Introduction
I had my money, I had my friends, and I asked them for advice. I traded stocks based on their suggestions. At first, I lost money, and eventually, I lost my friends. There are no free lunches in life. Similarly, stock markets don’t offer easy gains. While seeking help from others can be valuable, it’s crucial to understand the game for yourself. Markets are like car racing. Can you picture yourself driving a fast car while texting your friends for advice? You would crash quickly. It’s the same with markets. You need to equip yourself. As the saying goes, heaven helps those who help themselves. Wisdom suggests you should learn before you earn. Prepare yourself to be market-ready. You must know the game and its rules before playing.In this chapter, we will explore different types of market movements and their general phases. We will also consider various market participants whose actions lead to these phases and movements. Additionally, we will gain insight into the workings of economic and business cycles. After covering these basics, we will introduce you to the first tool in our toolkit: moving averages.
Market Basics
The Two Kinds of Markets Stock markets don’t always move as expected, just like our partners! We should be thankful for their training in handling life’s ups and downs. This experience helps us manage surprises and shocks. In short, dealing with volatility is a part of daily life, just as it is for stock market traders. Although each market day is unique, we can broadly categorize market movements into two common types: 1. Trending markets 2. Ranging or range-bound markets Understanding this basic classification is important. It will greatly assist you in navigating the market landscape. Markets are not random; their movements follow a pattern. Let’s explore how.Trending Markets Trending markets feature prices that consistently move in one direction over a significant period. When prices continue to rise, we call it an uptrend; when they keep falling, it’s known as a downtrend. In an uptrend, prices behave such that every high is higher than the previous high, and each low is also higher than the last low. In a downtrend, prices create both lower highs and lower lows. Yes, there are pauses in between the successively higher or lower levels. There are also periods of retracements, which are temporary price movements that go against the trend. Retracements may consist of minor dips or deeper corrections, but the trend continues as long as these pullbacks remain limited. The price will resume its original direction as soon as the pullback finds support in an uptrend or resistance in a downtrend. All market participants appreciate trending markets. Trending phases offer traders great opportunities to make money. It’s up to the trader to capitalize on a trend as long as it persists.For day traders, staying with a trend might mean holding a position for most of the day. This should only be done when the charts indicate strong signs of a trend day. It goes without saying that if the situation begins to turn against the trader, they should not stick around too long. Always remember that flexibility is essential for survival. On the other hand, if everything seems to be in your favor, there’s no need to rush your exit. Most traders underestimate how strong moves can exceed targets and yield unexpected gains. You don’t want to regret leaving the market too soon, so plan and develop clear strategies for all situations in advance. Stay logical, alert, and attentive to changes. This brings to mind a story. Some of you may have heard of Victoria’s Secret, the high-end lingerie brand. A Stanford MBA named Roy Raymond wanted to buy his wife some lingerie but felt embarrassed shopping for it at a department store. He recognized a gap in the market and envisioned a classy store where shopping for underwear wouldn’t feel awkward. He borrowed money from his in-laws and a bank and opened a stylish store called Victoria’s Secret with around USD 80,000. The store generated half a million USD in sales its first year. Raymond then launched a catalog, opened five more stores, and began to grow rapidly. Although he faced business challenges, most things were falling into place, and he was thriving. However, he didn’t stick with it even when the situation was favorable. He soon sold the business to Leslie Wexner for one million dollars. He lived happily ever after, right? Wrong. Two years later, the company was worth USD 500 million. Oops! Roy Raymond must have felt like jumping off the Golden Gate Bridge.Ranging or Range-Bound Markets Ranging markets are those where stock prices or indices form successive highs and lows at nearly the same level, unlike trending markets where there are consistent increases or decreases. The price movement in a ranging market typically creates two horizontal boundaries at some distance apart. The price fluctuates within these boundaries without making directional moves. You can identify this more clearly after observing at least two equal highs or two equal lows. There may be failed attempts to break out of the boundaries. When these breakouts don’t follow through, prices return inside the range and move toward the other end. Such failed breakout attempts provide trading opportunities toward the opposite end of the range. This represents a consolidation phase for market movement. It’s a time when the market rests and builds strength before making another leap. Sometimes, if the range is wide enough, traders might take positions within it. When the price finds support at the lower end, it moves toward the upper end, and vice versa. Traders often enter long positions at the bottom of the range with a target near the top or go short at the top of the range with a target near the bottom. Essentially, we trade against the boundaries, which is commonly known as fade trading. Trading in a ranging market requires specific tactics and isn’t easy unless you’re very good at timing your moves accurately. There are times when the range may be too narrow to trade. It’s usually best to stay on the sidelines during such periods.
Market Participants and Their Behavior Markets are shaped by the actions of their participants. It’s the buying and selling activity, or the lack of it, that determines the charts you see on your screen. Participants, whether buyers or sellers, can be grouped into two main types. Understanding these groups is crucial. It’s their behavior that reveals what you can expect from the market. By identifying the participants active at any moment, you can better anticipate outcomes and trade accordingly. Let’s refer to the first type as reactive players and the second type as active players. The Reactive Players Reactive market players buy or sell a stock when they believe its current market price is significantly above or below its fair value. They will purchase a stock if they think its market price is lower than its fair value. Conversely, they are willing to sell when they believe the market price is too high. Their actions push the price toward what they perceive as fair value. If they think a stock is overpriced, they will hold off on buying until the price drops. Similarly, sellers will only sell when the price rises to their perceived selling level. They react to the market conditions around them.If you analyze this behavior closely, you will notice that investors have a set valuation for a stock in mind. Their actions aim to keep the stock price near those valuation levels. This behavior stabilizes stock prices and, by extension, the overall market within a typical range. This range acts as a sort of equilibrium for the stock and the broader market. These conditions are known as trading or ranged markets. The range represents the area between the highest and lowest prices, defined by the movement of price within these boundaries. For example, the previous day’s range includes its high and low.Additionally, because reactive players generally have a shorter-term focus, they are reluctant to assign higher or lower valuations to the stock under consideration. Therefore, they do not engage in strong buying or selling that could push prices beyond this range. This situation leads to range-bound markets. If the price drops to the lower end of the range, buyers will step in, driving prices higher. If the price rises to the upper end of the range, sellers will enter, pushing prices down. These moves are typically limited and do not break out of the defined range. The market or the stock continues to fluctuate within these boundary levels. The Active Players It takes knowledgeable participants to move markets. Active players believe that a stock’s price can and should be either higher or lower than the equilibrium range set by reactive players. When these buyers or sellers enter the market with confidence in their price beliefs, they are willing to buy above the upper boundary or sell below the lower boundary. When this occurs with enough strength and volume, prices break out or break down from the established range. Active players are willing to buy at higher prices and sell at lower prices, believing that prices will trend further in their chosen direction. Their actions and strong convictions drive the prices away from the established norms. This can prompt more participants to get involved, as they realize they might miss out if they wait for a return to the previous range. The resulting participation can further push prices out of the equilibrium zone. This is how trends begin. The market shifts from trading conditions to trending conditions. The Two Market Phases Expansion Phase A market or stock is in an expansion phase when its price trends in one direction, and the daily range is relatively wide. These movements are driven by active participants who enter with strong conviction, willing to push the price to new highs or new lows. They may buy at higher prices if they expect even greater increases. Likewise, they may sell at lower prices if they anticipate further declines in the near future. If the price highs and lows stay within a clear band or between two parallel lines, this price band will slope either upwards or downwards, reflecting the trend direction. In these situations, strong momentum supports the clear sense of direction. Active participants are responsible for these moves, as their aggressive trading takes prices far from the mean value. Trading effectively in these markets requires specific techniques, which you must master to trade profitably. You can gain good returns by sticking with the trend until it ends, taking trades in the direction of the trend during price or time corrections. Expansion phases and trending moves work hand in hand. Contraction Phase A market is in a contraction phase when prices fluctuate within a narrow range. This phase is influenced by reactive participants who lack the confidence to push prices beyond a certain level, either up or down. Prices remain close to the mean value as perceived by these participants.There is a noticeable lack of conviction, with market players hesitant to pay more than their perceived price for purchases. They are also unwilling to sell at lower prices. As a result, price movements are limited until the range is broken or lowered. Supply pressure exists at the upper end and demand pressure at the lower end, but neither is enough to push prices outside the defined band. The markets keep switching between contraction and expansion phases. A contraction phase often accompanies a ranging market. Typically, contraction is followed by expansion, which can then lead back to another contraction. This pattern is normal. It allows the market to pause after a trending move before making another significant shift, whether in the same or opposite direction.
**Economy, Business Cycle, and Sector Rotation**
Stock markets respond to changes in economic activity and how these changes might affect stock prices. Investor sentiment surrounding expected economic and business developments drives the markets. This is why we say that markets anticipate the future. Positive expectations of economic growth lift markets, while fears of contraction lead to decreases in stock prices. Both the markets and the economy are in constant fluctuation and rarely reach equilibrium. The economy consists of many sectors or businesses. As the economy cycles between contraction and expansion, so do the business cycles in various sectors that make up the larger economy. The business cycle is a series of events that repeat over time, creating alternating peaks and troughs.This economic contraction and expansion is significantly influenced by interest rate cycles. Changes in interest rates affect different industries and sectors at various stages. The Reserve Bank of India adjusts interest rates to manage inflation. Thus, based on inflation levels, interest rates rise or fall. The economic activity across sectors either increases or decreases as rates change. When interest rates go up to control inflation, economic activity decreases along with lower inflation. Conversely, cutting interest rates can stimulate business activities. During economic expansion, businesses often create too much production capacity, expecting higher future sales. This excess capacity can become wasted when sales stabilize or decline. Expansion of business capacity is then unlikely until the excess inventory is cleared. This situation results in prolonged periods of low capital spending. The fluctuating levels of economic activity create varying cycles across different industry sectors, all of which may operate in different cycles simultaneously.At the beginning of an economic cycle, interest rates are typically lowered to stimulate business activity, particularly impacting rate-sensitive sectors. As a result, sectors like housing and automotive see an initial uptick, along with other consumer-driven areas. The idle capacities of these companies begin to be utilized as their sales recover. Generally, businesses do not require capacity expansion at this stage, leading to stagnant capital expenditure. Initially, sectors like capital goods and commodities may struggle. As the business cycle continues to improve, these sectors will gradually expand, which will eventually increase demand for capital goods and commodity sectors. By this time, the sectors that had been performing well may have already peaked. New sectors then take over the role of driving the markets forward. Increased capacity often leads to rising commodity prices, resulting in inflation. To manage inflation, interest rates are raised, which can negatively impact interest rate-sensitive sectors. Financial sectors, consumer-facing businesses, and retail consumption typically lead the economic cycle’s upward trend, while capital goods and commodities often lag behind. The greater the imbalance in the economy from equilibrium to its lowest point, the stronger the rebound towards equilibrium and positive growth. The commodities referenced here are industrial ones, not agricultural products, which are influenced by weather. In general, the business cycle moves between peaks and troughs, with an entire cycle lasting between three to five years. The central line in Figure 1.7 marks the equilibrium point. Expansion occurs above this line, while contraction takes place below it. Periods of expansion usually last longer than periods of contraction. This happens because it takes more time to build than to break down. Technical analysis helps identify sector turning points. At the start of an economic upturn, there is often a strong focus on quality businesses. Investors remember the pains of previous declines, so caution prevails. Over time, new gains and confidence reduce this caution. That’s when even struggling sectors can start to perform well.This summary outlines how the economy moves and how different sectors rotate within it. We can also see the market movements associated with each economic shift. It is vital for short-term traders, including day traders, to concentrate on these sector rotations and trade in the active sectors. If the strongest sectors like banks or technology begin to drop, traders should recognize that it may be challenging for overall markets to maintain high levels without support from crucial sectors that significantly affect the index. Holding onto stocks when conditions change is typically not a wise approach.
**Moving Averages (MAs)**
Markets do not move in straight lines, and they are inherently volatile. If you expect everything to go smoothly, you might have unrealistic expectations. There will always be a lot of noise in the markets. For instance, it’s essential to remember that an uptrend will have its share of down days, and a downtrend will experience up days. This is not just normal, it’s healthy. Those who regularly observe charts understand this well.Potential profits come from finding order within this chaos. This is where a moving average comes in. Once you learn to interpret and apply moving averages, they become a straightforward tool. Most trading software features this tool. Once you understand when and how to use it, you should have no trouble anticipating the market’s next move or your own.A moving average filters out the market’s random fluctuations by providing the average price over a specific time frame. For instance, a 10-day moving average is calculated by averaging the closing prices of the stock or index over the last ten days. On the next day, the calculation will include prices from Day 2 to Day 11, and so on. That is why we call it a moving average. As we continually drop the first day of the series and add the latest closing price each day, the average keeps moving. For a 20-day moving average, we do the same for the last 20 days. You don’t need to delve into complex calculations; you can plot moving averages using your charting software. Once you’ve done that, focus on using and interpreting them correctly to make money.
**Types of Moving Averages**
There are different types of moving averages, including simple moving averages (SMA) and exponential moving averages (EMA). It’s helpful to understand these variations and how they differ in their application. Exponential moving averages are calculated by placing greater weight on more recent prices, causing the EMA line to closely follow the price line. In contrast, simple moving averages treat all data points equally. The moving average for “X” days is determined by averaging the closing prices from that number of days. The value of “X” indicates the duration of the moving average line. The moving average length that investors and traders use can range from three to 200 periods. We will explore which specific moving averages to use when we define our day trading methods, but first, let’s look at a few more fundamental concepts about moving averages.
Characteristics of Moving Averages
1. The simple moving average (SMA) is less sensitive than the exponential moving average (EMA). SMAs respond more slowly to price changes compared to EMAs. As a result, short-term traders often prefer EMAs for quick trades. However, SMAs can still be used effectively for trading. The key is to stick to a consistent method that works for you. Every moving average can be useful if you know how to apply it.
2. Moving averages will be closer or farther from the price depending on their time period. A 10-period moving average stays closer to the price line than a 20- or 50-period MA. This occurs because the shorter period MA uses fewer data points. A longer period moving average has more data points, which can place it farther from the price points.
3. It’s important to note that when there is a sudden price increase or decrease, the price line immediately moves away from the MA lines, regardless of the time frame of the MA used (see Figure 1.9). This is very common. Often, during these times, the stock or index may try to move back towards the MA line. This behavior can create opportunities for alert traders.
4. When a stock’s price is consistently rising, the moving average line will slope upward. This upward slope indicates buying pressure and suggests that prices are likely to remain high or rise further (see Figure 1.10). The positive slope of the MA line signals an uptrend. Traders should maintain a bullish outlook for such stocks and look for entry points. During an uptrend, the price will usually stay above the MA line. We will discuss this in more detail when we outline our entry strategies. Conversely, in a declining stock, the MA line will slope downward, confirming that the trend is down and prices may fall further. Traders should take a bearish stance in such stocks and look for short entry points. Prices will generally stay below the MA line during a downtrend.
5. When markets are trendless, the moving average lines may either remain flat or fluctuate rapidly as prices crisscross the MA line (see Figure 1.10). At these times, directional moves won’t stabilize long enough to result in successful trades. Since it’s hard to hold a position in one direction for any meaningful duration, maintaining a directional bias is challenging. Occasionally, the price direction may change, leading to price movements crossing above and below the MA line, which can lead to whipsawing. As we move forward, we will learn how to navigate these periods. This behavior is common in range-bound markets, and as mentioned before, you can either trade the boundaries or wait for a clear trend to emerge.
6. When the trend is upward, any price pullback will likely attract buyers around the MA line. In a downtrending stock, efforts to push the price higher may encounter selling pressure at the MA line. Thus, the MA line acts as support during an uptrend, preventing further declines; while during a downtrend, it acts as resistance, limiting upward corrections or rallies.
7. Moving averages also signal changes in trend. When the price rises above the MA line from below, it indicates a shift in momentum and a change in participants’ outlook from bearish to bullish. This is confirmed if the price continues upward and the MA line begins to slope upward as well. Conversely, when the price drops below the MA line from above, it reflects a shift in momentum and the participants’ outlook from bullish to bearish. This is confirmed if the price continues to decline and the MA line slopes downward. The slope of the MA line is as significant as the current trend.
8. Moving averages are considered trend-following indicators because they are based on past prices. They do not predict future direction; instead, they respond to past data, which is why they are known as lagging indicators. Despite this lag, they effectively reduce market noise caused by volatile price changes. MA lines are powerful tools and can function as a complete trading system on their own.
9. We have learned that different MA lines use various data points for their calculations. Therefore, they will also display trends over different time periods. A 10-period MA will show the general price direction for ten periods, while a 200-period MA will indicate the prevailing trend over 200 periods. Longer moving averages take more time to shift direction and adjust their slope, making them less responsive to short-term price changes (see Figure 1.12 and Figure 1.13). A 10-period MA will react quicker and change more rapidly than a 50-period MA, which will take longer to confirm a trend change. This is because the 50-period MA uses more data points in its calculations.
10. Some moving averages that work well for intraday trading include the 20-period MA, the 50-period MA, and the 200-period MA. The 20-period MA will remain closest to the price action, while the 50-period MA will be slightly farther, and the 200-period MA will be the farthest from the price. The best upside trades typically occur when all three moving averages are sloping upward, are nearly parallel, and the price remains above all of them. Corrections may pull the price down to the 20-period MA, the SMA line, or even the 200-period MA, depending on the extent of the correction. The opposite can happen in a downtrend, where prices may be pulled upwards towards these MA lines during corrections. The best downside moves occur when all moving average lines are sloping downward, are nearly parallel, and prices stay below the MA lines.
11. During long consolidation periods or in range-bound markets, all three moving average lines may start to cluster closely together and become almost flat. This is the contraction phase we discussed earlier, indicating that the market is ranging. If market participants decide to let a trend resume, prices will begin to move higher or lower, depending on the direction of the new move. You can see in Figure 1.14 how the 20-period MA and SMA lines begin to slope up and down, respectively. Once all MA lines align parallel again, the trend is considered well-established. The 200-period MA will take longer to shift and will therefore remain relatively flat, but the resulting trend can still be significant and tradable. If the chart is a daily chart, the 20-period MA will be based on the last 20 daily candles. If it is an hourly chart, the MA line will be calculated using the last 20 hourly candles.