Profit From Prices

A book on stock market trading
By Jayesh Patel, CFA

Chapter 3 continues

Chapter 3

Stock Price Trends

 

Tops and Bottoms

TOP: A Top is formed when a stock that is in an up-trend changes its course and enters into a down-trend or goes Side-ways. The daily high price on the day this changeover occurs is called the Top (price). When you are looking at the historical prices or at a chart, it is straightforward to figure out various Tops most of the time. Sometimes, on the other hand, it is not clear particularly when a stock is in a Channel/Side-ways movement or fluctuating within some specific range of prices.

BOTTOM: A bottom is formed when a stock that is in a down-trend changes its course and enters into an Up-trend or goes Side-ways. The Low price on the day the bottom formed is called the Bottom (price).

A stock during its course keeps making successive Tops and Bottoms. If the successive Tops and also Bottoms are higher than Previous Top and Previous Bottom respectively, then the stock is considered to be in an Up-trend. If successive Tops and Bottoms are formed at prices lower than Previous Top and Previous Bottom prices, it is a down-trend.

"Chart courtesy of StockCharts.com"

After getting this thumb-nail sketch of Tops and Bottoms, Up-trends and Down-trends, let us take a closer look at them.

It is easy to spot an Up- or a Down-trend, or a Top or Bottom, on the chart above because we are looking at an historical chart. The Tops and Bottoms or the trends in the above chart are clear because we are looking at sort of a complete picture. A Top is not a Top unless prices are going down during the subsequent days’ trading. Similarly it is not certain/clear/obvious if the trend in a particular stock reversed today or not. For this, one has to look at the next few day’s price movement; and if the prices are going down during the subsequent days only then can we say: “Yes, that was the reversal” or “Yes, that was the Top”. Unfortunately, in trading stocks, the sooner the trend reversals and Top/Bottom formations are found, the more profitable the trading is likely to be. Ideally, to take maximum benefit, one should attempt to find a Top or a Bottom, or a trend reversal as soon as possible. The other side of the coin is- often the assessment about a Top/Bottom, or a trend reversal can turn out to be wrong. This is the flip side of trading. One can’t be correct all the times. Now the question is- how to find a Top/Bottom or trend reversals as early as possible?

Later in this book, I will explain how to identify a change in trend on the very day it is taking place. With confidence (and a proper stop-loss), a PFP signal will tell us that Today’s High price is likely to form a Top for the current trend, or Today’s Low price is likely to be the Bottom price for the next few days.

With PFP signals discussed in the following chapters, a person can answer various questions like:

Is the stock price trend in an Up-trend or a Down-trend as of the moment?

How likely is it that Today’s High price is going to be a Top price for the next few days?

Is Today’s Low price likely to be the latest Bottom for the current Down-trend?

As discussed previously, it is easy to label a day as a Top price day or a Bottom price day after looking at the prices of the subsequent few days. The more days we look forward, the more accurate we will be with our assessment. However in real trading, we don’t have the luxury of waiting for a perfect confirmation. We have to make a decision, and then a trade, as early as possible to be able to capture profit as much as possible from the forthcoming price movement. This often means we have to trade with insufficient information. We are likely to be proven wrong many times and that is where the stop-loss comes in to our rescue. On the other hand, waiting a few more days for additional confirmation does not make our assessment any better! It is possible that on the day of confirmation for the previous Top or Bottom, the stock might be forming the next Bottom or Top. Like a fresh MBA, we can’t wait for all information to be available particularly when we are trading stocks. Risk (uncertainty) is the second name of trading and the sooner we capture the current trend, the better and more profitable it is likely to be for us.

 

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