By: Chris Rowe — July 24, 2020
Every Million-Dollar Trade Starts Here…
It's impossible to overstate the importance of viewing the financial markets properly.
That's why we place so much importance on shaping your understanding of the physics of the markets (sometimes even more than we do on individual trading ideas).
Unlike the ever-evolving financial markets, education and skill are not moving targets...
The Most Important Factor to Understanding Price Behavior
The world's greatest market technicians say: "The best indicator of future price behavior is current price behavior."
And that begins with a fundamental truth: "The trend is your friend."
When charting stocks, exchange-traded funds, futures, commodities, currencies, or ANYTHING, identifying trend lines is where it all begins.
Trend lines are at the heart of every million-dollar trade idea.
The trend is the direction in which the market is moving. The market’s trends are characterized by a series of zigzags that resemble a series of waves with peaks and troughs. The direction of those peaks and troughs is what signifies a trend.
There are three types of trends:
- Horizontal trends.
An uptrend shows a series of higher peaks (highs) and higher troughs (lows). A downtrend shows a series of lower peaks and lower troughs.
A horizontal trend (aka, a neutral trend) shows horizontal, or equal, peaks and troughs, and reflects a period of indecision. This is also called a consolidation phase.
Stocks or indices trade sideways as the bulls and bears slug it out. Eventually, the previous uptrend or downtrend continues or moves in the opposite direction.
Relationships Among Trends
As you study charts, you’ll find that many different trends can all exist at the same time. Some trends tend to overlap each other. And there are trends within trends within trends.
For example, after identifying a long-term trend, you’ll find intermediate-term trends within it.
Zoom in, and you’ll find short-term trends within the intermediate trends, and so on. In other words...
Every trend is a small part of the next larger trend.
Many investors make a huge mistake by failing to realize how crucial it is to identify the trend appropriate to the time period they’re trading in… as well as the next larger trend.
This "holographic" view of the market is key, because the larger trends have a major impact on the smaller trends within them.
Therefore, whatever trend a trader uses for timing purposes (intermediate, short-term, etc.), he or she must always trade in the direction of the next longer trend.
Say you had to guess what the weather will be like three days from now. Knowing what's happened in the past few days (short-term trend) certainly helps.
But knowing what season you're in (medium-term trend) will easily help just as much. And knowing what part of the world you’re in (long-term trend) helps too.
If it was 55 degrees over the past three days... BUT it's February and you're in Buffalo, NY... you should probably think twice before predicting it'll stay 55 degrees!
Zooming In and Out
You can profit from a security's decline with bearish moves like short-selling a stock or buying a put option.
On the flip side, you can profit from an advance with bullish moves like buying a stock or a call option.
Smart investors will buy a security—or an in-the-money call option on the security—when the market is oversold in an uptrend.
They can sell short a security—or buy an in-the-money put option on the security—when the market is overbought in a downtrend.
Using very simple options strategies, it’s just as easy to profit from stocks or indices that do nothing but trade flat as it is to profit from an increase or decrease in volatility.
Repeating myself is probably even more annoying for me than it is for you. But I can’t stress to you enough how important this is, so I’ll repeat:
When viewing any chart, it pays to zoom in and zoom out:
- Zoom out to identify the direction of the next larger trend, and the next one after that.
- Zoom in to time the best execution on the trades.
Where to Start
The best way to approach the trading process is to start with the long-range charts (with a timeframe of several years)... and then work inward, toward the shorter-term charts (like one-year, six-month, and three-month charts).
It's also helpful to start with monthly and weekly charts for the longer-term view. Then check out the daily chart, which will be the chart you base your trading decision on.
Then, for even-more-precise timing (i.e., finding the best time of the DAY to enter your trade), check out the intraday chart.
Checking the intraday chart is especially useful when trading options. That's because a 2% movement in the stock could mean a 10% difference on the option.
The definitions of the different trends’ timeframes are somewhat fluid. Let’s start with the three basic trends we’ll be focusing on:
- Near-term trend (aka, short-term trend) = Days to weeks...
- Intermediate-term trend = Weeks to months...
- Long-term trend (aka, major trend) = Months to years.
Profit From the Trend
Remember this law of physics: "A body in motion tends to stay in motion... until a force or obstacle impedes or changes that motion."
Experience shows that a similar principle acts on stock prices (by acting on human behavior).
The main benefit of charting is that it lets us identify trends early, and then act on them by trading in the direction of that trend. The idea isn’t to try to anticipate what the market will do next, but instead to simply go with what the market is currently doing.
Your focus should never be on why the market is doing what it’s doing, but on what is occurring. It should be on where prices are in relation to the current trend.
Too many traders try to anticipate or guess what the market’s next direction will be.
But charts show us the market’s current condition. They reveal pictures of bullish or bearish psychology. Inertia does the rest by tending to keep things moving in the current direction.
Human nature doesn't change. This is why, when it comes to charts, history repeats itself. And that’s why the key to coming as close as we can to knowing the future is in understanding where we are in relation to the past.
The investor who can correctly interpret exactly what the market is saying, and act swiftly, will only become more and more comfortable and confident with experience.
Once you've identified all of your trends, your next step is to identify certain key levels on your price charts.
We'll say more about that in another conversation.
Founder, True Market Insiders