Trying to pick the direction of the market is something every investor grapples with. Especially in times of volatility where constant market noise can really cloud the picture.
There will always be shares that go against the broader trend of the market. However buying shares when the overall market is falling comes with a low probability of success. And trying to pick the general mood of the market just by gut feel isn’t likely to prove reliable either.
Despite all the complicated jargon that gets thrown around, the stock market is no different to any other market. Prices are determined by the interaction between its participants. That is, buyers and sellers — supply and demand.
A bullish sentiment drags more buyers into the market pushing up prices, just as bearish sentiment will send them away again. Trading against this sentiment can be a quick way to part with your money. Even if your decision is based on the best analysis available, the weight of money will be against you.
If you’ve been round the markets a while, there’s a good chance you’ve seen a profitable trade turn against you. Maybe it was profitable at the start, but you then watched it slip below your entry price before selling out in frustration at a loss. I know, I’ve done it.
There are strategies to avoid this. One is running a trailing stop that follows the share price up. The trick is though, that you don’t lower the stop level when the share price falls. Eventually the share price will hit your stop level and get you out of the trade.
It is a bit of a trade-off getting it right. You need to place the trailing stop far enough below the share price to give it enough room to move. After all, you don’t want to get stopped out of the trade from a minor correction within the main trend.
At the same time, you don’t want to put your stop level so far away that you give up a big chunk of your profit before the trailing stop is hit. Looking at the share price’s average true range and adding a margin on top of this is one way to calculate where to put it.
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Another strategy is to draw a trading channel on a price chart. A line that picks up the ‘lows’ on the chart becomes the support line. And a line that picks up the ‘highs’ on the chart becomes the resistance line. If the price falls through the support line, this can become the trigger to exit.
While these are purely price based strategies, there are others you can use to help pick a change in sentiment. Sentiment is important because it will always flow through to price, even if it doesn’t happen immediately. The market usually overshoots in both directions before it realises it’s gone too far.
What you’re trying to avoid is buying just as positive sentiment is flailing, and, selling out just as it gains momentum again. A change in sentiment can also be a powerful way to get in on a trend just as it’s forming.
It’s easy to always just focus on price. After all, this is how a share (or the index) is quoted. However, rather than just using price, another method to help pick a change in sentiment is through volume.
If a company comes out with some good news, you’ll typically see the share price jump. What drives this? A flood of new buyers coming into the market and bidding up the price. As the price rises, more sellers will get flushed out as they look to profit from the share price movement.
The better the news, the bigger the volumes will increase. But it doesn’t just work on the buy side. Any bad news will see a flood of sellers hit the market, pushing share prices down as buyers lower the price at which they’re prepared to buy.
Another way to look at volume is that it shows you the level of interest in a stock — good or bad. While it’s often too late to react after some news has come out, you can still use volume as a way to gauge the flow of money into or out of a stock (or market).
What you are looking for is a change in volume preceding a change in price direction. If a stock goes on a bullish run, a drop in volume could mean that the buyers are becoming exhausted. The market might now have more sellers than buyers — something that could see the price take a fall.
Similarly, if a stock is being sold off, a drop in volume could mean that the selling is exhausted and there are now more buyers than sellers. This might lead to a bounce in the share price as the weight of the selling tapers off.
Another way to check a change in sentiment is through an advance and decline indicator. No prizes for guessing what this does. It measures the ratio of the number of stocks that rose on the day versus those that fell.
As you’d expect, the higher the number of stocks advancing, the more money is likely to be coming into the market. And vice versa. As the advances drop and the number of declines increase, money is seen to be exiting the market. A change in this ratio could mean that the index is about to turn.
It wouldn’t be unusual to see the index climbing at the same time as the number of advancers are declining. All it means is that the market is getting pushed up by fewer stocks. That’s something you need to be careful of.
One thing I want to stress is that just volume or the advance and decline ratio in isolation aren’t enough to base a trade on. What they do, though, is add another piece in the puzzle of trying to work out sentiment — something that goes beyond just looking at price. And this is another tool that can help you decide when to enter or exit a trade.
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