This is Your Brain on Higher Highs (and Lower Lows!)
Traders are never more bullish than when markets are moving higher day after day. And they are never more bearish than when markets are marking lower lows day after day after day.
This emotion is rational — even to be expected. But in the final analysis, emotions that are rising and falling with the markets are emotions that can be very costly to traders.
Anyone who has spent any time trading, or around traders, knows that it is always better, in short-term trading as well as long, to trade with the trend. And the trend is defined as a series of either higher highs in the case of an uptrend or lower lows in the case of a downtrend. This is translated, at its most basic level, as buying stocks when they are making higher highs and selling stocks when they are making lower lows. Buy in the uptrend and sell in the downtrend.
But this approach, taken too literally, can result in problems for traders — especially in the short-term. Long-term traders are
— or must become — willing to endure the false breakouts when trends may or may not be about to begin. They must also be able to deal with the psychological stress of seeing gains shrink as trends come to an end as the markets, for however brief a time before the trade is exited, move against them.
Short-term traders, on the other hand, cannot afford such luxuries. Typically operating with less capital per trade than long-term traders, short-term traders do need to be mindful of the trend. But one of the best ways for traders to exploit trending markets in the short-term is somewhat counter-intuitive, and involves thinking of higher highs and lower lows in almost the exact opposite way that most think of them.
In his book, How Markets Really Work, Larry Connors presented research that showed the existence of a short-term edge for traders who bought markets making lower lows and sold markets making higher highs. Specifically, Connors and his research team looked at the market (the S&P 500 and the Nasdaq 100) over a 15-year period from 1989 to 2003. The challenge was to see whether or not markets had positive returns one-day, two-days or one-week after making multiple days of higher highs or multiple days of lower lows. The results were fascinating.
Connors discovered that “multiple-day lows far outperformed multiple-day highs.” The research revealed that when the market made five lower lows in a row, the average weekly gain was more than triple the average weekly gain for all time periods. On the other hand, markets that made five higher highs in a row actually showed losses over the following week.
Why is this so? There are a variety of factors at work, to be sure. But one of those factors is surely the “buy the rumor, sell the news” phenomenon. Often, when markets are moving higher day after day, they are being driven by anticipation of a certain event or announcement. And for traders who get into such markets early, this anticipation helps drive prices
— and the profitability of their trading positions — higher. But for traders who arrive after the consecutive highs, for example, have begun, the risks grow day after day that whatever mood is moving the markets higher will fade, leading to a reversal and trading losses.
We saw this happen a few weeks ago as the markets rallied off the late November lows in anticipation for the FOMC decision on December 11th. The markets moved higher and higher as expectations grew more and more ambitious. But by the time the day of the announcement arrived, the markets had priced in such a picture of perfection that the only possible result was disappointment. The market sold off sharply shortly thereafter.
This is why the TradingMarkets approach to trading is based on buying weakness
— the kind of weakness that can be found in a market making consecutive lower lows
— and selling strength. This approach, which we teach as part of the TradingMarkets Path to Professional Trading, works as well for buying good stocks that are experiencing profit-taking
— or even irrational panic selling — as it does for selling or short selling poor stocks that are showing momentary strength as a result of short-covering or speculative bargain hunting.
Traders can find out which stocks are making five or more consecutive higher highs or lower lows by visiting our
TradingMarkets Stock Indicators page. Every day this compendium of technical screens and indicators provides lists of stocks for traders that are likely to move higher or lower over the next day, two-days or one-week.
Click here to read more about our research into higher highs and lower lows.
And click
here to join our Path to Professional Trading course.