Stock Market Cycles

We will be talking about how to use market cycles to achieve profitable investing today.

The market goes through different phases and different strategies perform well under different market conditions.

The market goes through 4 cycles:

1) UPTREND

The uptrend phase is usually known as the bull market. The demand for stocks exceed supply. During the uptrend phase, the moving averages tend to be slopping up in a particular sequence. Prices also make high-highs and higher-lows.

When a market is on an uptrend, you will also find it easy to make profits. Long trades and trend following tends to do very well during an uptrend market cycle.

There are 3 patterns in an uptrend, so when would be a good time to enter the market?

• Bouncing off trend line / moving average

This is the regular wave pattern. It will usually bounce off one of the key moving averages or a trending support line.

When you see the price bouncing off in a very predictable way, take a long trade when it bounces off.

• Breakout from Counter Trend Line (CTL) Resistance

This happens when the price goes on an uptrend and then it starts making lower highs in a short term counter trend move before breaking out of it and going back up. This is an overall medium term uptrend with a short term counter trend.

You should enter when the price breaks out of the counter trend line.

• Breakout of Horizontal Resistance

During an uptrend, the price can also make very small consolidation patterns. This is not to be confused with the big consolidation distribution and accumulation.

What happens here is that the price goes up on the uptrend and then makes a small consolidation (same highs and tested at least 3 times to be a confirmed resistance) along the way and you want to buy when it breaks out of the resistance and enter a long trade.

Another option would be to wait for the price to pull-back after the breakout to test the support before entering a long trade. A pullback doesn’t always happen so it’s up to you which entry point you’re looking for.

So when does an uptrend end?

An uptrend phase usually ends when the price makes a final parabolic surge (when it’s highly overbought, far from the moving averages) and the subsequent pricing makes new highs. When this happens, you can be prepared for the market to go into a consolidation distribution phase or immediately into a downtrend.

For those of you who are more experienced, you know that when you see a parabolic move to the top, and you see a very powerful reversal pattern through the candlestick, you can begin to do a counter-trend short sell to make money as the market collapses.

2) CONSOLIDATION: DISTRIBUTION

This is the second phase that begins after the end of an uptrend. This is when institutions are slowly reducing and distributing shares of stocks. During this period of time, the market does not make higher-highs (Sideway movement) and the moving average starts to flatten.

During this period of time, trend following will no longer be profitable. But you can still make money from certain strategies such as swing trading (trade the range, divergence reversal, parabolic short) and non-directional options strategies (iron condors, short straddle, covered calls)

In this cycle, there are usually some repeatable patterns such as Double Tops, Triple Tops and Head and Shoulders.

During Double Tops, the price goes up, makes a high, comes down and makes another high (usually the same level as the first or slightly higher) before going down.

Some traders see the second top exceeding the high of the first top, wait for a bearish candlestick reversal pattern with overbought conditions, they will do a short and catch the trade going down.

Heads and Shoulders

This is another common pattern where the price goes up, makes a higher high and comes back down to a lower high.

Traders usually draw a neckline and once it breaks the neckline, they will shortsell and anticipate the downtrend.

3) DOWNTREND

Usually after a Consolidation: Distribution, the market will go into a downtrend. The downtrend is also known as the bear market and it can last anywhere from 1 – 3 years. During this phase, supply of shares exceeds demands.

The 50, 100, 150, 200 moving averages are also sloping down the sequence. Price also makes lower highs and lower lows.

This is also the time where easy profits are gained from short trade and short term trend following.

With this, when is the best time to enter the market during a downtrend?

• Bouncing off trend line/moving average

When you see this pattern with the price bouncing off a very predictable manner and when it rallies and hit a moving average, it’s very obvious that you want to sell once it has bounced and short-sell when it’s sloping downwards.

• Breakdown from Counter Trend Line Support

The prices will temporarily make higher lows a counter uptrend in the short-term  while being in an overall medium term downtrend.

When this happens, you can easily draw a counter trend line. You do not want to short sell when the price is above the counter trend line, but one it breaks the counter trend line, you can proceed to short it.

• Breakdown of Horizontal Support

The price can make mini consolidations on a downtrend. This is where the price goes down, hits a support 3 times before going down again. And you want to short when the price breaks below the support level.

You could also wait for a pullback to test the resistance and then short it then.

It is essentially similar to the long trades, just the opposite direction.

The downtrend bottoms when prices make a final plunge (highly oversold and far from moving averages) on high volume.

Capitulation happens when the price takes the final plunge through panic selling, this is when everyone has surrendered and there are no more sellers left.

This is also when you can use the capitulation strategy to buy for a quick counter trend trade upwards.

2 things can happen after the market bottoms, it either rebounds very strongly into a new uptrend or it goes through a consolidation: accumulation phase where the institution slowly accumulates before pushing it into an uptrend again.

4) CONSOLIDATION: ACCUMULATION

This phase begins after the completion of a downtrend, institutions are slowly amassing shares of stock. This causes the prices to move sideways (basing period), and the moving averages flatten. You will also realise that negative news does not affect the stock anymore.

You will notice that the stage will be completed once the key resistance level is broken and no new low is made.

Trend following is no longer profitable and profits come from swing trading (trade the range, divergence reversal, parabolic short) and non-directional strategies (iron condor, short straddle, covered calls).

During this phase, before the uptrend, there are some repeatable patterns.

Double Bottoms

This is when the price makes a low, goes up and come down into a slightly lower low.

For seasoned traders, once they see that the price has made a lower low and a powerful reversal candlestick pattern that’s bullish in nature, they could take a buy on.

Other than double bottom, it can go on to be a triple bottom pattern as well.

To summarise, you’ll find that the market goes through these 4 cycles and this is important to understand because whatever strategy you use will not perform all the time. It will perform under certain conditions and not so in other conditions.