The Downtrend

0 comments Saturday, June 16, 2007
A downtrend occurs when stock prices trace lower highs and lower lows. We can sometimes add a falling trendline to a chart by linking the high points.

As soon as we have two consecutive highs we can join them to make an unconfirmed falling trendline.

For the trendline to be confirmed, and hence validated, the price chart must respect it by rebounding from it a third time.

Confirmation of a falling trendline is a powerful sell signal.
After confirming a falling trendline, we stay out of the stock for as long as the share price stays below the trendline.

Many investors are attracted to stocks whose price is falling. These investors are in search of a bargain - a natural human instinct.

O'Shaughnessy* found, however, that a strategy of investing in stocks whose price had fallen significantly resulted in poor returns compared with other strategies.

It is preferable not to buy a stock whose price is in a downtrend. Wait for an indication the downtrend is over.

For some, the end of the downtrend might be signaled by a trendline break, shown in the chart on the right.

Others prefer to buy only after an uptrend has been confirmed. In the charts shown on this page, although an uptrend follows the downtrend, the uptrend is not confirmed.
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An uptrend occurs when stock prices trace higher highs and higher lows. We can add a rising trendline to a chart by linking the low points. This is shown in the chart.

Some trends continue for many months or years, others for days or weeks. We need an objective measure of the point at which a trend begins and ends.
As soon as we have two consecutive lows on a price chart we can join them to make an unconfirmed trendline.
For a trendline to be confirmed, and hence validated, the share price must respect it by rebounding from it a third time.
A buy signal is generated when the trendline is confirmed / validated.
Provided the share price stays above the trendline, we hold on to the stock.
We continue to hold until a sell signal is generated by a trendline break.
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Patterns in Stock Prices

Jesse Livermore's Trading Methods

At the heart of Jesse Livermore's spectacular trading success was the skill he acquired as an eager 14 year old transferring stock prices from ticker tape to quote board - the skill of deducing the likely future movements of stock prices.

Livermore said, "To invest or speculate successfully, one must form an opinion as to what the next move of importance will be in a given stock. Speculation is nothing more than anticipating coming movements. In order to anticipate correctly, one must have a definite basis for that anticipation... "

Livermore believed that, if you thought a stock would move in a certain way, you should enter a trade as early as possible after the market had confirmed your judgement.

What Patterns Did Livermore Look For?

Jesse Livermore liked to trade stocks whose price was moving in an obvious trend. He was not interested in trading stocks whose price was meandering - moving up and down with no strong trend - such as the one shown on the left.

The patterns he sought to identify were patterns in the prices. Modern traders - and indeed many traders in Livermore's time too - plotted the prices and volumes against time on a chart. Jesse Livermore, however, did not use charts. He preferred to look at the numbers themselves.

The Pivotal Point

Jesse Livermore wrote:

"Whenever I have had the patience to wait for the market to arrive at what I call a Pivotal Point before I started to trade; I have always made money in my operations."

Consider the chart on the left. The price had been trending downwards before rallying from a low of 40c. The rally could not be maintained, however, and the stock has retreated to 40c again. 40c has become what Jesse Livermore called a pivotal point. Any significant move either upwards or downwards from the pivotal point would be traded by Livermore.

If the stock were to break below, say, 37c, Livermore would sell short. If it were to break above, say, 43c, Livermore would buy. He would observe the price action carefully after the buy because 49c - the high of the earlier rally - is another pivotal point. If the price failed to rally above 49c - again by 3c, say - Livermore would exit from the trade.

Livermore said:

"I never benefited much from a move if I did not get in at somewhere near the beginning of the move. And the reason is that I missed the backlog of profit which is very necessary to provide the courage and patience to sit thourgh a move until the end comes - and to stay through any minor reactions or rallies which were bound to occur from time to time before the movement had completed its course."

The Normal Reaction

Once a stock had broken out of a trading range - such as the stock on the left, which has broken downwards - Livermore would begin trading. In this case the breakout is downwards and so Livermore would sell the stock short.

He would look for signs that the new trend was behaving normally and that it would be safe to stick with the trade.

Jesse Livermore would look for the following signs:

  • At the beginning of the move there should be an unusually large volume of shares traded.
  • Prices should move generally in one direction (upwards or downwards) for a few days.
  • A normal reaction should be observed - volume will decrease compared with the volumes observed during the initial trend, and the price may move against the trend somewhat.
  • Within a day or two of the normal reaction, volume should increase again and the price trend should be resumed.

Provided this pattern is repeated, it is safe to stick with a trade. If there should be a deviation from the pattern, it is a warning sign. If the pattern fails and the price moves against the trend by more than a little, it is a sign to exit your trade and preserve your profit.

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Jesse Livermore's Stock Trading Rules

Jesse Livermore's Stock Trading Rules

All successful stock and commodity traders have rules for buying and selling. Many traders today still use the trading rules Jesse Livermore first devised almost a century ago.

Jesse Livermore constructed his rules over several years while he learned by trial and error what worked on the markets. He was guided by one of his favorite principles:

"There is nothing new in Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again."

Trading Rules
  • Buy rising stocks and sell falling stocks.
  • Do not trade every day of every year. Trade only when the market is clearly bullish or bearish.
  • Trade in the direction of the general market. If it's rising you should be long, if it's falling you should be short.
  • Co-ordinate your trading activity with pivot points.
  • Only enter a trade after the action of the market confirms your opinion and then enter promptly.
  • Continue with trades that show you a profit, end trades that show a loss.
  • End trades when it is clear that the trend you are profiting from is over.
  • In any sector, trade the leading stock - the one showing the strongest trend.
  • Never average losses by, for example, buying more of a stock that has fallen.
  • Never meet a margin call - get out of the trade.
  • Go long when stocks reach a new high. Sell short when they reach a new low.

Other Useful Trading Guidance

  • Don't become an involuntary investor by holding onto stocks whose price has fallen.
  • A stock is never too high to buy and never too low to short.
  • Markets are never wrong - opinions often are.
  • The highest profits are made in trades that show a profit right from the start.
  • No trading rules will deliver a profit 100 percent of the time.

Source: http:/www.

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