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Determining Market Outlook: A Trader's Guide

Different ways to develop an opinion on the market

In the world of Wall Street, there is no shortage of colorful language used to describe one’s outlook on the markets. When using the key terms to describe your market sentiment (bullish, bearish, neutral or volatile), TradeKing is speaking from the perspective of the U.S. equities market, commonly referred to as the stock market. This may seem obvious, but it becomes necessary when discussing actionable ideas and evaluating relevant strategies. No matter your market opinion, there are many strategies you can use across five different types of securities.

How do you determine your outlook? There are many methods which can help you form an opinion, from gauging the overall stock market to just a single security. Several styles include fundamental analysis, technical analysis, top-down analysis, sector rotation, economic cycles, taking stock of sentiment and momentum, studying news events, volatility analysis and many others. Of course, none of us can predict the future. These methods can help you to make the most informed decisions possible when investing or trading.

When you use any of these methods, you are considering two things simultaneously: what is the current market environment? And what do you expect it to be in during the life of your investment or trade? These could be the same or completely different depending on the market environment.

Bullish outlook

Someone who is “bullish” holds the opinion that stock prices will continue to rise, or will rise in the future. Stocks aren’t the only thing in daily life you can refer to as “bullish”. If you’re “bullish on the weather” or “bullish on the Yankees”, you’d simply mean you expect a good outcome. A bullish investor has many choices of how to set this opinion into action.

Bearish opinion

“Bearish” is the opposite of bullish. Being bearish means a trader believes values will continue to fall, or are expected to fall in the future. Investors with a bearish sentiment may decide to use defensive strategies or get out of the stock market altogether and go into other securities. Not all bearish investors go into hibernation. It is possible to actively profit from a downward market direction.

Neutral stance

If your market outlook is “neutral”, you aren’t expecting stock prices to vary greatly from their current levels. Other similar terms include “stagnant”, “sideways market”, “range-bound” or “flat line”. It’s also common to use this term when not having a strong opinion either way on the market’s direction. But make no mistake. Neutral is not a synonym for not having any opinion at all.

Investors with a neutral opinion have many choices as to how to invest capital. If you don’t have an opinion or are unsure of how to arrive at one, this is much different from being neutral. If you fall into the “no opinion” category, hold off on trading or investing until you have a direction you’d like to pursue. Dive into TradeKing’s education and the Trader Network to help uncover the knowledge which can assist you in creating an outlook on the market.

Volatility on the horizon

Not only used to describe dangerous chemical compounds, “volatile” can also describe the state of the market now and in the future. Expected volatility may indicate fluctuations in market prices may be frequent, pronounced, and/or possibly more likely to occur.

Volatility can also mean uncertainty - and uncertainty can spill over into being unsure. However, being unsure conveys indecision in some respects, which is not the same as saying you fully expect volatility in the near term.

There are three schools of thought on how to manage expected volatility in the stock market:

  • Attempt to hedge or protect investments you currently have.
  • Steer clear of trading entirely and get out of the way until calmer times return.
  • Jump right in and try to participate in the increased trading activity.

How to determine your outlook on the market

Now that you understand the different stances a trader can take, how do you arrive at such an opinion? There are many ways. Here’s a brief overview of several commonly used approaches.

Fundamental analysis
Fundamental analysis helps investors determine the financial health of a company by analyzing a business’ core numbers: income statements, balance sheets and other indicators of financial stability. These figures help investors decide if a stock’s price is under- or overvalued. Fundamental analysis also considers other qualitative aspects, like if a company is competitive within its industry, if it is best of breed and has a strong brand, or if that industry is growing or shrinking. Fundamentally strong companies tend to see their stock prices go up over time, while fundamentally weak companies tend to see their stock prices fall. This method is widely used among long-term investors.

Technical analysis
Technical analysis uses past stock price movement, referred to as price action, to estimate prices in the future. This method involves recognizing chart patterns and evaluating other data such as volume, to attempt to indicate trends of supply and demand. Technical analysis assumes all critical information about a company is already known and figured in to the stock’s price, even data examined by fundamental analysts.

Two critical pieces of technical analysis are trends and support and resistance. The trend is defined as the main direction of a security's price over a period of time. Technicians expect a trend to continue, but as with anything in the stock market, there are no guarantees. Support and resistance are price areas of a stock chart which may indicate where a stock’s price could stagnate or highlight a potential price for a reversal in direction.

According to technicians, if a stock’s price is declining, support is a level below which prices are less likely to decrease. This is said to be because buying interest may increase at this price. Support may also be referred to as demand or a floor for the stock price. On the flip side is resistance. If a stock’s price is increasing, the resistance area is viewed as an obstacle which makes it less likely for a stock’s price to surpass. This is also known as supply, overhead pressure or a price ceiling.

Top-down analysis: Trading with the trend
Adherents of top-down analysis believe that one should place trades that are aligned with existing technical trends in the current marketplace. In other words, one ought to go with the flow instead of trying to swim upstream when placing a trade. Before trading an individual stock, top-down traders first evaluate the big picture in the current market environment and then gradually narrow their focus down, seeking out stocks that demonstrate exploitable behavior in sync with the broader markets. This provides a type of “Reader’s Digest” version of the technical state of the market without having to review every chart of every stock.

Usually the first step is to examine the price charts of the major indices, such as the S&P 500, Dow Jones Industrial Average, NASDAQ 100 or the Russell 2000, because these indices tend to have strong sway on stocks across the board. Once a major index in a poossibly sustainable trend is identified, the next step is to evaluate the charts of sectors which are related to the broader index of choice. If a sector is identified as a potential area of focus, traders may examine the smaller industries within that sector, or continue with an analysis of the component stocks themselves. Once you have entered a trade aligned with current trends, top-down investors will use this same method to monitor changes in the marketplace. As trends change, investors will adjust positions as needed, reducing or exiting holdings when appropriate.

Since top-down analysis is used to capitalize on current trends, and all the proverbial stars need to be in alignment, this method is generally better suited to shorter-term strategies. But since individual stocks do not operate in a vacuum, top-down analysis may also be supportive to longer-term investors, by attempting to help them see the forest through the trees.

Economic cycles and sector rotation
It’s a given that the economy phases through different cycles, performing well at certain times and not so well at others. History suggests that certain sectors will perform better or worse depending on where we are in the current economic cycle. Sector rotation involves the active buying, selling and possibly shorting of securities in particular sectors based on whether the economy is growing, peaking, declining, bottoming out, or resuming growth all over again.

For example, when the economy is booming, sectors that have historically performed well include automobiles, financials, retail and housing. In periods of economic bust, sectors that tend to have better profits than others include food and beverage, health care (particularly the pharmaceutical industry), and utilities. (The sectors that do well in bad economic times are often referred to as “defensive sectors” because they’re things people will need to buy no matter what’s happening in the broader economy.)

Depending on the source, there are approximately 13-17 different sectors in all, and certain sectors do better than others across the incline, peak, decline and bottom that make up an economic cycle. This may sound quite simple in theory. The tricky part is determining exactly where we are in the economic cycle. There are two reasons for that. First, economic cycles do not tend to adhere to a specific schedule. Second, the data that enables us to determine exactly where we are in these cycles tends to lag by several months or even longer. So a trader who successfully engages in sector rotation will have to be better than most in recognizing the signs that changes are coming in the broader economy.

Implied volatility analysis
This is a method used by option traders who try to estimate changes in the price of options that are traded on a particular stock. As you should already know if you trade options, implied volatility is an indicator used to gauge potential price movement in the underlying stock. Theoretically speaking, the greater the implied volatility, the greater the potential is for a price swing in either direction on the stock. But there is no guarantee this forecast will be correct.

Because it indicates the potential for price movements, all other factors aside, the higher the implied volatility, the higher the price should be for a given option.

The basic supposition of implied volatility analysis is that the implied volatility for any given option will tend to move within a given range, but over time it will tend to return to the mean. The more it moves toward the outer edges of the range, the more it will tend to snap back toward the mean like a rubber band that’s been stretched out and then released.

When implied volatility is closer to the lower edge of its range, it's more likely to increase over time. Therefore if all other factors remain constant, the option may tend to increase in price. The closer implied volatility is to the top of the range, the more it is likely to decrease over time. So the option could be more likely to decrease in price.

Of course, any potential price change in an option due to changing implied volatility assumes that all other factors are constant, including the price of the underlying stock. For that reason, this technique is usually used in conjunction with some other method for estimating potential price movement in the stock, such as technical analysis.

News cycle and news event analysis
There’s an old saying on Wall Street: “Buy the rumor, sell the news.” Based on rumors and hearsay in the marketplace, stocks will tend to move in advance of news events. That’s because traders will almost invariably try to anticipate what the news event will reveal before it is actually released. This method of predicting stock price movement is primarily used in relation to earnings announcements, however, you may be able to capitalize on other significant news events such as mergers & acquisitions, drug trials for pharmaceutical stocks, major court cases such as patent challenges, etc.

The objective is to estimate what the market consensus will be in the weeks leading up to a news event. If the rumors are positive, a bullish play should be run. If rumors are negative, a bearish play should be run. In general, the trade would be placed two to six weeks in advance of the news event, and the position should be exited before the announcement is released.

It might seem a bit counterintuitive to exit the position before the news announcement. However, holding onto the position through the news event may involve too much uncertainty. After all, the marketplace will have already adjusted the stock price for the expected results so a continuation in the same direction is somewhat unlikely. Furthermore, if the rumors were false and the news is not in line with what the market was expecting, the stock may completely reverse direction. Oddly enough, even if the results are completely in line with what the market was expecting, sometimes you will still see a price reversal anyway. It’s also important to note that if you’re trading options, the implied volatility of those options is likely to decrease after the news is released, so option pricing is likely to be adversely affected.

So perhaps we should adjust the old adage to say, “Capitalize on the rumor, bail before the news.”

Many ways to analyze the markets

Oftentimes investors will formulate one of four core opinions while analyzing the markets. This outlook ranges from having an expectation of increased fluctuation and volatility, to directional (bullish or bearish), or neutral. To determine your outlook, you can use one of these methods, or several in combination: fundamental analysis, technical analysis, top-down analysis, sector rotation, economic cycles, sentiment and momentum, news events, volatility analysis, and others. The list is nearly endless.

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