Lesson 4: Trend & Market Structure

This refers to how markets move over time, whether they are trending up, down or stuck in a sideways channel. You can really help your decision making by selecting stocks in the right structure.

Why this matters?

This really deals with how markets actually move over time. Most losses come from fighting the market.

People often act on emotions are against the prevailing trend. They:

Buy because something “looks cheap”
Sell because something “feels high"

Market structure stops that!

If you understand structure, you stop guessing and start aligning. Trading with the trend is so much easier than trying to guess reversal areas or just thinking - "the price has gone down 50 or 60%, it has to bounce soon". There's no doubt you can trade reversals, and there's a strategy that we love which does exactly that, but it has to be around structure - not a hope or a gut feeling.

This looks cheap doesn't it?

It's Aston Martin, and it's down 90% from it's IPO in October 2018. By June 2020 it was trading at around £5 having traded at £45 at launch. But then it falls another 90%. So thinking £5 must have been a bargain, 90% of your investment is gone! Don't ignore the structure. You can trade these type of stocks, but you cannot hold a stock like this. It will ruin you. Great cars (if you like that sort of thing) - terrible investment.

What market structure really means?

Market structure is simply trying to deal with how price moves from one decision point to the next.

Those decision points create:

Highs
Lows
Trends
Ranges

This structure is the framework everything else sits on.

The three structural states

All markets cycle between three states:

1. Uptrend

Higher highs
Higher lows
Pullbacks are opportunities, not threats

The market is rewarding buyers. We're looking for longs (to buy) and potential hold stocks for longer term moves. This is the FTSE 100 - trading above the 21 and 50 moving averages.

2. Downtrend

Lower highs
Lower lows
Rallies are opportunities for sellers

The market is punishing holders and price moves down. Don't hold if your market is in a structural bear market. The below chart shows the EURUSD on a daily time frame - it fails to push through the 50 EMA for over 1.5 years - no point trying to find longs here if you're looking for a a trend higher.

3. Range

No clear progression
Price oscillates between levels
Breakouts attract attention - most fail

Patience matters most here and you don't have to be in the market. Depending on your strategy, you can sit tight. Cash can be a position when managing your wealth. This is Tesla back in the early days. It's tests the hights a few times before dropping back into the range. Then bursts higher.

Higher highs and lower lows

Forget perfection. Structure is about direction, not symmetry or catching the exit price levels for your entry, target or stop loss.

An uptrend does not need:

Equal pullbacks
Clean angles
Pretty charts

There's a technical framework called Elliott Wave. This can be helpful but it requires some deeper technical ability in our view. Rather, lets keep this more simple and look for markets that are in clear uptrends or downtrends.

Pullback vs reversal

This is where people get it wrong.

Pullback

Happens within a trend
Respects prior structure
Volume usually contracts - at least that's what provide the context for a strong potential breakout.

Pullbacks reset momentum and allow the stock to consolidate, and continue the move.

Reversal

Breaks structure
Changes behaviour
Often messy and volatile

Reversals are harder to trade than trends. If you can catch reversals that then create the start of new directional moves, they're extremely profitable, but it might take a few attempts to enter.

Breaks and change of structure

There's a guide or framework we like to use here at FoundryStrat which breaks the market down into 4 core phases or stages. It's based on Stan Weinstein's great book Secrets for Profiting in Bull and Bear Markets. It's is a must read. Weinstein described markets moving through four repeating stages:

Stage 1 – Basing

Price moves sideways
Volatility contracts
Smart money accumulates quietly

Nothing looks exciting here. That’s the point. Like the Tesla example above.

Stage 2 – Advancing

Structure turns upward
Breakouts start to hold
Pullbacks become buying opportunities

This is where most of the money is made. There are ways to identify a break out from stage 1 into stage 2 where we look to buy a market and stay 'long'.

Stage 3 – Topping

Momentum slows and volume can rise on down days
Ranges widen out and the market doesn't push higher - it's stuck
Breaks of structure start appearing - topping patterns form including:
- Double tops
- Head and shoulders
- ABC corrections

Look at the below double top from Microsoft. There's a volume spike at each of the highs within that stage. Price sells off from each high on high volume. It breaks that range and doesn't recover, dropping away into stage 4....

And then one break becomes two and you're into stage four 4...

Stage 4 – Declining

Structure rolls over
Rallies fail
Selling pressure dominates

Capital preservation matters most here.

Why this framework still works

Stan Weinstein's book is fairly old now. He wrote it originally in 1988. Markets have changed. Human behaviour hasn’t and that's the key point. We can go back to the early 1900s and we still see these exact chart patterns playing out. The companies and industries might have been different, but human behaviour was the same. Look at William O'Neil's classic How To Trade In Stocks. the first hundred pages of that book are charts from over 100 years ago and you see these same characteristics.

Weinstein’s stages aren’t about prediction, they’re about recognition. You can use this framework to stop trying to pick turning points and start responding to evidence.

The key takeaway

You don’t need to call the top or bottom. We see so many of our followers and clients trying to catch falling knives - ie. price has fallen or is in freefall. A stock looks cheaper, but there could well be something more sinister going on. In every day human life, something that's cheaper, generally represents better value. But that isn't the case in stock markets.

You need to recognise: