Dubai: A not-so-well-known fact of investing, be it in cryptocurrencies, gold, currencies, or any other asset, is investors use upward and downward movements of the market to decide whether to buy or sell shares. But how do they make sense of such movements? Here’s all you need to know.
It’s not merely the movement alone that market traders look at – it’s the patterns that arise, alongside the deductions or forecasts that one is able to make looking at such trends – that’s the money-making skill that people look to perfect. Let’s look at how one can make such decisions.
What is a trend?
There is a specified duration for a movement to be considered a trend, however, the longer the trend moves (either upward or downward), the more noteworthy the trend becomes.
Holding onto the asset for a longer period of the trend aids buyers in earning good returns, rather than sellers as soon as they see an upward trend for a short period.
How do I identify market trends?
Markets are made up of several different kinds of trends, and it is the recognition of these trends that will largely determine the success or failure of your long and short-term investing.
Simply put, short-, intermediate- and long-term trends are the three kinds of trends that we see each day when studying market trends.
“One way to try and identify trends is by looking at averages,” explained Brody Dunn, an investment manager at a UAE-based asset advisory firm.
What are market averages, how to interpret them?
A market average is computed by adding up the prices and dividing it by the number of asset units like shares, for example. It is represented by a line connecting all the mean price points in a market chart.
The market average simplifies price data by smoothing it out and creating one flowing line (as indicated in the two images below). This makes seeing the trend easier to spot. It is a widely used indicator that smooths out price trends by filtering out the noise from random short-term price fluctuations
As a general guideline, if the price is above a moving average, the trend is up. If the price is below a moving average, the trend is down.
Understanding averages, psychology of markets
Market averages or trend lines can act as ‘support’ or ‘resistance’. This is because the average acts like a floor (support), so the price bounces up off of it. In a downtrend, a moving average may act as resistance; like a ceiling, the price hits the level and then starts to drop again.
“Given the understanding that the psychology of the markets actually moves the markets, we can acknowledge that psychology develops and ends the trends we are going to look at today,” said Dunn.
“Most investors, once invested in an uptrend, will stay there looking for any weakness in the ride up, which is the indicator needed to jump off and take the profit.” This is what is referred to as ‘market psychology’, which simply describes the overall sentiment steering market trends and prices.
How do trends work? How can I benefit?
An upward trend or ‘uptrend’ is marked by an overall increase in price. Nothing moves straight up for long, so there will always be oscillations, but the overall direction needs to be higher in order for it to be considered an uptrend.
Image Credit: Sabrina Jiang / Investopedia
Recent swing lows should be above prior swing lows, and the same goes for swing highs. Once this structure starts to break down, the uptrend could be losing steam or reversing into a downtrend. Downtrends are composed of lower swing lows and lower swing highs.
“While the trend is up, traders may assume it will continue until there is evidence that points to the contrary,” Dunn added. “Such evidence could include lower swing lows or highs.”
What do investors do when markets go up?
While the trend is up, investors or traders focus on buying, attempting to profit from a continued price rise. When the trend turns down, traders focus more on selling or shorting, which is essentially attempting to minimise losses or profit from the price decline.
“Most (not all) downtrends do reverse at some point, so as the price continues to decline, more traders begin to see the price as a bargain and step in to buy,” Dunn added. “This could lead to the emergence of an uptrend again.”
Trends may also be used by investors who are focused on changes in revenue, earnings, or other business or economic metrics. For example, analysts may look for trends in earnings and revenue growth.
Image Credit: Sabrina Jiang / Investopedia
What if there is no such trend? What to make of it?
If earnings have grown for the past four quarters, this represents a positive trend. However, if earnings have declined for the past four quarters, it represents a negative trend.
The lack of a trend, which is a period of time where there is little overall upward or downward progress, is called a ‘range’ or ‘trendless’ period.
Often times over any trendless period, the value of your holding positions often deteriorates (in your favor), and your returns often remains flat.
Key takeaways
Simply put, as the price moves lower, it starts to attract buyers interested in the lower price. Similarly, when the price moves higher, it attracts sellers looking to sell at a profit.
In order to understand trends, understanding market averages, otherwise known as trend lines, are vital. When the price is moving upward or downward, so is the market average or trend line, albeit with a lag. After a price turning point, the price crosses the moving average line.
If the recent prices move above the trend line, as indicated in the images, buyers buy, else if prices move below the trend line, sellers sell. This is why it is a good indicator as to when to buy or sell any investment asset by simply drawing a market average line and identifying the trend.
However, tracking such trend lines or market averages are not a completely sound science. “Such averages work quite well in definite trending conditions but poorly in choppy or range-bound conditions,” said Dunn.
“Adjusting the time frame can remedy this problem temporarily, though at some point, these issues are likely to occur regardless of the time frame chosen for the average(s) or trend lines.”
