by Thomas DeMark & Thomas DeMark, Jr.

Market highs and lows differ in frequency and duration, depending upon the time frame one applies.  For the most part, short-term highs and lows may not have much of an impact upon the overall market picture or trend.  Obviously, at major turning points, short-term price bottoms and tops will coincide with and evolve into long-term price bottoms and tops, since longer-period market price moves are comprised of a series of shorter-period market price moves.  Personally, our trading efforts are most often devoted to these short time frames.  This enables us to participate in many short-lived price moves, and, at the same time, (market conditions justifying), also allows us to extend our holding period for a longer period of time.  Since any market turning point could extend into a significant bottom or top, we encourage day traders to hold their trading positions longer on occasion.  However, because short-term signals may only be effective for a short period of time, we advocate protecting market positions at all times with stop losses.  Because markets move in a series of price waves over various time periods, it is important for a trader to prudently place a stop loss and to do it consistent with the time interval which meets his or her trading preference and style.

Price never moves straight up or straight down, even when price moves are news-driven.  There are rare instances when each trade over a short period of time will be consecutively higher or lower, but these moves will eventually be punctuated with price reactions until the price surge finally dissipates and trading normality resumes.  Typically, price moves unfold in a series of waves.  Traders’ collective interpretation of the impact of any news developments upon a market determine the direction and intensity of these waves.  Since the market is a discounting mechanism, as soon as news is released, traders evaluate and process the perceived impact that it may have upon a security.  The convergence of all these traders’ expectations is reflected in one figure – price.  Ultimately, the critical determinant of price movement is the degree of buying and selling pressure.

One important aspect of price movement which is often overlooked by overzealous traders is the fact that, over time, the intensity of both buying and selling diminishes.  The reason is that as more and more traders commit their funds to the market, the reservoir of similarly disposed traders diminishes in size.  Our research indicates that markets form bottoms, not because there is a group of smart buyers who are driving prices upward; rather, figuratively speaking, the last seller has sold and by default price moves sideways or higher.  Conversely, markets form tops, not because there are smart sellers who are forcing prices downward, rather, figuratively speaking, the last buyer has brought; therefore, price moves sideways or lower. 

To illustrate this observation, consider the fact that as price moves higher, more and more trend followers enter the market.  Usually, fundamental research becomes more positive, convincing the fundamentalists to enter the market as well.  As the news continues to be favorable, more and more investors enter the market.  At the same time, traders who were negatively disposed toward the market reverse their positions from sellers to buyers.  Ultimately, the buyers exhaust themselves and the buying and selling pressure arrive at a standoff.  Once the last buyer has bought, price declines.  Keep in mind that the reverse scenario holds true in cases where a market’s price is declining.  These same principles can be applied to market activity on a time scale as short as one minute and consisting of a series of price ticks to much longer periods of time.

With these market-timing principles in mind, our research has uncovered certain market behavior and tendencies which occur near market tops and bottoms.  For instance, we have found that a general skepticism is often associated with market lows.  In this case, if price had declined for a period of time and news continues to bleak but price actually rallies, this event suggests that there is an apparent absence of sellers required to perpetuate the decline.  Traders’ prayers, hopes or promises will do nothing to force price lower; only additional selling can accomplish that goal.  Similarly, as a market rallies, news and analyst recommendations reflect this bullish market outlook.  Ultimately, all the potential buyers have bought into the position and, despite additional favorable news it is insufficient to sustain the rally unless a renewed source of buying develops.  Again, prayers or promises will not move the market higher; only additional buying is capable of doing that.  Our observations indicate that market bottoms are accompanied by negative news, just as market tops are usually formed with the release of positive news.  Furthermore, when a market is incapable of rallying despite goods news, it is often indicative of an imminent retreat in buying and a potential downside price reversal.  Conversely, when a market is unable to decline despite negative news, it is often a sign that there is a decrease in selling pressure and a potential upside reversal is pending.  At major market turns, the news is often so extreme that the sellers and buyers collectively exhaust themselves and the market is susceptible to establishing a meaningful reversal in trend.  Since markets typically exaggerate advances and declines, opportunities arise for alert traders who are prepared for these price reversals.  The challenge for a trader is to differentiate between the real and the perceived low- and high-risk opportunity zones.

The interaction between supply and demand determines price.  Market expectations and news create occasional price imbalances and present traders with opportunities to profit.  Fear and greed swing the price pendulum in any market.  Fundamental information, such as earnings forecasts, new product introduction, crop reports, government policies, money supply, interest rates, and a host of other variables, are important factors influencing valuation.  However, market sentiment and traders’ perceptions have a dramatic impact and are oftentimes responsible for exaggerating and extending price movements.  The impact of non-fundamental contributing factors, such as stop losses, margin calls, and so forth, cannot be measured but their influence is also significant.

Stock market specialists and option market makers play an important role in the marketplace.  They supply liquidity to a market by providing supply when a market rallies and by providing demand when a market declines.  Their method of trading is to operate against the prevailing market trend.  Obviously, doing so is not always profitable – occasionally, markets will perpetuate a trend longer than expected.  But, most often, retracements and market reactions allow those traders to offset their trades and continuously reset them.  With proper discipline and money management, these professional traders are able to produce consistent profitable returns.