Hi guys, welcome back to our stock trading class.
In this chapter, we will introduce a technical method that helps to improve your trading skills in the stock market.
Have you ever come across the following scenario?
You buy a stock at $20, and it soon hits a new all-time high at $25. Now you are confident about securing greater gains, and that makes you continue to hold the positions.
Suddenly, the stock price drops to $21, and you lose most of your gains. You start to panic but still manage to persuade yourself to hold until the next rebound. When the price finally rebounds to $25, you sell the stock in fear of the price falling again.
Guess what happens next?
The stock skyrockets to $50 right after you sell it.
The good news is you're not alone. Many investors tend to sell profitable positions too early out of fear that their potential gains will evaporate quickly.
Actually, there's an old saying in trading which goes: "let your profits run." This is an expression that encourages investors to resist the impulse to sell profitable positions too early.
To do that, you need to identify the market trend.
The market trend is just like the changing weather. It's warm in spring and summer, where everything is flourishing. But when it turns to autumn and winter, the temperature drops down, leaves fall off the trees, and plants start to wither.
Market trend changes are very similar to weather changes. When the stock market is in an uptrend, investors are optimistic about the stock market because the expectation is that stocks will also see an uptrend.
This is what we call a bull market.
When the stock market is in a downtrend, even the best stock could witness a decline, and pessimism will be widespread in the market.
This is what we call a bear market.
If we look at the US stock market in the past seven decades, we will find that it is composed of bulls and bears.
For example, the dot-com boom in the 90s represents a typical bull market. From 1995 to March 2000, the Nasdaq Composite Index rose by more than 400% at its peak. However, the tech bubble burst in 2000, which was followed by a bear market that lasted for several years. The index fell more than 70% from its peak by October 2002.
The famous trend trader Ed Seykota once said: "The trend is your friend, except at the end when it bends." This explains why identifying the market trend is so important. By following the trend, a trader could make better buying and selling decisions.
To identify the market trends, there are two handy technical indicators, i.e. Price Action and Moving Average.
Price action is the movement of a security's price plotted over time. As a stock moves up and down, a series of highs and lows will be formed.
If the highs get higher and the lows get higher, the stock is in an uptrend. Conversely, if the highs get lower and the lows get lower, the stock is in a downtrend.
Another way to identify the market trend is using moving average. Moving average is a line showing the average stock prices over a given period. If the stock price is always trading above the line, the stock is in an uptrend. Similarly, if the stock price is trading below the line, this represents a downtrend.
The time frame of a moving average can be set freely.
For example, a 5-day moving average shows the average of the closing prices in the past five days. A 20-day moving average shows an average of the closing prices in the past 20 days. A 5-day or 20-day MA presents a good picture of short-term trends. If you'd like to identify long-term trends, other time frames can also be set, such as the 60-day or 120-day MA.
To sum up,
it is important to follow market trends, which can be identified using the two indicators we introduced: Price Action and Moving Average.
Congratulations on gaining a further understanding of stock trading!
Stay with us, and we will introduce some other useful strategies for beginners in the next chapter.