Stock prices may appear random, but there are repeating price cycles, which are predominantly driven by the participation of large financial institutions. Large institutional buying plays out in four distinct phases:
A trader must have a strategy to take advantage of price action as it is happening. Understanding the four phases of price will maximize returns because only one of the phases gives the investor optimum profit opportunity in the stock market. When you become aware of stock cycles and the phases of price, you will be prepared to profit consistently with less drawdown.
The accumulation phase begins when institutional investors – such as mutual funds, pension funds and large banks – buy up substantial shares of a given stock. Price forms a base as the shares of stock are accumulated. Institutional investors must buy over long periods of time so as not to conspicuously drive up the price of the stock, giving them a long time horizon.
This phase is not a lucrative time for retail investors to buy, as capital will be tied up, or the investor may experience a large drawdown of capital. However, recognizing the signs of accumulation gives insight to future opportunity. During this phase, price moves mostly sideways in a range. The range is identified by variable pivot highs and lows (Figure 1) and whipsaw-type price movement.
The cup and handle is another price pattern indicating accumulation. The handle is a higher pivot low and may signal the end of an accumulation cycle. A higher-high in price above the rim of the "cup" can lead to a new leg up.
The accumulation phase can wear down your capital as the price will swing in both directions. Sometimes it is useful to add an indicator to help identify non-trending conditions. The average directional index (ADX) is a trend strength indicator, and the example in Figure 3 shows the price moving sideways. The ADX has been added to show trend strength. An ADX of less than 25 shows low trend strength, indicating non-trending conditions. The ADX rises above the 25 level when there is trend strength.
During the markup phase, price breaks out of range and begins a sustained uptrend. An uptrend is defined as a series of higher pivot highs and higher pivot lows. This stage is when the price begins moving up. The big money has established a position and retail investors are now invited to join in the profit party. This is the most profitable time to own the stock – an opportunity to let your profits run. The earlier you can recognize this stage, the more you can profit.
Use trend-trading strategies during this stage. An example of a trend-trading strategy would be to draw a trendline along with the pivot lows and stay long above the upward trendline. Entering a stock early in the markup phase leads to the greatest potential profits. Classic trend trading involves entering the stock at pullbacks above the trendline (Figure 4).
The ADX helps us see the transition from the accumulation phase to the markup phase. When the ADX rises above 25 at the same time as a new high in price, the trend may be starting. The best trends will have an agreement between the indicator and price, as noted in Figures 5 and 6. The trend is truly your friend and lets your profits run.
Figure 6 also shows a triangle pattern in the accumulation phase and then a new price high, showing us how the markup phase begins and a trend is born.
Uptrends occur in this cycle and price makes higher highs. When trend momentum is increasing, as seen in higher ADX peaks, we can expect the trend to continue.
Rectangle patterns represent price consolidation and can happen when stock shares are being accumulated or distributed. Recognizing the sideways trend leads to the best strategy for profit. An investor can be out of the trade for this period or, if there are dividends and/or options, another strategy might be to hold and collect dividends and sell covered calls. It is easier to identify in hindsight, but learning to recognize consolidation when it is happening provides an edge in profit trading.
In Figure 7, you can see rectangle price patterns in the markup phase for the Energy Select Sector SPDR, which leads to a continuation of the trend as seen in Figure 8. A new high in price from a rectangle pattern is a technical buy signal. A new low in price is a technical sell signal.
The distribution phase begins as the markup phase ends and price enters another range period. The shares are being sold over a period of time—the opposite of accumulation. This time, the sellers want to maintain higher prices until the shares are sold.
Whether it is distribution or accumulation is less easy to discern at this point. It is more important to be prepared for the next signal, rather than trying to predict the next move.
One of the most common distribution patterns is known as the head-and-shoulders pattern (Figure 9). Rounding or a dome shape (Figure 10) indicates distribution preceding the markdown stage.
The last phase of the stock cycle is the markdown phase. Markdown begins when the price makes a lower high and no new high (Figure 9).
Markdown follows a distribution, which is when institutions sell inventory, either for redemption reasons, simply taking profit, or to change position into another stock or sector. The markdown phase is a downtrend (Figure 11).
Be careful that emotions do not rule trading during the markdown phase. Price is always the signal to watch; a series of lower pivot highs and lower pivot lows will signal a pullback in price or a trend reversal. A reversal is when price direction changes completely from the direction it was headed. Successful investors ensure that gains are banked, and money-management rules will not allow for holding a declining issue.
The Bottom Line
The study of stock cycles will give investors a heads-up on trending conditions for a stock, whether sideways, up or down. This allows the investor to plan a strategy for profit that takes advantage of what the price is doing. The entire cycle can repeat or not. It is not necessary to predict it, but it is necessary to have the right strategy.
Now you can apply this information to learn to manage risk. Once you have a gain, have a plan to keep some: A gain is not a profit until you bank it. You can use a stop-loss as part of your trade-management plan to help you capitalize on your gains. Smart investors who recognize the different price cycles are able to take the best profit opportunities. The good news is that you can learn to make the right trade at the right time.