The Power of Stock Market Trends

In this post, we will be looking at the power of stock price trends to profit immensely.

If you look at prices on a stock chart, it may seem like it is moving randomly but they often exhibit repeatable patterns that can be exploited.

When we can identify these patterns, we can anticipate the direction of prices with a high degree of probability.

Prices of stocks tend to move in trends – like the way water moves in a current.

THE TRUTH OF THE TREND

The most important principle of trading and investing is an established trend in price is statistically more likely to continue in the direction of the trend than it is to reverse.

Once you’re able to identify a new trend and the reversal of the trend, you can profit immensely from it.

In fact, that is how a lot of money is made from the market.

Essentially, there are 3 kinds of trends a price can move into:

PRICE ON AN UPTREND

There are times where the market is in an expansionary phase when there is growth in the economy or the company and the market is optimistic and bullish.

The price will exhibit an uptrend pattern.

On an uptrend, you will notice that prices still fall, but every time it falls, it goes back higher. In other words, the price makes higher highs and higher lows.

When the stocks are on an uptrend, there’s a higher probability that the price will continue moving up over time.

When this happens, we will always want to buy the stock or stay in the position when it’s on an uptrend. We use the term “Going Long” – buying in anticipation of the price going up.

The best time to go long is when the price makes a temporary fall or dip in the uptrend. Because we always want to buy as low as we can to make more profits as it moves higher.

How do you know when’s the lowest point of the dip?

You won’t buy the stock directly at its lowest point because it has the probability of going even lower and even be a beginning of a downtrend.

You must always wait for the price to go down enough and bounce off and continue the uptrend. It should bounce off a key support line or a key supporting moving average.

I like to use moving averages. In this chart below, I use the 50, 150 and 200-day moving average (the blue, green and red lines)

These moving averages are drawn with the computer charting software so it’s objective and based on math.

When you look at stock prices, they very reliably bouncing off their moving averages. In this case, it tends to bounce off the 50 moving average during this period of time.

When you see a pattern like that, it is very obvious that the way to make money is to buy the moment it bounces off the 50 moving average.

PRICE ON A DOWNTREND

This is the opposite of an uptrend.

There are times where the market will reverse into a downtrend, during times of crisis, uncertainties, and recession. The market is pessimistic or bearish.

On a downtrend, prices do still move up but every time the price goes up, it goes lower. The price makes lower highs and lower lows.

Here’s one of the most important rules: You never ever buy a stock when it is on a downtrend!

When it’s on a downtrend, there is a high probability of the price going lower and lower.

So, no matter how cheap the stock is, never buy it on a downtrend because cheap can get cheaper and low can get even lower.

You never fight and swim against the current. The current will pull you down and you will drown.

No matter how good you think the company is, don’t buy the stock on the downtrend, always wait for reversal of trend.

In fact, on a downtrend, you want to sell the stock or to do a short-sell so that you profit as the price moves down.

The best time to sell the stock on a downtrend is when the price makes a temporary high when it rallies.  You sell at the highest point before it collapses.

Again, you must always wait for the price to go up in the short-term rally, hit a resistance and bounce back down. You sell only when it bounces back down.

The best resistance to use would be the moving averages.

Take a look at the 50, 150 and 200 moving averages in the chart below.

The price pattern is very predictable, every time the price rallies, it gets stuck and it comes back down. When you see something like that, the moment it rallies to 150, it resists and comes down, you short the stock.

You will want to look for stocks with these very repeatable patterns and that’s how you make money from trends.

PRICES IN A CONSOLIDATION

When a stock is on an uptrend, it will be in a consolidation for a while before breaking out to continue the uptrend or it may reverse and break into a downtrend.

The consolidation is a phase where the price is neither moving up nor down, the market is uncertain.

You can see in the chart below that the price is rallying up but the moment it hits the top, sellers rush in and push the price down and the pattern continues.

Hence that can tell you that at that level, there are a lot of sellers waiting to sell and supply exceeds demand and we call that a resistance.

At the same time, the price can’t go down very much because as the price goes down, buyers rush in to push the price up and they do it consistently, telling you that buyers are waiting at that level because subconsciously, they feel that is the cheapest price.

This is why it’s stuck in consolidation.

The general rule of thumb is not to buy when it is in the consolidation phase because it can get stuck there for weeks/months or even years.

You only want to buy when the price breaks out of the consolidation pattern into a new uptrend or break down into a new downtrend.

Finally, you have to understand that there are many types of trends.

TYPES OF TREND

Look at the picture below, if the term is in 5-10 years, it’s a long term uptrend.

There are also higher-highs and higher-lows.

However, in this long term uptrend, there is also medium-term trend which lasts for 6 months to 1 or 2 years.

This is a medium-term downtrend, on a long term uptrend.

If you’re a long-term investor, you can buy the stock anytime as long as it is on a long-term uptrend.

But if you’re a medium-term investor, you will not want to buy during the high points of the medium trend. Because you will see the price going down between 6 months – 2 years!

Of course it will go higher in 5-10 years but you wouldn’t want your money to get stuck and not be able to do anything.

You will only want to buy when it’s on a medium-term uptrend on a long-term uptrend stock.

Now if you’re a short-term trader, you must also look at the short-term trends.

You can see a short-term downtrend on a medium-term uptrend, and you will only want to buy when it is a short-term uptrend on a medium-term uptrend on a long-term uptrend stock.

In other words, all 3 trends must be aligned before buying.

Let’s look at a real example: McDonald’s

In 5 years, it is in a perpetual uptrend.

Within the long-term uptrend, there are medium-term trends, and you can see a medium-term downtrend on a long term up trend.

So, if I am a medium-term investor, I would not want to buy on the downtrend. I only want to buy when the medium trend reverses back up.

And within this medium-term downtrend, you can see a short-term uptrend too.

Could you buy on a short-term uptrend in a medium-term downtrend? Well you could, it’s called a counter-trend trading and it’s riskier.

So, I rather buy on a short-term uptrend during a medium-term uptrend on a long-term uptrend where all 3 trends are aligned.

Remember, at the end of the day, you have to employ different strategies for the different kinds of market trends.