Breakdowns Beget Opportunities for Bulls and Bears
When markets start moving lower, many traders have been conditioned to think only of opportunities on the short side. And since many traders are not short sellers, there is a tendency to see falling markets as nothing but bad news.
Some give lip service to the idea that stocks are merely “coming in” or are “becoming cheaper” or are “on sale.” But the predominant bias to the long side
— combined with a financial media that celebrates new highs wherever they appear, and slumps whimpering in a corner when it comes to new lows
— makes it difficult for many traders to believe what they may know deep in their hearts to be true: that in order to buy low and sell high, stocks actually have to be “low” in the first place.
The TradingMarkets approach to trading (click here to join our course, the Path to Professional Trading) embraces the idea of buying low and selling high. Our research has proven to us over and over again that there is a reason this investing adage has stood the test of time.
Who was selling stocks like Adobe Systems
(
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PowerRating) in the first half of December of this year? Many of them were traders who got long those stocks and many others back in November, when everyone thought subprime mortgages had bested Osama bin Laden as the biggest threat to Western Civilization.
Buy weakness and sell strength. Every trading technique, every method, every system we teach and encourage traders to use is based on this simple premise.
What does this mean in practice? One thing it means is that when markets are breaking down, there are some stocks that are in generally good shape and are experiencing what amounts to profit-taking. These stocks are likely to continue moving higher shortly afterward.
At the same time, there are other stocks that are in generally bad shape and are experiencing a true breakdown to lower levels. These stocks are likely to continue moving lower.
The trick is learning how to tell the difference between the two. For us, the 200-day moving average serves as the “line in the sand” when it comes to what stocks are in generally good shape and experiencing temporary weakness, and what stocks are in generally rough shape and whose temporary strength often masks true, potentially enduring, weakness.
As Larry Connors wrote in his book, How Markets Really Work, whether a stock was above or below the 200-day moving average made much of the difference as to whether, for example, new highs were to be avoided, or new lows to be bought. In sum, he discovered that weakness above the 200-day moving average is often a bullish opportunity. On the other hand, strength below the 200-day moving average is often illusory.
You can see and learn more about this approach to trading by studying our TradingMarkets Stock Indicators page. Look and see what conditions are really bullish for stocks and which are really bearish. Even if you do not use these specific indicators, understanding them
— and how they really work — will help you a great deal in buying low and selling high, the goal of any trader or investor, in any timeframe, short or long.
Click here to read Larry Connors’ trading primer, “Five Mistakes to Avoid in a Market Trading Below its 200-day Moving Average.”
David Penn is Senior Editor at TradingMarkets.com