Option Investor

Stock Buying Basics: Trend Reversals

Printer friendly version

Analysts use many different technical indicators to generate signals when specific buy or sell parameters are met. Cycle analysis; the study of repetitive rhythms in price action, can also be helpful in initiating technical trades.

The stock market historically moves in identifiable cycles. To be a successful investor, you must be able to determine the current phase of activity. Historical bottoms or cyclic lows are the most common signals that analysts attempt to uncover. These downside support areas are more reliable and take longer to develop than the cyclic highs. Using a long-term, monthly chart of the DOW, it is relatively easy to spot the current rhythm. The most recent bottoms occurred in 1990, 1994, 1998 and 2002-2003. The big question is: "When will the next upward cycle begin?"

When using long-term technical analysis, it is critical to understand that market cycles usually precede economic cycles. The many facets of our economy that determine the overall financial health of the nation are anticipated by the emotion of the market. Any study that compares key historical events with the movement of a major index will demonstrate how war, recession, or a presidential election can influence the current cycle.

It is very important to be familiar with the common investment indicators used to determine the overall movement of the market and apply this knowledge as a practical part of your trading strategy. Here are some timing strategies that work well with cycle analysis.

KEY REVERSALS: A daily price range with a high that is above the previous day's high and a low that is below the previous day's low. This is often referred to as a "outside trading range" day. Most analysts agree that a close above previous day's final price is a bullish signal. If this type of price action occurs during a bottom in the cycle, a reversal is likely in progress.

DIVERGENCE: Buy and sell signals are often developed using oscillators such as RSI, MACD, Stochastic, and other types of momentum indicators. Divergence signals often occur at cyclic turning points. An example might be when an issue makes a substantial move then has a small short-term reaction, which is followed by a new low or high for the trend. The last price appears to perpetuate the overall trend but the actual outcome is often a major reversal.

CHANNELS: These patterns, including multiple bottoms and tops, define markets that are established in trading ranges. They can make it easier to observe rhythms and establish opening prices more effectively. For example, a bullish trading signal will be apparent when an issue breaks-out above the high of a recent channel while a cyclic low is occurring.

There are many other useful indicators and the successful trader will strive to learn to utilize every available tool and resource to gain an accurate sense of the current market cycle.

Covered Call System Newsletter Archives