In this article, we will dive a little deeper to understand different investing concepts and terms. My goal is that, by the end of this article, you will be able to understand how I look at the market cycle, train your eyes with some examples, and discuss how it can affect our investing/trading decisions.
Concepts
1. There are different types of investors/traders
- Fundamentalists. Those that only focus on the company’s fundamentals like earnings, sales, margins, Price to Earnings ratio, book value, etc without looking at the stock charts. The chart has no value when it comes to their decisions. The company’s balance sheet is what matters.
- Technicians. Those that only focus on the stock charts without caring much about the company’s fundamentals.
- Techno-Fundamentalists. Not a very popular/known term. But this is pretty much where my investment style falls. I only buy stocks that have very strong fundamentals. But base my buy and sell decisions on the charts.
There is no good or bad investment style and this is really the beauty of investing. There is a style that suits your goals, timeframe, and emotional strengths/weaknesses. Know yourself and pick what works for you. It might take some time and some trial and error. But eventually, you will figure it out.
2. Trend
The stock market doesn’t always move up or down. It zig-zags. And this is exactly what creates a “trend”. As investors/traders, we need to understand what a trend is and be able to eventually identify it.
Uptrend
It is a series of higher highs and higher lows (HH and HL)
Downtrend
It is a series of lower highs and lower lows (LH and LL)
As an investor, what do I gain from learning how to identify the trend? Simply speaking, I want to be involved in the markets as long as we are in an uptrend and sidestep the market (be in cash) whenever the market is in a downtrend.
3. Moving Averages
The moving average (MA) is a simple technical analysis tool that smooths out price data by creating a constantly updated average price (I borrowed this definition from Investopedia).
Simply speaking, MA is just a line on the chart that calculates the price over a certain period and draws a smooth line to show it. The period is adjustable, it can be 9, 21, 50, 200 (minutes, days, weeks, months, etc), or whatever you like.
For the purpose of this article, we will be using only the 9 and 21 ema (exponential moving average).
Below is a daily chart for Apple. See how the blue and yellow Moving Averages track the price.
Market Cycle
In this section, we will utilize some of the concepts above to be able to understand how the market or a stock moves.
What is the importance of understanding the market cycle?
- Protect investments against vicious declines and market turns.
- Ability to keep the winning stocks running for as long as possible and not exit too early as well as exit (cut losses) when an investment is not behaving as expected. Ride Your Winners & Cut Your Losers.
- General understanding of the psychology of buyers and sellers and what is occurring at a certain point of time.
“Gaining Money Is An Action, Maintaining Money Is A Behaviour”
Unknown
There are tons of resources talking about the general market cycles, but the concept that I use here was explained to me and published by my good friend Oliver Kell, who won the US Investing Championship in 2020 by generating a 941% return in 1 year.
Generally, a stock, or the market in general, will move in the following steps represented in the 2020 TSLA chart shown below.
Follow this buying and selling story sequence with me.
1–Exhaustion Extension: After a certain stock/market goes up in price, eventually the move will exhaust and the stock will experience an extension move that would signal it is time for a move downwards. This is normally accompanied by a wide space between the price and the 9 & 21 moving averages.
2-Wedge Drop: The battle between buyers and sellers gets extended, but remember from the last move (Exhaustion Extension) that buyers have exhausted their buying power. This is when a wedge drop occurs signaling that the sellers are in control for now and pushing the price below the 9 & 21 moving averages.
3-EMA Crossback: Buyers will try to gain control again against sellers and they will manage to run the price up to the 9 & 21 moving averages.
4-Reversal Extension: In the above stage buyers were still exhausted so sellers take over and they push the price down hard to what exactly is the opposite of the Exhaustion Extension. Here, sellers ran out of power.
5-Wedge Pop: The opposite of the Wedge Drop. The buyers/sellers battle continues, but this time, the buyers are in control and they push the price higher. See price jumps above the 9-day & 21-day moving averages.
6-EMA Crossback: Sellers try to gain control that they push back the price to the moving averages.
7-Base and Break: Here, buyers take back control, they keep pushing the price up, but in a stair-stepping behavior. The price goes sideways (bases) where the buyers and sellers get into equilibrium. Then, buyers push the price upwards outside the base.
It is important to note that on the way up or down, there can be several “bases and breaks” until one side (buyer or sellers) gain full control.
Previous Winners
I totally understand that the above concepts might be a bit too much and can get confusing. In this section, I will put some charts showing some of the past winners with the above market cycle steps applied.
In the stock market, and when reading charts, there is absolutely nothing better than spending extra time and effort to practice. Go over charts, study cycles, and understand what caused certain moves.
Current Market as of October 28th, 2022
Since we have been in a vicious bear market (down trending) since the beginning of the year, it can possibly be wise to study the price cycle the of S&P500 (The largest 500 companies listed by market cap) so far. It is not clear yet if the actual reversal extension is in or not. We will see!
Remember, investing is about risk management and making the most money when you are right and losing the least when you are not. It is not a prediction business, but rather an interpretation one.
