Determining General Market Direction

Extracted from the book: Trend Trading for a Living, Thomas K. Carr

Five different types of market conditions

• Bullish strongly trending
• Bullish weakly trending
• Bearish strongly trending
• Bearish weakly trending
• Range-bound (or nontrending)

BULLISH: STRONGLY TRENDING

The Focus: It should be on long setups, particularly breakout plays.

Characteristics: Everything goes up, and up a lot, nearly every day. The bulls are completely in control and win every battle with the bears. Making money is easy in a bullish strongly trending market, as long as you have the right entry system. But the drawback is that when this kind of market reaches a top, the sell-off can be quick and harsh and can wipe out months of hard-won gains in a matter of days. So in a strong bull market you must always be careful to play defensively against a possible reversal of momentum.

How to Play It: Here we can say that a bullish strongly trending market is a great market to be in if you are already long. But if you are coming late to the party (and hopefully not too late), your best play is to look for stocks that are breaking out to new highs from periods of consolidation. You must make sure these breakout plays are confirmed by the various technical indicators we use. If price is making a new high but the indicators are not making new highs, then you have bearish divergence and you should move on to another chart.

BULLISH: WEAKLY TRENDING
The Focus: It should be on long setups, particularly pullback plays.

Characteristics: This is a tougher market to trade, since the pullbacks tend to be more frequent, steeper, and
longer-lived. In a weakly trending market, corrections can last a couple of weeks. This can be frustrating if you are sitting on open long positions. Ultimately, the bulls are in control, but it can seem for days on end that the bears have moved in and made themselves right at home. However, this is one of the best markets in which to find great risk/reward scenarios in our setups. Those lengthier pullbacks serve to take a lot of the risk out of a trade, so our stop-loss can be closer to entry, and our exit targets can be that much further away.

How to Play It: Here we can say that a bullish weakly trending market is an ideal market for trend trading. You should find stocks that are showing strong trending action (normally stronger than the general market itself ) but have pulled back to an area of support. This pullback should be confirmed by oversold indicators, and the current daily candlestick should put in a reversal bar of some kind before you consider an entry.

Selling Winners and Holding Losers

Extracted from the book: Quantitative Trading Strategies,  Lars Kestner
Studies of human bias in economic situations shed light on how the mind affects trading
decisions. In one such study conducted in 1998, Terrance Odean, professor of finance at the University of California, examined 10,000 accounts at a large discount brokerage firm to determine if individuals’ trading styles differed between winning trades and losing trades made from 1987 and 1993. He found a significant tendency for investors to sell winning stocks too early and hold losing stocks too long. Over his test period, investors sold approximately 50 percent more of paper profits on winning trades than they sold of paper losses in losing trades.
Based on the data, Odean concluded that winning stocks were sold quicker and more frequently than losing stocks. Although the results were a bit surprising, this behavior by investors could make sense. When we buy stocks, we’re placing a bet that a company is undervalued. Stocks that increase in value are logically
becoming less undervalued as they rise, while stocks that decrease in value are logically becoming more undervalued. Winning stocks that have increased in value could be considered not as cheap as when they were purchased. Losing stocks that have declined in value could be considered cheaper than when purchased. In this case, it makes sense to sell the winning stocks that have become less cheap and
hold losing stocks that have become cheaper.
Although the logic is sound, Odean’s results show that the opposite actually occurs. Winning stocks that were sold continued to rise, while losing stocks that were held continued to fall in value. In the year following sales, stocks sold with gains by individual investors outperformed the market by an average 2.35 percent. At the same time, losing stocks that were held underperformed the market by an average of 1.06 percent. Odean discovered, on average, that investors underperform the market by selling their winners too early and holding on to their losers too long. Based on purely economic terms, it’s unclear why they behaved in this manner; psychology may provide the missing link. Clearly, the more profitable course of action suggested by the study is to buy winning stocks and sell losing ones. Two theoretical underpinnings dominate the tendency to sell winners and ride losers: prospect theory and mean reversion theory.