Welcome back! This lesson is, perhaps, the most important in this course: What makes up a trend? And we’re going ...
Welcome back! This lesson is, perhaps, the most important in this course: What makes up a trend? And we’re going to get to the details in just a little bit. But first I want to go over a really important concept that needs to sink in, for you to be able to take full advantage of Technical Analysis: the idea that in Technical Analysis, everything comes down to Price.
The price of the stock tells you everything. As a technical analyst, we’re not worried about whether a stock is undervalued or overvalued; we’re not worried about whether yesterday’s earnings report for Infosys is fully reflected in today’s price of Infosys. The price, as we know from the Big 3 Tenets of Technical Analysis, takes all relevant information into account.
“Price is King” – and while this might seem like a really basic principle, the implications are incredibly powerful.
We’re going to go back 28 years; that is to 1987. If you’re an investor or a trader, the year 1987 should ring a bell. In finance, October 17th, 1987 is known as “Black Friday”. The Dow Jones Industrial Average – the US equivalent to India’s Sensex and the most watched index in the world, fell a staggering 22% during one trading day.
A monthly chart from July 1987 through January 1988 shows that the crash occurred mid October and caused a sharp fall. From August through October, the Dow rallied from 2400 up to 2700 within 2 months: that’s a 12.5% surge. What’s really interesting, however, is what happens when you do a quick search to try to figure out why and how the crash occurred. It turns out that there is no consensus at all! There’s just so much information from all sorts of theories that have risen – ranging from political events occurring around the world, inflation concerns, the introduction of computerized trading, overvaluation of the markets, to a lack of liquidity in the markets.
Call me crazy, but if the world’s brightest economists can’t figure out why the stock markets crashed 22% during a single day, then perhaps their approach is not perfect. What’s even more interesting, perhaps slightly humorous, is that immediately after the event occurred, 33 of the “most prominent economists in the world” met in the United States. These scholars, who spent the vast majority of their lives dedicated towards trying to not only prevent, but also find answers to situations like this, concluded that the next few years, and I quote, “would be the most troubled years since the 1930s”, when the Great Depression occurred and completely destroyed the American economic system.
It turns out that, contrary to what that panel of economists predicted, the markets flourished – from November 1987 through November 1989, the Dow Jones Industrial Average went up in value by almost 50%.
So why are we bringing up this story from almost three decades ago? Because one savvy trader, Paul Tudor Jones, did the complete opposite of what all the fundamental analysts did: he simply looked at the price charts, saw that a downward trend was imminent, and shorted the market right before the market crashed. It was pure technical analysis, with the basic foundation built upon the idea that the market might be overpriced as a whole. And he went on to make billions of dollars.
For Paul Tudor Jones to have been able to make that trade, he must have been able to see something in the price charts. And, as we’ve mentioned over and over again, technical analysis is all about trends. Let’s go over the different parts of a trend.
If you recall, we covered the three types of trends: uptrends, downtrends, and sideways trends. How do we objectify an uptrend? Using candlesticks, ofcourse.
Take a single candlestick bar, add a second bar to it. When the low of the second bar is higher than than the low of the first bar, this is called ‘breaking the previous bar’s low’. When you have multiple bars breaking the previous bar’s low and creating new highs, you get a ‘rally’. The opposite is a ‘decline’. The meeting point of a rally and a decline is called a ‘swing high’. And when the market turns from a decline to a rally, we witness a ‘swing low’.
Let’s take a step back and think about why a swing high would form. We talked about how trends form when accumulation and distribution occurs; that is, when demand picks up, the markets rally upward, and vice versa when there is an overabundance of supply. Therefore, when you hit the point in time when supply overtakes demand, you hit a peak – this causes a ‘resistance point’, an important indicator in technical analysis, and a swing high gets formed. The opposite is true with swing lows – demand overtakes supply, ‘a support level’ is created, and an ensuing swing low develops.
When a number of bars congregate, the swing high will be the highest point among them all, and it’s identified by the high of the bar (not the close).
Three Kinds of Trends: How to objectively define them?
We’ve briefly gone through the types of trends. For a proper uptrend to form, you need to see consecutive higher swing lows. Downtrends are just the opposite. A downtrend is formed when we notice consecutive lower swing highs.
Check out this example – During the last 7 months of 2014, crude oil prices began a long, arduous fall. Cairn India, which refines crude oil, saw its profits shrink. This naturally got reflected in its stock price – numerous instances of consecutive lower swing highs.
If you recall, at the beginning I mentioned that this lesson is, perhaps, the most important in this course. Do you now realize why? Let’s go back to that infamous 1987 crash, but extend it from January 1987 through the end of 1987 using weekly charts. Now place yourself in August or September of 1987. Are we in an uptrend? Keep that thought in mind. Because if you cannot conclusively answer “yes”, then you would have never been caught up in that mess. Isn’t it amazing how a simple chart can be so powerful?
The next lesson is going to:
• take this concept of breaking apart a trend
• and understanding the different components behind it
• and expand on it by showing you how to build an objective trading system.
If that sounds interesting, then I’ll see you in the next lesson!