Trading With Primary And Secondary Trends

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Trade With The Trend, But Which One?

Trading both sides of the chart is one way to super charge your trading. You can effectively increase the number of effective signals you get by simply opening yourself up to trading both bullish and bearish positions. I don’t mean you should be trading both at the same time, at least not on the same asset (unless your trading spreads), I mean you have to be open to taking either a bear or bull signal when one presents itself. This may also sound a bit like I am suggesting trading against the trend but that is not the case either. Think about it like this, every uptrend consists of a primary trend and a secondary trend. The primary trend is the longer term trend, whether it be a bull trend or a bear trend. Every primary trend is dotted with secondary trends, these are the consolidations, pullbacks, bounces and corrections that form as nearer term greed/fear briefly overpowers the longer term driver of the rally.

As traders we are taught to follow the trend in order to maximize profits. As binary traders we tend to focus on directional trades. This means, at least for me, I tend to focus on only using trend following signals and trend following trades. If the market was moving up I would trade calls, if down puts. If the signal was strong I would use short expiry, typically one week or shorter, and if the signal was week I would use a longer expiry, usually end of the month or one month. If the signal was not present, unclear or at the potential end of a movement I would also use longer expiry, in order to give the market time to “move on” from whatever it was that was causing the uncertainty. This method works well with binary but upon reflection I realized that I was only trading in line with trend about 66% of the time. What.

You Can Trade Against The Trend

Yes, it’s true. With the right approach you can trade against the trend. The strong signals and even the weak signals were paying off because they followed the primary and secondary trend. It was the uncertain signals and times of indecision that were the ones not profiting and it was because the secondary trend had changed. Take for example the chart below. There is a strong primary trend following signal that I would have a one week expiry on and followed up with additional one week trades. As the market moved up the indicators form divergences that point to a stall in the rally on at least a near to short term basis. At this time I would have switched to monthly expiry in order for the trades to weather the near term fluctuation but if you look here you will see that it didn’t pay off because 30 days after the peak the market was still trending sideways and at a 30 day low. An end of month may have worked depending on where I got in but it would have been dicey. The key here is that the market was still trending sideways 30 days later , this is because there was a change in trend that I was not taking advantage of.

The chart above shows only the long term primary trend. When the market reached a point of indecision switching to a longer term expiry makes sense but is not the best choice. The primary trend is still up but the secondary trend has changed so a change in tactic is also appropriate. The first and safest assumption is that the market has entered a near to short term consolidation range. By this I mean one that may last a few days to a few weeks. Look at the chart below. The secondary trend changes from up to sideways and that changes lasts for about 6 weeks. This means that during that time it will be possible to begin trading from both sides of the chart. When the asset reaches the top or a peak within the sideways trend puts are the right choice. When the asset reaches the bottom of the range or peaks within the sideways trend switching back to calls is the right thing to do. However, with a change in trend and trading tactic should also come a change in expiry.

Trades made against the primary trade should be shortened. They just won’t last as long because they are more likely to find support, at least in the near term, and be reversed. This is when I start using end of week, 3 day and end of day expiry. This is also a good idea when trading in line with the primary until the secondary trend moves back in line with it because you just don’t know how long the consolidation is going to last. Of course, as time goes on additional primary trend following signals will develop and at that time the longer term expiry can be employed; one month for the weaker signals and then one week once the signal becomes strong. Since making this revelation I have been able to improve my success rate dramatically. Now, instead of blindly making those longer term trades with the hope the market would move in time I change tactic with the secondary trend and capture more, profitable, trades.

Dow Theory

What Is the Dow Theory?

The Dow theory is a theory that says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high and is accompanied or followed by a similar advance in the other average. For example, if the Dow Jones Industrial Average (DJIA) climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit within a reasonable period of time.

The Dow Jones Industrial Average

Understanding the Dow Theory

The Dow theory is an approach to trading developed by Charles H. Dow who, with Edward Jones and Charles Bergstresser, founded Dow Jones & Company, Inc. and developed the DJIA. Dow fleshed out the theory in a series of editorials in the Wall Street Journal, which he co-founded.

Charles Dow died in 1902, and due to his death, he never published his complete theory on the markets, but several followers and associates have published works that have expanded on the editorials. Some of the most important contributions to Dow theory include the following:

  • William P. Hamilton’s “The Stock Market Barometer” (1922)
  • Robert Rhea’s “The Dow Theory” (1932)
  • E. George Schaefer’s “How I Helped More Than 10,000 Investors To Profit In Stocks” (1960)
  • Richard Russell’s “The Dow Theory Today” (1961)

Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.

The theory has undergone further developments in its 100-plus-year history, including contributions by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s. Aspects of the theory have lost ground, for example, its emphasis on the transportation sector—or railroads, in its original form—but Dow’s approach still forms the core of modern technical analysis.

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Key Takeaways

  • The Dow Theory is a technical framework that predicts the market is in an upward trend if one of its averages advances above a previous important high, accompanied or followed by a similar advance in the other average.
  • The theory is predicated on the notion that the market discounts everything in a way consistent with the efficient markets hypothesis.
  • In such a paradigm, different market indices must confirm each other in terms of price action and volume patterns until trends reverse.

Putting the Dow Theory to Work

There are six main components to the Dow theory.

1. The Market Discounts Everything

The Dow theory operates on the efficient markets hypothesis (EMH), which states that asset prices incorporate all available information. In other words, this approach is the antithesis of behavioral economics.

Earnings potential, competitive advantage, management competence—all of these factors and more are priced into the market, even if not every individual knows all or any of these details. In more strict readings of this theory, even future events are discounted in the form of risk.

2. There Are Three Primary Kinds of Market Trends

Markets experience primary trends which last a year or more, such as a bull or bear market. Within these broader trends, they experience secondary trends, often working against the primary trend, such as a pullback within a bull market or a rally within a bear market; these secondary trends last from three weeks to three months. Finally, there are minor trends lasting less than three weeks, which are largely noise.

A primary trend will pass through three phases, according to the Dow theory. In a bull market, these are the accumulation phase, the public participation (or big move) phase, and the excess phase. In a bear market, they are called the distribution phase, the public participation phase, and the panic (or despair) phase.

4. Indices Must Confirm Each Other

In order for a trend to be established, Dow postulated indices or market averages must confirm each other. This means that the signals that occur on one index must match or correspond with the signals on the other. If one index, such as the Dow Jones Industrial Average, is confirming a new primary uptrend, but another index remains in a primary downward trend, traders should not assume that a new trend has begun.

Dow used the two indices he and his partners invented, the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), on the assumption that if business conditions were, in fact, healthy, as a rise in the DJIA might suggest, the railroads would be profiting from moving the freight this business activity required. If asset prices were rising but the railroads were suffering, the trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market is in a downturn, there is no clear trend.

5. Volume Must Confirm the Trend

Volume should increase if the price is moving in the direction of the primary trend and decrease if it is moving against it. Low volume signals a weakness in the trend. For example, in a bull market, the volume should increase as the price is rising, and fall during secondary pullbacks. If in this example the volume picks up during a pullback, it could be a sign that the trend is reversing as more market participants turn bearish.

Reversals in primary trends can be confused with secondary trends. It is difficult to determine whether an upswing in a bear market is a reversal or a short-lived rally to be followed by still lower lows, and the Dow theory advocates caution, insisting that a possible reversal be confirmed.

Special Considerations

Here are some additional points to consider about Dow Theory.

Closing Prices and Line Ranges

Charles Dow relied solely on closing prices and was not concerned about the intraday movements of the index. For a trend signal to be formed, the closing price has to signal the trend, not an intraday price movement.

Another feature in Dow theory is the idea of line ranges, also referred to as trading ranges in other areas of technical analysis. These periods of sideways (or horizontal) price movements are seen as a period of consolidation, and traders should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed. For example, if the price were to move above the line, it’s likely that the market will trend up.

One difficult aspect of implementing Dow theory is the accurate identification of trend reversals. Remember, a follower of Dow theory trades with the overall direction of the market, so it is vital that he or she identifies the points at which this direction shifts.

One of the main techniques used to identify trend reversals in Dow theory is peak-and-trough analysis. A peak is defined as the highest price of a market movement, while a trough is seen as the lowest price of a market movement. Note that Dow theory assumes that the market doesn’t move in a straight line but from highs (peaks) to lows (troughs), with the overall moves of the market trending in a direction.

An upward trend in Dow theory is a series of successively higher peaks and higher troughs. A downward trend is a series of successively lower peaks and lower troughs.

The sixth tenet of Dow theory contends that a trend remains in effect until there is a clear sign that the trend has reversed. Much like Newton’s first law of motion, an object in motion tends to move in a single direction until a force disrupts that movement. Similarly, the market will continue to move in a primary direction until a force, such as a change in business conditions, is strong enough to change the direction of this primary move.

A reversal in the primary trend is signaled when the market is unable to create another successive peak and trough in the direction of the primary trend. For an uptrend, a reversal would be signaled by an inability to reach a new high followed by the inability to reach a higher low. In this situation, the market has gone from a period of successively higher highs and lows to successively lower highs and lows, which are the components of a downward primary trend.

The reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs. This happens when the market establishes a peak that is higher than the previous peak, followed by a trough that is higher than the previous trough, which are the components of an upward trend.

A Look at Primary and Secondary Markets

The word “market” can have many different meanings, but it is used most often as a catch-all term to denote both the primary market and the secondary market. In fact, “primary market” and “secondary market” are both distinct terms; the primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors.

Knowing how the primary and secondary markets work is key to understanding how stocks, bonds, and other securities trade. Without them, the capital markets would be much harder to navigate and much less profitable. We’ll help you understand how these markets work and how they relate to individual investors.

Key Takeaways

  • The primary market is where securities are created, while the secondary market is where those securities are traded by investors.
  • In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public offering (IPO).
  • The secondary market is basically the stock market and refers to the New York Stock Exchange, the Nasdaq, and other exchanges worldwide.

Primary Market

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example of a primary market. These trades provide an opportunity for investors to buy securities from the bank that did the initial underwriting for a particular stock. An IPO occurs when a private company issues stock to the public for the first time.

For example, company ABCWXYZ Inc. hires five underwriting firms to determine the financial details of its IPO. The underwriters detail that the issue price of the stock will be $15. Investors can then buy the IPO at this price directly from the issuing company.

This is the first opportunity that investors have to contribute capital to a company through the purchase of its stock. A company’s equity capital is comprised of the funds generated by the sale of stock on the primary market.

A rights offering (issue) permits companies to raise additional equity through the primary market after already having securities enter the secondary market. Current investors are offered prorated rights based on the shares they currently own, and others can invest anew in newly minted shares.

Other types of primary market offerings for stocks include private placement and preferential allotment. Private placement allows companies to sell directly to more significant investors such as hedge funds and banks without making shares publicly available. While preferential allotment offers shares to select investors (usually hedge funds, banks, and mutual funds) at a special price not available to the general public.

Similarly, businesses and governments that want to generate debt capital can choose to issue new short- and long-term bonds on the primary market. New bonds are issued with coupon rates that correspond to the current interest rates at the time of issuance, which may be higher or lower than pre-existing bonds.

The important thing to understand about the primary market is that securities are purchased directly from an issuer.

Primary Market

Secondary Market

For buying equities, the secondary market is commonly referred to as the “stock market.” This includes the New York Stock Exchange (NYSE), Nasdaq, and all major exchanges around the world. The defining characteristic of the secondary market is that investors trade among themselves.

That is, in the secondary market, investors trade previously issued securities without the issuing companies’ involvement. For example, if you go to buy Amazon (AMZN) stock, you are dealing only with another investor who owns shares in Amazon. Amazon is not directly involved with the transaction.

In the debt markets, while a bond is guaranteed to pay its owner the full par value at maturity, this date is often many years down the road. Instead, bondholders can sell bonds on the secondary market for a tidy profit if interest rates have decreased since the issuance of their bond, making it more valuable to other investors due to its relatively higher coupon rate.

The secondary market can be further broken down into two specialized categories:

Auction Market

In the auction market, all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. Thus, theoretically, the best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually agreeable prices to emerge. The best example of an auction market is the New York Stock Exchange (NYSE).

Dealer Market

In contrast, a dealer market does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. The dealers hold an inventory of security, then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. An example of a dealer market is the Nasdaq, in which the dealers, who are known as market makers, provide firm bid and ask prices at which they are willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for investors.

The so-called “third” and “fourth” markets relate to deals between broker-dealers and institutions through over-the-counter electronic networks and are therefore not as relevant to individual investors.

The OTC Market

Sometimes you’ll hear a dealer market referred to as an over-the-counter (OTC) market. The term originally meant a relatively unorganized system where trading did not occur at a physical place, as we described above, but rather through dealer networks. The term was most likely derived from the off-Wall Street trading that boomed during the great bull market of the 1920s, in which shares were sold “over-the-counter” in stock shops. In other words, the stocks were not listed on a stock exchange, they were “unlisted.”

Over time, however, the meaning of OTC began to change. The Nasdaq was created in 1971 by the National Association of Securities Dealers (NASD) to bring liquidity to the companies that were trading through dealer networks. At the time, few regulations were placed on shares trading over-the-counter, something the NASD sought to improve. As the Nasdaq has evolved over time to become a major exchange, the meaning of over-the-counter has become fuzzier. Today, the Nasdaq is still considered a dealer market and, technically, an OTC. However, today’s Nasdaq is a stock exchange and, therefore, it is inaccurate to say that it trades in unlisted securities.

Nowadays, the term “over-the-counter” refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE, or American Stock Exchange (AMEX). This generally means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies.

$13.4 trillion

The market cap of the New York Stock Exchange, the largest stock exchange in the world. Stock exchanges are considered to be part of the “secondary” market.

Third and Fourth Markets

You might also hear the terms “third” and “fourth” markets. These don’t concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions. The main reason these third- and fourth-market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor.

The Bottom Line

Although not all of the activities that take place in the markets we have discussed affect individual investors, it’s good to have a general understanding of the market’s structure. The way in which securities are brought to the market and traded on various exchanges is central to the market’s function. Just imagine if organized secondary markets did not exist; you’d have to personally track down other investors just to buy or sell a stock, which would not be an easy task.

In fact, many investment scams revolve around securities that have no secondary market, because unsuspecting investors can be swindled into buying them. The importance of markets and the ability to sell a security (liquidity) is often taken for granted, but without a market, investors have few options and can get stuck with big losses. When it comes to the markets, therefore, what you don’t know can hurt you and, in the long run, a little education might just save you some money.

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