In general, we like to see stocks going up and dread extended declines. Although individual investors will all have different time frames they consider, they tend to define an up trend as a series of rising prices in their preferred time frame.
Likewise, a down trend will consist of a series of lower prices. Technical analysts generally define a down trend as a series of lower highs and lower lows. The chart pattern is generally clear when a down trend develops as the chart below demonstrates.
Arrows demonstrate that for the majority of the time period shown, the stock has been making lower highs and lower lows. However, the next chart shows the same stock over a longer time frame and the pattern is less clear.
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The arrows now show the trend may not be as steep as it was in the first chart.
Trends Are Relatively Rare
Our second chart above shows that stock prices can, and do, move sideways for extended periods of time. This is a monthly chart and the stock is trading at about the same level it was at two years earlier. The down trend that preceded the trading range is clear and it also lasted about two years.
While down trends, like the ones shown on the left side of the second chart, provide a clear message to many traders. This type of stocks are often avoided. The chart makes clear that buying into a decline can be akin to catching a falling knife.
However, despite the risks associated with buying a stock in a down trend, many investors are tempted to do so. They believe the decline offers a buying opportunity, often with reasoning similar to the idea that the stock was a buy at $30 so it must be a bargain at $15, or $10, or even $2.
That chart shows that investors who bought could be trapped in a losing investment for an extended period of time while they wait for the recovery to develop. That’s because rather than rally immediately, stocks often form bottoms with a pattern known as a trading range.
Some analysts believe stocks only clearly trend, either up or down, about one third of the time. This means they spend about two thirds of the time in a trading range. While the exact amount of time that stocks trend could be debated, the important point is that investors should expect prices to be in a trading range the majority of the time.
This can be frustrating, but it can also be profitable to understand the anatomy of the trading range.
Investor Sentiment Creates the Trend
When stocks are in a clear up trend, the reason is generally easy to understand. The company’s fundamentals are likely to be improving. This could be seen in sales and earnings. New products or increased demand for existing products drive improvements to the company’s financials.
Eventually, these trends reverse in almost all cases. The growth rate of earnings and sales slows or even declines, and that too drives a change in fundamentals for the company.
Most of the time, fundamentals change slowly. That indicates much of a stock’s price movement is driven by something besides fundamentals. In fact, sentiment, or how investors feel about a company drives the changes in stock prices over the short term.
Facebook provides a recent example. There weren’t any immediate fundamental changes in the company in March when the price fell.
But, there was a shift in sentiment about the company. Facebook data was used in a manner many individuals are uncomfortable with. As the news was breaking, it was impossible to understand the impact the news would have on the company’s financials.
However, traders didn’t need to wait for the next quarterly financial statement to know how they felt about the news and the stock. They immediately became concerned that this news could change the company at a fundamental level. And, they sold rather than waiting for confirmation of that belief.
Now, it will take time for more facts to come to light and even more time for the potential impacts to be fully assessed. This is likely to weigh on the stock price and that means the stock is likely to remain in a relatively narrow trading range for some time.
At the simplest level, up trends show enthusiasm, down trends show concerns related to the company’s business, and trading ranges demonstrate uncertainty.
Profiting From Trading Ranges
Because stocks tend to spend the majority of the time in trading ranges, it can be important for traders to have some strategies for trading these times. The recent price action in the SPDR S&P 500 ETF (NYSE: SPY) provides an illustration of a strategy.
There are two trading ranges at work in the SPY. The narrower range is highlighted in the blue rectangle. Aggressive traders could buy when prices reach the lower bound of the rectangle and close their position, or even enter a short trade, at the upper bound.
The lower edge of the trading range is expected to offer support, an area where buyers enter the market and support prices. That makes this a low risk entry point. Resistance, or an area where sellers expected to enter the market and resist further advances, is expected at the upper limit of the trading range.
Conservative traders could wait for breakouts. They would buy when prices break out above the upper resistance of the trading range and sell, or go short, when prices break out of the support level identified as part of the trading range.
In the chart of SPY above, a green line marks resistance of the larger trading range and the solid red line shows the expected support level. A break of either of these lines will signal that a longer term trend is likely to develop.
Trading ranges can be used to implement short term trading strategies based on support and resistance or long term strategies based on break outs. Either strategy can be profitable, and either is based on understanding the importance of the trading range.