Some traders believe that the market moves in cycles with price action unfolding in rhythmic patterns. One example of a cycle in nature is the amount of time in a day. The Earth completes a full rotation on its axis every 24 hours, following a cyclical pattern. An accurate forecast of daylight can be developed from this cycle. Traders have identified similar recurring cycles in the stock market.
Various techniques are used to identify cycles in the markets. The simplest approach is visual, such as noticing that stock market lows often occur in October. This allows the trader to mark lows each October and expect highs halfway through the cycle in April.
More sophisticated mathematical techniques include the Fourier transform and more precisely define cycles.
Cycles are described by their phase (the amount of time since the last bottom), amplitude (the size of the move from high to low), and frequency (the time between two consecutive bottoms or consecutive tops).
Multiple cycles are at work in any market at a given time. That makes it impossible to forecast market action with absolute certainty since expected highs and lows for different cycles can be in conflict. Cycle analysis can be a valuable tool for traders when used with other indicators.
How Traders Use It
The chart below shows weekly prices of SPDR Dow Jones Industrial Average (NYSE: DIA), an ETF that tracks the Dow Jones Industrial Average. A 52-week cycle with a bottom in October has been added to the chart. Some of the cycle lows are seen very close to bottoms in price. This simple approach only works occasionally and would not be a winning trading strategy on its own.
Traders use cycles as an approximate guide to market timing. With a cycle, the trader can identify the probable turn date for a market in advance. A top is due 26 weeks after a bottom in the example shown. Traders can look for other indicators to confirm the market reversal near the predicted dates where a market turn is predicted by the cycles.
While some cycles come nearly on schedule, there are other times when cycles can invert and the price action moves completely opposite to expectations. This can be seen at the top in 2007 (near the middle of the chart example) when a cycle low was expected but a top occurred instead. Market moves following a cycle inversion can be rapid and large, and that is what happened when the cycle failed in 2007.
Why It Matters To Traders
Cycle analysis can be successfully used by some traders and some markets do seem to generally follow cycles. This can be a valuable forecasting tool and many traders will know the key dates when market turns are predicted by cycles. They will usually only take the trading signals when they are confirmed by other indicators.
(This article originally appeared on ProfitableTrading.com.)