My father judged the quality of a restaurant based on how long the queue was or how many tables were full as he scanned the dining room after being seated. He wanted to know what the crowd was doing but sometimes the crowd was wrong and the restaurant was bad. Likewise, use of a trend indicator representing crowd activity provides a good starting point for an assessment of the many stocks we hear about on a daily basis.
Noise and opinions surround every stock.
- Price is at the top
- Crash is coming
- Momentum is slowing
- Bottom is in
- Good news is coming and price is going to rocket!
Every comment has the potential to create moments of doubt on the validity of your analysis. Maybe they are right. Maybe they are not.
Crowd behaviour and what the traders and the investors are actually doing is important. We want to trade in the right direction and be alert for any signs of when the crowd may be changing their mind.
Using a past trade and a potential trade, we show one type of trade set up with a high probability of success and one type we prefer to avoid.
Opening the daily chart of Resolute Mining – RSG, Figure 1, a new leg of the uptrend has emerged. The lines of the short-term GMMA and the long-term GMMA are widely separated indicating good buying support from both traders and investors. Crowds have gathered, enthusiastically buying up the stock.
In comparison, notice the price action from before where price was unable to move above the 0.30 resistance level. Trader selling pushed price down all the way to the lower edge of the long-term GMMA. The lines of the short-term GMMA had expanded out in the downward direction. Over the short-term the crowd of traders were exiting.
Figure 1
This most recent uptrend leg appeared strong, making the probability of price pushing above the 0.30 resistance level on the high side.
From the RSG daily chart in Figure 2, price did break out and held above the 0.30 resistance. In hindsight, the better entry was after the first candle closing above 0.30. We joined the party a little on the late side. A position was opened at an entry of 0.36 as marked with an ATR stop loss of 0.28 and a profit target of 0.44.
Figure 2
Price continued to rise as traders and investors were buying. Separation of the lines in the short-term and long-term groups showed strength in the uptrend. Crowds were still gathering and the enthusiasm for RSG continued.
Our profit target was reached and the trade position was closed at 0.47 as marked by the star. This was a profit of 36%.
After the trade was closed, traders sold the stock down two more times and on the third sell off the short-term GMMA fell through the long-term GMMA. The uptrend was broken as the short-term GMMA sat under the long-term GMMA in the order of a downtrend. Notice the formation of the bearish head and shoulders pattern, another signal preceding the trend breakdown.
Let’s turn briefly to an example of a type of set-up to avoid as a trader.
Figure 3
On the daily chart of Krakatoa Resources – KTA, Figure 3, the GMMA trend indicator showed an obvious downtrend with the short-term GMMA group sitting under the long-term GMMA group. Investor selling was strong as the lines in the long-term group were widely separated and in a downward direction.
Traders had also been selling the stock. One previous attempt by traders to extend a leg over the upper edge of the long-term group had rejected and failed.
The crowds here were selling and we prefer not to join them if we are trading from the long side. One spike at the end of a downtrend wasn’t suddenly a good set-up for a trade. It didn’t mean the crowd had changed their minds about the prevailing trend.
Better setups like the RSG trade shown tends to lead to a higher probability, positive outcome. The sign of a good restaurant isn’t always where the crowds gather just as crowds of people don’t always mean a stock is trending up. Read the crowd, join them if the set-up conditions are right and beware the temptations of the outlier.