Markets run in cycles similar to weather patterns.
- Autumn: Distribution/sideways at the top
- Winter: Crash/bear market
- Spring: Accumulation/sideways at the bottom
- Summer: Boom/bull market
But the difference with markets is the element of randomness. With the weather, we can predict when winter is more or less going to start and how long it will last. Unfortunately, we can’t do that with markets.
Let’s imagine for a moment that we didn’t have calendars to help us mark when the seasons are going to change. How would we then accurately predict them?
We would see the leaves turn brown and fall off, followed by cold days. It wouldn’t be long until we connect falling leaves with cold days and beautiful blossoming flowers with hot summer days. We would then be able to predict the next season and prepare accordingly. Fortunately, history and science make this prediction much easier today.
With markets, however, we can only suspect or speculate which market we’re in. And as time goes by, we know for sure which market we were in. For example, if it was down 20% we were in a bear market. But unlike weather patterns, we cannot predict how long it will last or when the next season will start.
Spot the pattern
There are patterns one can look for that signal the start and end of each season. Unlike leaves blossoming or falling, patterns in the market are more probabilistic than deterministic. Some patterns are fundamental, some are technical. We also know weather patterns last 3 – 4 months and are largely the same every time, but the same cannot be said for the market’s “seasons”, having varying durations, volatility, and range.
One of our roles and responsibilities as investors and traders is to study the patterns and position ourselves accordingly. Just as our ancestors chopped more wood in autumn to stock up for winter.
Example
One of my favourite patterns to look for is a bullish/bearish divergence that signals the slowing down of the prevailing trend. It uses price and an oscillator (a technical indicator that measures the momentum of price change in a period).
When the price hits a lower low and the oscillator a higher low it’s called a bullish divergence. This signals that sellers may be running out of steam. The inverse would be a bearish divergence, where the price hits a higher high and the oscillator a lower low, indicating that the buying momentum has slowed down.
I like looking for 3 things in market turns:
- Reversal candle: Not critical
- Divergence: Bullish divergence
- Confirmation (a break of the prior resistance/support): Critical
The chart below shows a bullish divergence followed by a break of resistance.
An important reminder
Patterns are probabilistic, not deterministic. Sometimes a car slows down for a speed bump, sometimes it slows down to stop and turn. Just because there’s a divergence doesn’t mean the prevailing trend is over and it’s a turning point. And always remember risk management.
Traders share a peculiar characteristic: they’re fiercely competitive, but only with themselves. In practice this means that they see every outcome as an opportunity to learn, and they’re brutally honest about both their failures and successes. This also means that they’re hungry for knowledge. They don’t sleep easy with unanswered questions. And they’re seldom satisfied with just one answer.
Njabulo Nsibande is a founder of Village Trader, and Sakha Ingcebo investment club. His interest in trading began in 2016, alongside a rash of Instagram ‘fx traders’…
Find him on Twitter: @njabulo_goje.