Reading a Trend

Understanding the nature and character of a trend gives us an invaluable advantage in making a trading or investment decision. In past articles we have looked at classic ways of understanding trend behaviour including a straight edge trend line and a crossover of two moving averages. These tools tell us about trends, but they do not help us understand the character of a the trend. Is the trend weak, or strong, or stable, or volatile? I use a Guppy Multiple Moving Average indicator to understand this character of the trend because it captures the changing differences between price and value.

A crossover delivers two messages about the market. The first, and most commonly understood, is a message about price. Today’s price is higher, or lower, than the average price over two time frames.

The second message is about value. At the moment in time when the two averages crossover there is a fleeting agreement about the value of the stock.  Price is what we pay for a stock and value is what we think the stock is worth. Generally we try to get stock at a price that is below what we believe is its true value. Changes in value drives the market. As soon as there is agreement about value, then we can expect disagreement. It is human nature. Imagine a popular newsletter recommended stock BDCFG as an excellent, sure fire, cannot fail, buy at $1.50. The market is closed and the last traded price for BDCFG was $1.50. If you wanted to buy BDCFG tomorrow on the open, would you bid $1.50 knowing that many other people had also read the same newsletter?

With such widespread agreement on value from the people who read the newsletter, you need to bid $1.52 just to get ahead of the crowd. Other readers bid even higher, just to be sure of getting stock. Still others will watch the open of the market, perhaps at $1.55, and then bid ahead of the market at $1.58 to get the stock.

The key  point is that where there is agreement in the market about value, it is usually followed by disagreement.

We see this in action when we take a group of moving averages. We assemble a group of 3, 5, 8, 10, 12, and 15 day exponential moving averages to track this short term traders  think. We cannot know for certain that these are short term traders, but it   provides a guide to short term movements in the market. It is convenient to think of these as representing traders.

The chart shows two characteristics. When there is widespread agreement amongst traders about value - when the averages all converge – it is often followed by an explosive move as the moving averages start to move apart. Traders outbid each other to get hold of stock.

This is the second characteristic of the chart display. When the averages are very wide spread - when people get too carried away about the price of a stock when compared to value - the price collapses. This type of chart shows bubbles of short term excitement.

The market is driven by two groups – traders and investors. Investor activity provides stability in a trend so if we can understand their behaviour we can make a better decision about the strength of the trend.

We track the inferred behaviour of investors  using a group of 30, 35, 40, 45, 50 and 60 day exponential moving averages. We see the same pattern with this group.

Think of these as six fund managers. They all decide the stock is worth adding to their portfolio. The only way they can get stock is to outbid their competitors. Because they often want very large blocks of stock, they have no choice but to pay a bit more than the current market price.

To put their analysis into action they have to buy stock on the open market and beat their competitors. The common agreement on value is shattered when they start buying stock. Just like traders, when investors agree about value, it is followed by a disagreement about value. And, at the point of maximum disagreement, the price collapses. Their activity is a fractal repetition of the activity of the traders.

As the chart shows, when we track the implied activity of both groups - traders and investors - the Guppy Multiple Moving Average indicator is particularly useful for identifying major shifts in the trend. When both groups converge and agree about value, then this is a signal for a very major change or acceleration in the trend. When only one group gets carried away - usually the traders - we know how much impact they are likely to have because the Guppy Multiple Moving Average shows us where the long term agreement of values lies.

In more advanced application of the Guppy Multiple Moving Average the relationship between each of the groups is used to help determine the type of trading opportunity. It is also used to evaluate the potential for a trend break to succeed. These aspects assist traders in making better decisions about the best trading approach to use with each opportunity.

Applying the Guppy Multiple Moving Average in a wide range of trading situations is discussed in detail in  Trend Trading. This powerful tool helps traders to understand the mood of the market. Unlike just two moving averages, what is important is not the price reading, but the relationship between the way the two groups value the stock in the current market.

Daryl Guppy is a full time trader and author of   Trend Trading, Trading Tactics and Better  Trading. He runs trading workshops  in Australia, Asia, China and the US. He can be contacted via www.guppytraders.com.

© Guppytraders.com Pty Ltd ACN 089 941 560. All rights reserved 2005. This article has been prepared by Guppytraders.com Pty Ltd and licensed to ASX. The views are those of the author and not necessarily of ASX. This material is educational and it is not intended to constitute financial advice.

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