are frantically dumping -- after holding them through a tortuous ride down the slippery slope. This is the phase of accumulation.
Divergence Analysis
It's natural for up trends or down trends to run out of steam and reverse. Like a ball thrown in the air, the market goes up, slows for one reason or another, eventually comes to a halt, and then starts down. The same thing happens in reverse in the market, although this is not a natural motion of the ball -- unless of course it bounces.
The beginning of the end is normally accompanied by high volume, providing lots of stock for the specialist to sell short! Just like a force applied to move the ball upward against gravity, so too you have a last-gasp propulsive force of volume that moves a stock into its final phase. This force declines as buying power dries up, and gradually the price slows as well. The ball analogy now breaks down, because the number of stocks that continue to go up in the closing months, weeks or days actually decreases. This is to say that the advance-decline line decreases.
One of a variety of oscillator techniques, divergence analysis keeps track of changes that occur in the price velocity and is intended to detect the decline in speed as the price continues to move in its trend. If the trend is up, for instance, and the rate of change of the price decreases, this reflects the fact that the stock is losing steam and will soon reverse. And if the trend is down and the rate of change, again, decreases, this too reflects the fact that the decline is losing steam and will soon reverse.
Duration Analysis
Rebutting the divergence theory, somewhat, Thomas DeMark says that the true test for a reversal comes -- not from the reduction in speed -- but in the duration of the impulse of force. He feels that the divergence is merely a symptom of a condition that may appear at tops or bottoms, and that the real cause is the length of the oscillator's stay at the high levels of rate of change, when the price is being powered upward.
The volume that starts the big bang is generally quite heavy, but it can last longer than normal and thereby can become even more powerful. It is this normal versus abnormal that DeMark draws to our attention.
He argues for a difference in the price results, depending on the number of days over which the high oscillator readings occur. If the number of days is less than six, for example, use of divergence as a tool is viable. But if the number of days is greater than six, say, this suggests internal price strength and therefore a likely continuation of trend rather than a reversal.
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When the price of an equity retreats, in the sense that it begins to go counter to your trend, you would like to know whether it's at the beginning of a reversal of trend or merely in a normal correction in the trend. You would therefore like to get a grasp of the expected extent of the retreat. To this end you could use cycle theory and Fibonacci ratios. If the price change stays within the limits indicated by certain Fibonacci ratios, you can say that the retracement is just a correction. Otherwise, you may be in trouble.
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