Why Do Markets Trend?

Asad Dossani

The first piece of advice I received as a trader went like this: Trade with the trend. The trend is your friend. Most traders have heard some form of this line. Probably right when started trading.

And of course, this is great advice. As traders, our goal is make money by identifying trends. Most trading systems and indicators apply this concept.

Now, markets don't always trend. Sometimes, they are range bound. And when this happens, a trend following strategy loses money. It's estimated that markets trend around one third of the time.

Let's take a step back. And think about this more deeply. Why do markets trend in the first place?

An early piece of research found something called the post announcement earnings drift. This study examined how stocks responded to earnings announcements. When the announcement was positive, the stock was likely to drift upwards for a few weeks. And vice versa for a negative announcement.

The conclusion here is that the earnings information didn't get incorporated into the stock right away. It took a few weeks. The result was an upward trending stock.

One way to interpret this is that information takes time to reach the market. A few people buy the stock when the earnings are good. Then as more people learn about the stock, the buying continues. And this creates the uptrend.

This is one explanation for why markets trend. On the other hand, this explanation seems less valid today.

This initial study was done many years ago. Back when information came only from newspapers. So it's easy to imagine a time lag. But today, everyone has access to real-time information.

Another reason for trending markets could be the existence of trend following traders. Suppose the price of a stock goes up. Some traders see this as a sign of an uptrend, so they also buy. The stock continues to rise, and traders keep buying. The result is an uptrend.

The same thing can happen for a stock going down. Imagine a group of traders who've bought a stock and placed a stop loss below the current price. Then the stock falls. This triggers stop losses, leading to more selling. The price then falls even more. The result is a downtrend.

I have no definitive answer as to why markets trend. But it's an interesting question with many possible explanations. It's all part of gaining a deeper understanding of financial markets. And ultimately, this deeper understanding leads to more profitable trading strategies.

Now I want to hear from you in the club. Why do markets trend? Feel free to provide your own reasons in addition to the ones I've already discussed.

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2 Responses to "Why Do Markets Trend?"
ABHIJIT
17 Oct, 2016
sir firstof all the view posted by u is perfect and with that to some extent i will add that the markets trend because of its dynamic nature and that lures people to ride the sea saw wave.as a general view.But technically its the bargain mechanism that generates trend.Like 
KAMALAKSHAN
30 Sep, 2016
Sir. Very interesting and helpful With regards, KAMALAKSHAN,Like 
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