Success on the stock market depends on your ability to predict it. What is market timing and why is knowing how to predict the market so important for a successful strategy?
Winning or losing in the stock market depends on your ability to predict the price of a particular asset. One way to do this would be to flip a coin and trust your luck. However, you might be more comfortable with gambling under these conditions. Stock market investing is more technical.
Over the years, strategies to predict the stock market have been developed. None of them are infallible. However, some of them have had quite positive results and have been taken up by investors.
Unlike a long position, market timing is an opportunistic strategy to take maximum advantage of asset price movements. Normally, an investor makes a buy decision at a low or uptrend and a sell decision at a high.
The difficulty of market timing is therefore to know how to predict these up and down price movements.
It is precisely this difficulty in predicting prices that makes market timing a dangerous game. One could even say that it is impossible to predict the price of an asset consistently and efficiently. However, market timing is attracting more and more investors because of the possibility of making a fortune overnight.
Nevertheless, you will see that market timing requires time for a trader who must necessarily perform continual studies and analyses in order to guarantee a minimum of success.
The risks of losses are very real when it comes to market timing. Indeed, despite the various indicators and signals that you can use, you cannot be 100% sure of the evolution of market prices. Nevertheless, to mitigate this possibility, market timers adopt a conservative strategy and withdraw in case of high market volatility.
Market timing enthusiasts also agree that 2/3 of their investments is more than enough to produce significant capital gains over the long term.
There are two main techniques for predicting the price of an asset: fundamental analysis and technical analysis.
A company's stock, the easiest example for our explanation, evolves over time thanks to several factors.
We can, for example, mention performance, results, future prospects or the quality of its human capital. These factors are taken into account in the fundamental analysis of the financial asset that is the share of this company. This type of analysis is thus suitable for a stock market trader and an investor who wants to invest in the capital of a company.
The objective is to identify the intrinsic value of the share in relation to the current market value in order to determine whether it is appropriate to buy or sell the asset concerned. Indeed, if this intrinsic value is higher, an increase of the prices in the medium and long term is expected, and vice versa.
Applied to other assets, fundamental analysis consists of identifying the economic, social, political or environmental factors that may impact the price of an asset. It is then a matter of predicting the real consequences of these factors and taking a position in relation to the predictions.
Generally, fundamental analysis is performed with a view to medium and long-term positioning. However, it can happen that certain factors have immediate consequences on prices. This is, for example, the case of geopolitical conflicts or the announcement of the NFP in the USA which often have immediate impacts on the market.
Company shares, if we take the previous example, also depends on another factor: the law of supply and demand. This law generates more or less important movements on the prices and generates different positions taken by the investors. This explains why the price of an asset changes from second to second.
However, there is virtually no way to predict these different trader behaviors. The only alternative that financial experts have found is chart analysis.
Technical analysis or chart analysis is based on a visual and graphic representation of price variations during a certain period. These graphs allow us to see trends and predict future price movements through the use of different indicators.
The various theories used for technical analysis have been formulated from several studies of past price movements. Indeed, there is no reason why signals recorded in the past should not be effective when they reappear later. In general, investors have retained only those predictive price theories that have yielded fairly positive results.
Once again, these theories are theories rather than rules, since stock exchange forecasts are not an exact science. Many investors went broke thinking they were following these theories to the letter. Others, on the other hand, got rich thanks to them.
Here are some examples of well-known theories on forecasting stock prices.
The Fibonacci ratio, or retracement strategy, is used to predict the support and resistance levels of an asset. The method is used after the end of an upward or downward trend, followed by a theoretical correction.
It consists of graphically considering the peak and trough of the trend and scaling them from 0% to 100%. The next step is to draw horizontal lines at the Fibonacci levels : 23.6%, 38.2%, 50%, 61.8% and 78.6%.
These correspond to the theoretical support or resistance levels of the theoretical correction. Prices should then move in the same way as the first trend.
The Elliott Wave theory is based on a graphic observation of prices and trends. In particular, it states that in each upward or downward trend, we find 5 Elliott waves that repeat themselves in an endless cycle. But in the same way, in each wave, we find the same 5 waves and so on.
The 5 Elliott waves then take a common form. In an uptrend, there is a 5-3 cycle movement.
The first part of the cycle consists of five waves: an impulse, a smaller correction, another impulse, another smaller correction and a final impulse.
It will then be followed by a second part with three waves: a larger downward impulse, a small upward correction and a final downward impulse. After this cycle, if the trend is still up, prices will follow another similar cycle.
The logic of Chartist patterns is as follows : when prices move according to a certain pattern, they will then have to move in the same way as those of other assets before. In other words, they will have to reproduce the same trend. After a downtrend, for example, prices will have to follow a strong uptrend. Knowing this and being able to spot and interpret them can make an investor money.
More specifically, patterns are used to determine support and resistance levels. There are two main categories:
There are obviously several chartist figures, but investors only really trust about 20.
The use of signals allows you to visually enhance the price charts. Instead of just bar charts or Japanese candlesticks, for example, you use lines or areas that are more representative of trends. The most experienced investors even use more complex signals such as LSMA indicators or Nyquist frequency.
One of the best known is the Hull moving average, which is nothing more than an arithmetic average. However, it better represents the upward or downward trend and allows an investor to position himself.
Among the more practical signals, Bollinger Bands are also worth mentioning. These are two lines placed at a fixed distance from the moving average on the chart, forming a band encompassing the prices. This band shows the volatility of prices and predicts strong movements when the bands tighten.
These are just two examples of the most well-known signals for stock market investors. There are dozens of them, many of which are not well known. On the other hand, since almost all of them are controversial theories, investors almost always base their choice on their personal experiences with this or that signal. This is why traders, whether beginners or experienced, almost always react in different ways in the stock market.