Trends and the Technical Trader
Traders in the financial markets can loosely be divided into two groups. In the first group is the trader who relies primarily on fundamental analysis. This type of trader focuses on the fundamentals of a company - Price to Earnings Ratio (P/E ratio), Return on Equity (ROE), Price/Earnings-to-Growth (PEG ratio), Earnings per Share, Growth Rate, etc. - and attempts to ascertain whether or not a company's financial situation, future growth potential, and other considerations warrant investment in that company. Seldom does a trader in this area look at one simple fundamental, such as a company's P/E ratio, as the determination to invest is based on a multitude of criteria. Those that invest based on fundamental analysis are usually bent towards a more long-term investment view. Rarely would a fundamental investor take short-term profits simply because a stock went up after a few weeks.
Some of the richest investors in the world are fundamental investors. Investors like Warren Buffet have made a fortune by determining which companies are undervalued and have excellent growth opportunities, and avoiding companies that are overvalued, mismanaged, and/or simply lack the financial stability or growth opportunities that other companies have.
There is no shame in basing your long-term investing decisions on fundamentals; in fact, it may be foolish to do otherwise. However, there is a second type of trader, the technical trader, who bases their investment decisions on a completely different set of criteria. The fundamental investor determines what position to take when evaluating the security's current price with the other fundamental factors in their evaluation. The technical investor looks at both the current price and past prices to help determine the probability of future-price movement. In this analysis, the technical trader uses a wide variety of technical criteria to help determine what direction a particular security will go in the coming days, weeks, and months.
What is a Trend?
In this article, and in coming months, this newsletter will focus on the technical criteria that trader's use in evaluating whether to buy or short a security. The topic for the first of these articles is easily determined as the first thing almost every technical trader does—to determine whether the security they are looking at has been going up, down, or been moving in a stagnant direction. Perhaps there is no more basic tenet of technical analysis than to determine what direction the security has been going on a short, intermediate, and long-term basis. In technical analysis, the term used to indicate the direction a security has been moving is called the trend. In simple terms, if a security is going up, it is said to be moving in an up-trend; if it has been going down, it is said to be moving in a downtrend.
Standardization of Probability
The reason we care about the direction the security is headed relates to a simple word that you are going to here numerous times in the coming months—probability. When we flip a coin and it comes up heads three times in a row, we would never say that it has been trending heads as we know that a standard coin has a 50 percent probability of coming up heads and a 50 percent probability of coming up tails. This standardization of probability nullifies any "trend" that has developed by flipping the coin. Heads can come up heads 50 times in a row, and it still does not make the probability coming up either heads or tails any more than 50 percent.
The standardization of probability occurs whenever the exact probability of a certain outcome is determinable. This occurs in many areas (one reason Vegas makes a killing on us), but it does not occur in the financial markets. The financial markets are not a game of chance where securities have an equal chance of going up or down on any given day. While there is certainly an element of unpredictability, the technical trader relies on the probability of certain outcomes in determining whether to enter a trade. In simplistic terms, if a security has gone up X amount of days in a row, then it is more probable that it will continue to go up the next day then to go down. On the contrary, if it has gone down X amount of days, then the technical trader realizes the security has a higher probability of going down the next day than up. Naturally, it will eventually reverse course (and there are many technical indicators that can increase the probability of identifying these moments), but until it does, we stick with the probability of what is likely to occur.
The logic behind the probability of trends continuing relate to human action, emotion, and decision making. For example, fear and uncertainty are often the catalyst behind certain downtrends, and push securities well below where they would normally trade. On the contrary, hope, excitement, greed, and exuberance can often be the human emotions behind an uptrend. Whatever the emotion is, the technical trader uses a standard chart to identify the trend a stock has been heading. The chart below is that of an easily identifiable uptrend.
While, from the onset of the first green candle, there are 42 up days and 32 down days, determining a trend of a security is not quite that simple. For technical traders, an uptrend consists of higher pivot highs and higher pivot lows. Don't get hung up on terminology here, as a pivot is simply the high and low points of the candlestick which forms the support and resistance levels of a particular security. Next month's article will focus on pivots, and the concepts of support and resistance.
If you are not an expert at identifying trends, then take the time each day to pull up a few stock charts and identify what the trend has been for the last seven days, the last thirty days, and the last six months. Identify the highs and lows during this time, draw a line (called a trend line) connecting these highs and lows for the time period in question and go from there. In time, identifying trends will be an almost instantaneous reaction to the time frame you are looking at on the chart, and you can start applying additional technical analysis principles - which will not be as simple.