Understanding market trends
Have you ever looked at a stock’s price chart and got noticed the daily ups and downs? Yet, underlying all these daily fluctuations is a certain market trend. This can be seen over a longer period of time.
Nailing this market trend is what technical analysis is about. As a technical investor, you would look at historical price patterns and form an opinion about market trends. Accordingly, you will decide your course of action vis-à-vis a stock. This is why understanding market trends is so important. And that is what this section will be about—what are market trends; application in stock selection; how to identify market trends, and how to analyse them to make profitable investments.
What is market trend?
As we discussed an earlier section, stock prices can be volatile in the short term. They don’t necessarily move in a straight line. However, as you zoom out and look at slightly long-term price patterns, you will discover a better defined market trend.
In general understanding, a trend is the broad upward or downward movement of a stock’s price over time. Upward movement is called an uptrend, while those which move lower over a period of time are said to be in a downtrend. Investors have a tendency of buying stocks that are seemingly in an uptrend and selling the ones in a downtrend.
However, stock prices move in a zig-zag manner. In technical analysis, we don’t identify a trend simply based on how far up or down a stock price has moved over a period of time. We concern ourselves with the specifics--how much the stock rose when it moved up, and how little it fell in a downtrend. In other words, we look at how high the share price touched – the top or how low did it fall – the bottom.
Let us look at some key jargons first. These often repeat in technical analysis :
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Tops or Peaks :
When we hear the word ‘peak’ we think of a mountain. Exactly the same way, if you look at a stock chart, you can see many hills and mountains. The tip is called a peak, even in stock market parlance. Just like the mountain peak is the highest point, the stock price peak or top is the highest price the stock touched.
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Bottoms or troughs :
Turn the mountain upside down and you get a valley or a trough. It is the lowest point on ground. Exactly the same way, stock charts too have a ‘bottom’ or ‘trough’ – the lowest price the stock fell to.
Now, let us look at the three types of market trends :
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Uptrends :
In an uptrend, both the peaks (tops) and troughs (bottoms) of a stock chart keep increasing successively. So, every day or so, the stock price touches a new high and falls lower than it did previously. Don’t be mistake; this need not be a lifetime high. It could be the highest the stock touched in the past few days, weeks or months too. This steady rise in tops and bottoms indicates that the market has a positive sentiment. It expects the stock has a higher chance to appreciate more than depreciate. So, more investors buy, thus driving the price higher. Similarly, each time the stock falls, investors see it as an opportunity to buy even more. They don’t wait for it to fall to the previous level. They buy the stock before that. This arrests the fall.
Let’s suppose a stock has moved as follows over the previous seven weeks—Rs 60, Rs 52, Rs 63, Rs 55, Rs 65, Rs 57 and Rs 69. As we can see, each peak—Rs 60, Rs 64, Rs 65 and Rs 69—is higher than the previous. Similarly, each trough is also higher than the previous. This is a classic uptrend.
In contrast, some uptrends are marked by prices falling more each time and rising less. We will touch upon this later in this segment. Although the stock might still go up, its growth comes at a very high risk for you.
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Downtrends :
A downtrend is a pattern, where a stock is falling constantly. Not only are successive peaks lower, successive troughs are also lower. This means that investors in the market are convinced that the stock will fall further. Each little rise in the stock’s price is used by investors to sell their existing quota of shares. No further buying takes place at these levels. Such a stock must not be bought, no matter how much its price has fallen—especially if you are short-term investor. If you are a long-term investor, you may want to wait until the stock price falls further.
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Sideways/ horizontal trends :
In a sideways trend, a stock doesn’t move notably in either direction during an extended period. Peaks and troughs continue to be constant and there is no significant move to decide whether to buy a stock or not.
Why should you understand market trends
All the best things happen only with patience and determination. Even if this sounds complicated, hold on and implement in your investments.
Understanding market trends is important because it tells you which stocks are expected to move up, and how much risk there is along the way. If you sell before the price hits its peak, you may lose out on good profits. Similarly, if you buy before the price falls to its lowest point, then you may make less profit when you finally sell it.
How to identify market trends
We have already described the different kinds of market trends. Now, let’s see how to identify market trends with the help of an example.
Suppose the price of a hypothetical stock at the end of each of the previous six weeks was Rs 35, Rs 38, Rs 27, Rs 40, Rs 24 and Rs 41. The price chart of such a stock would look something like this:
If you look closely, you will discover that every time the stock falls, it falls by a greater percentage than it did on the previous occasion. Each of the three troughs of the stock chart—Rs 35, Rs 27 and Rs 24 are successively lower than the previous. Similarly, every time the price rises, it rises less than before. Notice how gradual the increase from Rs 38 to Rs 40 and then to Rs 41 is.
A first-hand observation would suggest that the stock has done well because it has appreciated from Rs 35 to Rs 41. However, a closer look will reveal that the quality of the appreciation has been low.
In this case, the stock has only appreciated by about 17% overall. However, along the way, it has fallen by as much as 40% on one instance. Why would somebody risky such a big loss for such a mediocre return? This is why understanding market trends is important.
An analysis of market trends in this way is referred to as trend analysis. A key aspect of technical analysis is a ‘trendline’.
Here’s a look:
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Trendlines :
In order to perform effective technical analysis, it is critical for you to understand what is a trendline. A trendline is a line that connects all the troughs or all the peaks in a stock chart with each other. A trendline that connects the peaks helps you chart the growth that a stock has displayed over a period.
A trendline that connects the troughs helps you track the risks inherent in the stock. You may even use a combination of the two trendlines to see the general trend of a stock’s price over a specific period of time. The combination of two trendlines is called a channel. We will take a closer look at trendlines in another section, later.
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Market value may not approach intrinsic value sometimes :
Investors have different risk appetites and return expectations. By understanding stock market trends, they can align their portfolios to these requirements. For example, if you are investing for your retirement, you may want to invest in safe stocks, for the long term. You would invest in stocks that offer reasonable growth without seeing sharp price falls. By performing technical analysis of stock trends, you would be able to pick moderately upward-trending stocks, with upward-trending troughs.
On the contrary, if you are a relatively young investor, your preferences might be different. You would probably be able to take a bit more risk. Consequently, you would use your understanding of market trends to pick stocks that have shown a massive increase in peaks. In return for this, you may be able to accept a small decrease in troughs.
What next?
In the next section, we will discuss market trends further. We will look at the different types of market trends and discuss their importance to stock selection. click here.
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