How To Find The Trends Of The Stock Market In An Easy Way
The importance of following trends in the stock market
Trading is speculative in nature, so you'll make a profit when you correctly identify the way a market's moving and 'buy' or 'sell' share CFDs accordingly. When the movement in market price (say, in this case, your underlying stock price movements) go in one sustained direction, with a lot of groundswell support behind it from other traders and investors, that's a trend.
If you manage to pick up on a trend and open your position during the right period of time, you can still get in when the pricing is low (relatively speaking), before the action happens. The many other traders who pile into the trend after you serve to drive the price even further in your favour, so that you can close your position 'in the money' with a profit made. And how much of a profit depends on how good your timing was.
However, if you're incorrect, all of that market momentum can work against you, resulting in a sizable loss. 'Fading the trend', as it's called in trading lingo, is not unlike surfing. You can ride the wave when you're successful in your forecasting, but also get wiped out if you're incorrect in your predictions or timing. So, how do trend traders maximise their chances of getting it right?
How to identify stock market trends? Trend analysis
What is trend analysis? It's the study of recent stock price movements of your underlying market, and other data, using technical analysis. This is to try and determine how the underlying share price your stock CFD is moving, so that you can trade the trend.
Here are the most popular tools and indicators that traders use for market trend analysis:
- Moving averages
- ADX indicator
1. Trend lines
Identifying and drawing trend lines are a popular way for traders to 'take a step back' and see the overall direction of their market and possible trends.
The idea here is to identify your stock chart's support and resistance levels (the recent highest points and lowest points that your share price has reached) and create a visual, diagonal line connecting these points to determine whether or not your market is in an uptrend, a downtrend or a horizontal 'sideways trend'. This should ideally give you a strong idea as to where the individual stock is headed next - whether it'll rise or fall in price.
Most commonly, you'll use a drawing tool to draw your own trend lines, although many trend traders use technical indicators as well, such as the MACD, to help.
2. Moving averages
The moving average indicator is one of the most popular ones with many traders. This indicator (also known as the ‘Simple Moving Average’ indicator or SMA for short) is an overlay on your chart which aims to indicate the direction of the stock price's trend with a single line. However, you can also use the ‘Exponential Moving Average’ indicator (EMA) for more information.
One of the most well-known ways to determine stock market trends using moving averages involves using either two SMA lines of differing length, or two different EMAs. If the shorter line crosses from above the longer time length’s line (the LMA), it might signal a change in the market's direction and the start of a new trend. If the shorter period MA crosses above the longer MA, it could indicate the start of a new uptrend or positive momentum - and vice versa for a new downtrend or negative momentum.
The MACD indicator is another very well-known way to use moving average lines, but in a different way. 'MACD' actually stands for 'Moving Average Convergence Divergence', and it focuses on whether a stock chart's moving average lines are getting closer together or moving further apart. If they are diverging, that's often the sign of more momentum in a certain direction in that market, which could signal the start of a trend. If instead lines are converging, it may mean that the trend strength of an existing market direction is waning.
Another common way to use the MACD indicator is to watch whether or not the MACD's lines cross over what is known as the 'zero line' or 'signal line'. Similar to the crosses mentioned in the above point, when the MACD crosses the line from below to above the zero line, it may mean the market's heading into a strong uptrend. When the MACD crosses from above to below the signal line, that can mean the stock price is headed into a downtrend, or even a bear market.
The Relative Strength Index (RSI) indicator aims to measure the amount of momentum - or 'strength' - a trend may have. Traders often use the RSI in the hopes that it will give them forewarning of a change in market direction by showing when a trend is ending or even beginning.
The theory behind this is that the market will always try and correct itself when an underlying asset (like the CFDs underlying stock price) has moved too far away from what's considered its intrinsic value. The trader hopes to find out whether or not that underlying stock price is currently overbought (a lot more 'buyers' going long than there are 'sellers' going short) or oversold (a lot more sellers going short than there are buyers going long).
Generally, a market that's overbought will soon go into a downtrend as it has become 'overvalued'. Meanwhile, an oversold market will often trend upward soon as it has become 'undervalued'. A common strategy here is that, when the RSI's line reaches above 70, it's a sign that the stock CFDs price will likely soon fall as it's become overbought. Meanwhile, if the RSI line drops below 70, it's seen as a sign that the stock CFDs price may soon rise as it's become undervalued because it's oversold.
5. ADX indicator
The ADX is similar to the RSI in that it is a momentum indicator - but it measures the strength of a trend direction in a different way. The ADX indicator is a line that 'scores' the trend strength of the direction your stock price is heading in, from 0 to 100, almost giving you a 'percentage grade' of how strong its price direction is.
An often-used strategy here is to watch the ADX line to see if it goes over 25 or drops to below 20. The ADX line dropping to below 20 is interpreted as signalling a weak trend without much momentum. However, the ADX rising to above 25 is seen as the sign of a strong trend
...But a trend in which direction? Many traders of the ADX indicator also use it in conjunction with two other lines: the positive directional indicator (called the +DI line) and (called the -DI line). Similarly to moving averages, if the +DI line crosses the -DI line while the ADX line is above 25, this may be the sign of a strong upward trend beginning for that underlying stock price which your CFD is trading on.
A strong downtrend starting is thought to be true if the -D line crosses over the +D one instead, while the ADX line is above 25. And if either happens while the ADX line is below 20, that's considered a weak trend which may not have the momentum to last very long.
Method number two: fundamental analysis
While share market trend analysis is most often associated with technical analysis, you absolutely can use fundamental analysis methods to spot new stock market trends.
Why? Because what looks like trends to many traders is often the market correcting itself on an overvalued or undervalued stock, and may be undergoing a reversal and, essentially, giving off 'false signals' that can't always be picked up by technical analysis methods of trend analysis alone. This is what fundamental analysis excels at. It is an accounting-style analysis of a company's financial 'fundamentals' to determine the intrinsic value of its share price.
With fundamental analysis, you would look at your chosen company's recent and past financial statements, studying things like their sales and profits figures, cash flow, EBITDA and total assets under management, among other numbers or metrics that can be used to assess the financial health of a company. You'll also look at how much debt the company has and any notable future growth prospects.
You'll then compare this to the company's historical performance, as well as to peers and closest competitors in its industry. This should give you an overall idea of how well the company is doing and whether it should be poised for better or worse performance in the near future.
All of this will hopefully help you to determine whether that stock (or one of its peers or rivals) is overvalued or undervalued at its current share price. Overvalued stocks will oftentimes be headed for a downturn or be downward 'trending', while the opposite is true of undervalued stocks (which can also sometimes be a way to identify growth stocks too).
Method number three: How to read the news to uncover stock market trends
Often, the biggest trends are caused by some sort of catalyst. Big shake-ups in your chosen stock's company or its industry at large, events like earnings reports and even shifts in economics on a macro scale can all affect share prices massively.
So, one important way to stay abreast of potential future trends is to stay plugged into market news. Know when your company (and its closest competitors) are releasing their latest financials, when leaders in their industry are due to make important announcements and even when macroeconomic events like central bank meetings or announcements of figures like Nonfarm Payrolls are due to take place.
The heightened market activity that occurs around these are often fertile ground for emerging market trends - so the more you know about the news as it relates to your CFD stock and its sector, the better. It may be a good idea to follow the economic calendar, industry news publications and even potentially the social media of your chosen company's most senior leaders!
Managing your risk while trading trends
Riding a trend can be like riding a wave with the power and momentum behind you, if you predict its direction correctly and you time it right. But all that power and momentum can also be dangerous if you time it or forecast incorrectly, which can lead to significant losses for you.
It's also worth noting here that, like the ocean, markets are unpredictable. Even with all the right tools and years of practice, they can move in ways that no one expected. This is why having a good risk management plan is so crucial.
Here are some ways to manage your risk, thereby doing everything you can to secure whatever profits you make, and limit whatever losses you suffer too:
- Choose your position size correctly, never trading with too big a position before you know your market well enough
- Set stop-loss orders, to close unprofitable positions at the level you choose, or the next best price, to limit your losses
- Also set take-profit orders, which similarly close successful positions at the level you choose to lock in profits (depending of course on slippage)
- Also choose your level of leverage you use when trading using CFDs carefully, as leverage involves inherent risk and these are complex trading products. Find out more about leverage
In conclusion: the TL;DR summary
- Predicting trends in the stock market is a vital tool for any trader who hopes to make a profit. If you predict a current trend or a future trend correctly, you'll likely make a profit - and how much of a profit you'll make often depends on how strong the trend was and how well your entry and exit aligned with the market's time period in which the trend occurred
- There are several ways to do what's known as trend analysis. The most common way is use use technical indicators, like moving averages, the RSI, the MACD and the ADX indicators, to try and determine trends using technical analysis
- Other methods of predicting trends involve fundamental analysis to determine if a stock is overpriced or undervalued, and watching the news closely for signs of an impending trend caused by events and headlines
- No matter which method is used, risk management is a vital part of the process. This involves being careful about your position size and leverage amount, and setting stop loss and take profit orders to have the best chance at holding onto any profits you may make, while limiting any losses you may incur
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