If you knew today what was going to happen tomorrow, you could adjust your plans to match the future events. In a sense, investors attempt to do the same thing by trying to predict whether a stock's price will fall or rise, a technological breakthrough will stand the test of time or whether a company's leadership will continue to perform. To achieve this, many traders analyze trends and cycles in a stock's performance.
Cycles in financial markets are exactly what the word implies -- regularly repeating patterns. Just as the year is divided into four seasons that repeat at regular intervals, the stock market tends to fluctuate in a cyclical pattern. The four seasons in the cycle of a financial market are a downturn, which then stabilizes for a time when it reaches its lowest point; an upturn; and finally another temporary stabilization when it reaches its highest point. Careful analysis of a cycle might offer insight into whether the current price will rise or fall and, in some instances, might provide clues to when the next phase in the cycle might be.
Within cycles, it is often possible to identify trends. Trends are typically shorter-term patterns than cycles. Rather than providing a picture of all phases of a cycle, trends show the direction in which a stock, or the market, is moving or has moved in the past. The longer a trend lasts, regardless of which direction it is taking, the longer it will take to reverse. Short-term trends, therefore, change more quickly and can literally reverse themselves in a matter of weeks or even days. Monitoring trends can sometimes provide warnings that a high-priced stock is beginning to decline in value or that a deflated stock is on the verge of rallying.
Moving averages show how prices move over time. In effect, a moving average takes cyclical data and evens it out since the mean price, rather than the highs and lows, are the target. To create the most basic moving average, a time period is chosen and the data for that period is collected. Suppose you wanted to analyze a stock's price over a 21-day period. You would find the average price for the first 21 days. Each day thereafter, you would remove the first day's information from the calculation and add in the current day's information. Because the average is recalculated daily, it is said to be a moving average. The analysis is more reliable when longer periods are chosen to compute the moving average.
Analyzing Trends and Cycles
Whether you rely on trends or cycles to make investment decisions depends on your goals, your portfolio and your comfort level with the methods. As a rule, analyzing cycles over a long period are typically more reliable predictors of long-term changes. Trends usually show short-term fluctuations. It is also important to remember that within a cycle, the market might not show a clear trend during the period you need to analyze. Nevertheless, day traders tend to rely more on trends, investors who are in for the long haul often prefer cycles and both trend and cycle moving averages are commonly used by both types of investors.
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