Have you been wondering why after you sell your losing stock it has gone-up like a rocket the next few days? Did you experience buying a stock and went down drastically after a day or two? The market seems to have a stubborn mind on its own. Hmmm…I was thinking that as well. Indeed, market is smart and it goes in a mysterious ways.
However, unpredictable as it may be, people have noticed that financial market has been following trends, cycles,and patterns. The ever-famous Dow theory says ” History repeats itself!” Somehow, people tend to outsmart the market and have tried to decode it to forecast its future direction.
Jason Cam in his book ” The Trading Code” crafted a very simplified version of the Stock Cycle. He explains the 4 stages of the price action that we need to learn, which can be both applied to the market or a particular stock. By knowing this, you would know that the market has its own seasons, like a farm that has a season for planting and harvesting.
Stage 1: Accumulation
After a steep downtrend, the public has lost interest in the stock or is too traumatized to even look at it. Price reaches rock bottom after exhausting the selling spree and is starting to consolidate. What seems to be dead meat to the general public is actually a feast for big funds (such as mutual funds, pension funds, and large banks).
After some time, the public realizes that price isn’t going down no matter how they sell and they start to think that maybe, price may have hit the bottom already. A bullish sentiment starts to fill the air as stock market analysts and forums notice that the stock may be too overextended to the downside already and maybe ripe for a timely recovery. At this point, the large funds have already accumulated huge volumes of shares that the public unknowingly sold to them. Now it’s time for breakout! Enter stage 2.
Stage 2: Mark-up (Public Participation)
Something that won’t go down, must be going up! At this point, half the sellers have already exhausted their supply and the other half is changing their minds and having second thoughts on selling further. Just as fear is slowly fading, good fundamental news comes out of nowhere. It can be earnings, dividends, or some rumors that’s music to the public’s ear.
The bullishness attracts more bullishness and news spreads about this wonder stock that is making everyone in the stock market little bit richer everyday. Those who were not able to get in see the stock inching higher and higher. Trading groups and forums are cheering and the public realizes that it’s time to bet big on this one. Greed sets in. Panic buying occurs. Everyone wants to get a piece of the pie at whatever price. Buyers pile up at the bids and sellers are scarce at the ask. Stage 3 has begun!
Stage 3: Distribution
When everyone who is buying, then who is selling to them? They are buying from big funds who were able to accumulate in Stage 1. The big funds quietly sell in tranches to the public so as not to depress the price and halt the uptrend. Soon enough, despite the buying frenzy, price isn’t advancing anymore.
Why is that so?
When you feel like everyone is buying but price isn’t moving, then there must be something big blocking the way. At this point, institutions and big funds are distributing their shares to the public, the ones they accumulated in Stage 1.
Stage 4: Mark-Down (Sell-Off)
Bids are dry and sellers are piling up. Those who came late are now long and wrong. And to add insult to injury, news of low sales or rumors of management problems come out of nowhere. Fear sets in and panic selling commences leading to a breakdown. At this point, the big funds are not buying anymore that’s why the price seems free-falling.
Price enters a downtrend, a series of lower highs and lower lows. The public sells on panic. The more seasoned traders who were caught at the wrong side sell on rallies. Countertrend traders try to catch rebounds and then sell on rallies with little profit. Institutions and big funds start buying as the trend matures. And the cycle begins AGAIN!
You, on the other hand, do not have the money or the time that the big institutions have. But you can master your timing. As you’ve noticed, the crowd is usually late in buying and selling so you must cautious in following the crowd (source: The trading code)