In last week’s MarketPulse we explored one of the oldest debates in the markets: Fundamental analysis versus technical analysis. We discussed that the major difference between the two was fundamental analysis is the study of value, whilst technical analysis is the study of price. In previous MarketPulse articles we have discussed that the two (value and price) can often diverge quite significantly. When this happens, technical analysts have a distinct advantage over fundamental analysts. In this article we will explain the nature of trends and how technical analysts use trends to their advantage.
Why might price and value diverge? Well, unlike what many academics (who have probably never traded a share in their lives!) postulate, markets are far from rational creatures. If recent market gyrations have taught us anything, it’s that prices can move much further than investors’ opinions of correct value – both to the upside and to the downside. Instead of a random walk, prices tend to trend. It is this considerable movement of prices in one direction for an extended period of time which can transform the best-laid fundamental plans into sure-fire loss making enterprises.
Fundamental analysts tend to place a greater importance on their perceived value of a security, and far less importance on the trend of the price in that security. They believe that despite the prevailing trend in prices, their fundamental view of the value of that security will hold sound.
If the price of a security they own is falling, and they believe it is valued significantly more than the market is willing to give them, they will prefer to hold that security until the market ‘comes to its senses’ and revalues it back to the correct price. If the fundamental analyst owns a security which no longer represents significant value, they will sell that security despite a strong uptrend. In this case they believe the ‘crazy overzealous investors’ who pushed the price up to unsustainable levels will eventually see the error of their ways and dump the security, forcing prices back to a more reasonable level.
This flawed strategy means that most fundamental analysts tend to hold on for too long in downtrends and sell too early in uptrends. This forces them to ride their losses and cut their profits short. As we all know, this is the exact opposite of what good investing is all about: riding your profits and cutting your losses short.
The irony of this is that trends are generally easy to spot – they manifest themselves as rhythmic, persistent price movements in a specific direction. There are 3 types of trends:
Short-term trends, which typically last from a few days to a few weeks;
Medium-term trends, which typically last from a few weeks to a few months;
Long–term, or primary, trends, which typically last from a few months to over one year.
In each case, there are different phases of a trend which a trader will need to identify.
This phase of a trend is characterised by pervasive price movement in a certain direction. When the market is trending higher we say that it is in a bull trend and when it is trending lower we say that it is in a bear trend.
The market is made up of buyers and sellers. When one party is keener than the other to transact they will cross the spread to transact with the other party and price will move. This is when the market is in disequilibrium and therefore in motion. This is the best time for traders to be in the market, always trading in the direction of the trend.
When the desire of the party who has control over the trend wanes, or the opposing party to the prevailing trend increases their activities, the market tends to move back into equilibrium. Each party appears to be content with the price level and how many securities and how much money they have. Another term used to describe a trend contraction is a “consolidation”.
Consolidations in uptrends are called “accumulation” and consolidations in downtrends are called “distribution”. Trends may either continue out of a contraction or reverse direction. More often than not, the trend will continue in the direction it was travelling before the contraction. This is known as a “continuation”. Contractions often present trading opportunities given recommencement of the trend often occurs with a rapid price movement otherwise known as a “breakout”.
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Climax phase (reversal phase)
Trends will reverse when the desire of buyers to continue to transact at increasingly higher prices (for bull trends) and the desire of sellers to continue to transact at increasingly lower prices (for bear trends) collapses. Price can then move rapidly in other direction as the buying or selling power of each party respectively is exhausted, providing little resistance to the counter-move.
The trend is your friend, even if it bends
As with all trends however, the technical analyst knows that one can’t ever say exactly when a trend will come to an end. One will only know after the fact that a trend has ended. Therefore, the best technical analysts accept the fact that they will on occasion buy just before the end of a great uptrend, and also, potentially sell short just before the end of a great downtrend. They accept that these trades will end in losses.
Note however that the best technical traders do not fear such losses. Rather they embrace them as part and parcel of their overall trading approach. Losses are inevitable in trading. The technical trader rests assured that trends do exist, and that by trading in the direction of the trend for as long as possible, they will earn the greatest return from the markets.