Have you asked yourself, “Is this the right time to buy or am I missing potential profit by selling to early?”
These questions and the decision to trade thereafter plague every trader.
Thats why I want to introduce you to a 100 year old forgotten trading theory that can show you the right time to get into your trades.
This theory became popular in the 1920’s but is all but lost to most traders today.
Seasoned traders and pure beginners will benefit by knowing this simple yet vital method of placing trades, and even you can make a fortune by following these simple principles.
Let me show it to you.
How to read market direction using this theory
Markets, be they equity, commodity and forex markets move in three’s.
The major, or main movement, lasts from one year to several years and the more experienced traders keep an eye on this seven-year main cycle.
The secondary movement, called the medium swing, lasts between a couple of weeks and three months.
Minor movement’s range from hours to a month.
This means that you can identify the direction trend; Either bullish (the market is going up) or bearish (the market is going down).
You identify upward trends where the market makes successive higher highs and higher lows.
Take a look at the chart below and take notice how each major low is higher than the next and that each major high is higher than the previous high
Upward Trending Chart
To identify the downward trend notice where the market makes successive lower lows and lower highs.
Downward Trending Chart
How to know when it’s the right time to buy
Within the upward and downward movements, the markets move in three phases.
The Accumulation Phase starts the bull market with informed investors accumulating when market sentiment in in the ‘doom and gloom’ mode near the end of the downtrend. Prices are attractive and shares have priced in bad news.
This is difficult to identify as most investors think that things will get worse.
The Public Participation phase follows as the negative sentiment diminishes characterised by increased earnings and stronger market data.
Investors get more involved and start to rise in number as conditions improve, this sends prices higher.
This phase is the longest, and this is where technical trend traders like to buy.
During the blowout, also called the Excess Phase, markets move quickly higher on better than expected earnings and peak economic data.
This is where the general trader now feels comfortable to participate.
I call it the time when your hairdresser or barber starts giving you investment advice. Everyone is convinced that the market is heading up for Mars and beyond, buying frenzies occur and valuations go out the window.
The smarter buyers in the first and second phase start selling in anticipation of a downtrend.
Upward Bullish Cycle Chart
How to recognise the right time to sell
The beginning of a bear market starts with the distribution phase.
Informed investors sell into the overbought market. Sentiment remains positive making this phase difficult to identify. Selling pressure increases and is confirmed when a higher high/low fails.
As business conditions worsen, you enter the bear public participation phase.
Technical investors start selling, confirming the market has turned downward.
This phase is similar to the bull phase that lasts the longest.
The panic phase is sometime quick and always brutal. Most buyers in the excess phase will now panic and indiscriminately sell.
When the situation looks the worst and there is no sight to markets recovering, the bull accumulation phase begins repeating the cycle.
The Dow premises you can’t afford to ignore
The market discounts everything
One of Dow’s early premises is that the market discounts everything.
This means that the price right now includes all known information, may they be fundamental, technical, psychological, economic, political and future expectations.
This is not to say that all traders know all the information, giving rise to price movements.
The volume must confirm the trend
An increase in volume traded in an upward trend confirms the continuation of the trend.
Traders are willing to buy the share believing that the direction is upward.
A decrease in volume in the correction period shows that less traders are willing to sell.
The opposite will occur in a downward trending share.
If the volume starts to decrease in an upward trend it’s an indication that the buyers are running out of steam and a reversal to downtrend is imminent.
The trend remains firm until a reversal occurs
This is one of the most difficult disciplines of trading and the most important to being successful.
Seeing the bigger picture and remain in your trade until you see the clear reversal of trend using the rules of change in trend, as defined as lower highs and lower lows or higher highs and higher lows.
Within the primary trend, there can be many small secondary corrections.
These short-term reversals tend to spook investors out of their positions early.
If the primary trend remains intact, you must maintain the position, believe that it’s a short-term correction, and do not pre-empt the trend reversal.
Putting it all together:
The four easy steps to entering a perfect trade
By using the Dow Theory when you first make your investment decisions, your trades will simply be more profitable.
Your first thought has to be, is the market trending upward or downward. Confirm your observation by making sure that an uptrend has higher highs and higher lows and a downtrend has lower highs and lower lows. Make your trades in the direction of the market, never against it.
Confirm that the volume supports the trend.
Determine where you are in the three phases of a trend. This will give you an idea of the potential of the trade. For example, in the accumulation phase of an upward trend you can hold on to the trade for a long period with confidence. In the excess phase, you have to be nimble and prepare yourself for a reversal of trend.
Place your trade with confidence that you are trading in the right direction. Close the trade only when you see a clear reversal.
And there you have it, how a 100-year-old forgotten theory can make you a better trader!
Vunani Private Clients