Trending Markets And Price Reversals

Despite the fact that many "trends" are in fact the result of the totally random movement of stock prices, many traders will not invest against a trend that they believe they have identified. Two of the most well-known sayings of market timers are "Make the trend your friend" and "Trust the thrust."

Martin Zweig, a well-known market timer who uses fundamental and technical variables to forecast market trends, has forcefully stated: "I can't overemphasize the importance of staying with the trend of the market, being in gear with the tape, and not fighting the major movements. Fighting the tape is an open invitation to disaster."7

When a trend appears established, technical analysts draw channels that enclose the path of stock prices. A channel encloses the upper and lower bounds within which the market has traded. The lower bound of a channel is frequently called a support level, and the upper bound a resistance level. When the market breaks the bounds of the channel, a large market move often follows.

The very fact that many traders believe in the importance of trends can induce behavior that makes trend following so popular. While the trend is intact, traders sell when prices reach the upper end of the channel and buy when they reach the lower end, attempting to take advantage of the apparent back-and-forth motion of stock prices. If the trend line is broken, many of these traders will reverse their positions: buying if the market penetrates the top of the trend line or selling if it falls through the bottom. This behavior often accelerates the movement of stock prices and reinforces the importance of the trend.

Options trading by trend followers reinforces the behavior of market timers. When the market is trading within a channel, traders will sell put and call options at strike prices that represent the lower and upper bounds of the channel. As long as the market remains within the channel, these speculators collect premiums as the options expire worthless.

6 Figure 17-1b covers February 15 to July 1, 1991; Figure 17-1e covers January 15 to June 1, 1992; and Figure 17-1h from June 15 to November 1, 1990.

7 Martin Zweig, Winning on Wall Street, New York: Warner Books, 1990, p. 121.

If the market penetrates the trading range, options sellers are exposed to great risks. Recall that sellers of options (as long as they do not own the underlying stock) face a huge potential liability, a liability that can be many times the premium that they collected upon sale of the option. When such unlimited losses loom, these option writers "run for cover," or buy back their options, accelerating the movement of prices.

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