How to identify stock market trends
The basics of making money on the stock market is to buy at a certain price in order to sell for more and make a profit. To do so, one can buy at a low price, confident that it will increase, or short sell in order to buy again at a lower price... In any case, the aim is obviously to make money.
To guide their decision-making process, traders and investors have to identify the stock market’s overall direction and price trend in order to make the best decisions according to their strategy. If prices are likely to increase, it may be a good idea to buy. If prices are likely to go down, it might be best to steer clear for a while. So, when wanting to make money, market trends should be any trader’s focal point. Trend trading is and always has been the most popular approach to trading. Even "swing traders" factor stock market trends into their market analysis.
There are three basic approaches to determining and measuring a market’s trend, which we will outline below.
A discretionary analysis involves looking at a chart and observing whether the market appears to be going up or down. The general direction of a market may appear obvious at a glance and may not require further analysis.
The issue with this approach is that it relies on a subjective and fairly simplistic perception of trends. Without an objective method, it is virtually impossible to build a rule-based trading method, making the whole process highly subjective. Unless your method is objective and based on specific criteria, you will not be able to test it accurately over time and determine whether or not your strategy is viable.
Higher highs and higher lows
A very popular approach to identifying an upward trend is to observe ascending peaks and troughs on a market price chart – this is what we call higher highs and higher lows. On the other hand, a downtrend can be identified when a price pattern shows lower highs and lows.
Bullish trend on the Apple stock:
Trends usually take place over the long term. However, as we have mentioned in previous articles, it is very important to identify the time frame within which one wishes to trade.
For instance, a trend can be bullish in the short term and bearish in the long term. Whether a trader is looking to make money over the next few weeks or the next few years, the same chart will lead to radically different decisions.
This is where a discretionary analysis falls short, for instance, because looking at trends requires taking into account various factors which can otherwise be misleading. Therefore, any trader must be very clear with the time frame they wish to operate within: days, weeks, months, or years.
Generally speaking, and for the purpose of this article, we refer to market trends as an evolution over at least several months. Other time frames can be specified as short-, medium- or long-term trends.
Simple moving averages
Moving averages from different time periods have long been used as trend-following indicators.
This basic technique of graphical and technical analysis boils down to these principles:
- When the market price is above a moving average, the trend is bullish
- When prices are below a moving average, the trend is bearish
New traders are often fond of short-term moving averages because they follow prices more closely. While they can be useful, a short-term moving average is not the most suitable way of measuring trends because these are more of a long-term evolution.
The 50-day simple moving average and the 200-day moving average are two of the most commonly used moving averages. For this reason, they are usually "self-fulfilling prophecies”, as a substantial number of traders observe these results and make decisions accordingly.
Therefore, it is worth including these two moving averages on all of your charts. While the 200-day moving average may be too slow a trend indicator to your liking, it can be very useful for support and resistance levels. The 50-day moving average will be more popular with those who wish to measure trends on a shorter term.
Downward trend on the Zoom stock:
Let’s take a practical example with the Zoom stock trend charted above; the 50-day moving average is in purple and 200-day moving average in green.
In November 2021, the market dips below the purple average at a price of $440. In March 2021, the market dips further below, crossing the green average at a price of $350.
Therefore, selling against the 50-day average appears to be the better choice. However, the market briefly crosses above the moving average in February 2021. For traders with a short-term strategy, it would have been necessary to close the short position.
The key takeaways here are that:
- The 200-day moving average provides a stronger signal and with less volatility
- However, stock market trends can sometimes change very quickly and abruptly
Finding optimal entry and exit points is never easy, but that is what the whole game of trading or investing is about!
Last Update on 07/04/21