When you’re just beginning to trade stocks, it’s simple to be overwhelmed by the sheer amount of information out there. But there is one fundamental principle that all successful traders know: the market trends. Whether it’s trending up, down, or sideways, being able to recognize these trends is essential to making profitable trades.
Understanding Market Movements
The stock market operates much like a roller coaster with price swings going up and down. As a trader, your role is to determine what the prevailing market trend is and trade accordingly. Is the market going up? Is the market going down? Or is the market consolidating within a given price range?
While this may sound easy in theory, it’s much harder to identify the market’s direction when you’re live trading. In hindsight, it’s simple to look at a chart and say, “Oh, this was an uptrend, followed by a downtrend.” But when you’re actively trading, it becomes much more challenging to make these judgments in real-time.
The Common Mistake: Misreading Market Trends
One of the largest errors new traders commit is misunderstanding price action. For instance, suppose a stock price moves higher, forming a series of higher highs and higher lows. This is obviously an uptrend. But suppose the price begins to pull back?
Most traders, particularly new ones, notice this pullback and believe that the trend has reversed. They may enter a short position believing the price will keep going down. But this may be a big mistake.
The important error here is misunderstanding what a valid low or high is. For a trend to reverse, price needs to break critical points of support or resistance. Making a temporary high or low doesn’t indicate a trend reversal.
Identifying Valid Highs and Lows
To make it clearer, let’s dissect how to recognize a valid low or high. The market produces higher highs and higher lows when it’s in an uptrend. A low is only a valid low if it breaks the previous high. Therefore, if the price makes a low but fails to break the previous high, it’s not a valid low. The trend is still on, and the market is still bullish until the price breaks the previous low.
This is a very important concept because it keeps you from entering trades too early. Rather than entering a short position simply because the price corrects, you need to wait for confirmation that the trend really is reversing.
The Importance of Waiting for Confirmation
Let us take an example. When the price is trending higher and making higher highs and higher lows, you would be justified in thinking this an uptrend. But when the price makes a new low, you would not assume automatically a downtrend is being created. You have to wait for confirmation. A bearish trend would only be established if the price penetrates the latest higher low.
By waiting for these confirmations, you prevent the usual pitfall of rushing into trades based on hasty assumptions. This simple method can prevent you from entering trades that will eventually result in losses.
The Same Principle Works for Downtrends
During a downtrend, the price makes lower highs and lower lows. You cannot count a high as a valid high until the price breaks the previous low. If the price reverses upwards, but fails to break the previous low, it is not an indication of the beginning of an uptrend. It will only reverse the downtrend once the price breaks the previous low.
Why This Is Important for New Traders
Knowing how to properly identify correct highs and lows is an extremely effective tool for beginning traders. It keeps you from getting caught up in reacting overbearingly to price moves and allows you to trade based on a clearer understanding of what the market is doing. By learning this basic concept, chart reading will come easily, and you’ll be halfway to achieving success as a trader.
Key Takeaways for Beginners
Understand Market Trends
- Recognize how to determine if the market is trending up, down, or consolidating.
Avoid Premature Trades
- Await confirmation to enter or exit trades. Don’t expect the trend to turn merely because the price makes a pullback.
Use Valid Highs and Lows
- A valid high or low will break the previous high or low. It’s very important when determining trend reversals.
Don’t Complicate It Too Much
- Many newbies get sidetracked by complicated indicators and strategies. Learn the basic first, and the rest would follow naturally.
Patience Works
- Don’t hurry into a trade. Learn to understand market movements and wait for confirmation to act.
Conclusion
In order to be a successful trader, it’s important to know the basics of market trends. By knowing how to identify valid highs and lows, you’ll have the clarity necessary to make better trading decisions. Don’t dive into trading without knowing the market structure—spend some time learning these fundamentals, and you’ll be positioning yourself for long-term success.
As you keep developing your skills as a trader, the ideas of highs and lows will come very naturally. Having a sound understanding of them, you can then begin to develop your trading plan and learn about more sophisticated strategies. But don’t forget that trading is a process and having the skills from the basics will always be your greatest strength.