Trading With Primary And Secondary Trends

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Trade With The Trend, But Which One?

Trading both sides of the chart is one way to super charge your trading. You can effectively increase the number of effective signals you get by simply opening yourself up to trading both bullish and bearish positions. I don’t mean you should be trading both at the same time, at least not on the same asset (unless your trading spreads), I mean you have to be open to taking either a bear or bull signal when one presents itself. This may also sound a bit like I am suggesting trading against the trend but that is not the case either. Think about it like this, every uptrend consists of a primary trend and a secondary trend. The primary trend is the longer term trend, whether it be a bull trend or a bear trend. Every primary trend is dotted with secondary trends, these are the consolidations, pullbacks, bounces and corrections that form as nearer term greed/fear briefly overpowers the longer term driver of the rally.

As traders we are taught to follow the trend in order to maximize profits. As binary traders we tend to focus on directional trades. This means, at least for me, I tend to focus on only using trend following signals and trend following trades. If the market was moving up I would trade calls, if down puts. If the signal was strong I would use short expiry, typically one week or shorter, and if the signal was week I would use a longer expiry, usually end of the month or one month. If the signal was not present, unclear or at the potential end of a movement I would also use longer expiry, in order to give the market time to “move on” from whatever it was that was causing the uncertainty. This method works well with binary but upon reflection I realized that I was only trading in line with trend about 66% of the time. What.

You Can Trade Against The Trend

Yes, it’s true. With the right approach you can trade against the trend. The strong signals and even the weak signals were paying off because they followed the primary and secondary trend. It was the uncertain signals and times of indecision that were the ones not profiting and it was because the secondary trend had changed. Take for example the chart below. There is a strong primary trend following signal that I would have a one week expiry on and followed up with additional one week trades. As the market moved up the indicators form divergences that point to a stall in the rally on at least a near to short term basis. At this time I would have switched to monthly expiry in order for the trades to weather the near term fluctuation but if you look here you will see that it didn’t pay off because 30 days after the peak the market was still trending sideways and at a 30 day low. An end of month may have worked depending on where I got in but it would have been dicey. The key here is that the market was still trending sideways 30 days later , this is because there was a change in trend that I was not taking advantage of.

The chart above shows only the long term primary trend. When the market reached a point of indecision switching to a longer term expiry makes sense but is not the best choice. The primary trend is still up but the secondary trend has changed so a change in tactic is also appropriate. The first and safest assumption is that the market has entered a near to short term consolidation range. By this I mean one that may last a few days to a few weeks. Look at the chart below. The secondary trend changes from up to sideways and that changes lasts for about 6 weeks. This means that during that time it will be possible to begin trading from both sides of the chart. When the asset reaches the top or a peak within the sideways trend puts are the right choice. When the asset reaches the bottom of the range or peaks within the sideways trend switching back to calls is the right thing to do. However, with a change in trend and trading tactic should also come a change in expiry.

Trades made against the primary trade should be shortened. They just won’t last as long because they are more likely to find support, at least in the near term, and be reversed. This is when I start using end of week, 3 day and end of day expiry. This is also a good idea when trading in line with the primary until the secondary trend moves back in line with it because you just don’t know how long the consolidation is going to last. Of course, as time goes on additional primary trend following signals will develop and at that time the longer term expiry can be employed; one month for the weaker signals and then one week once the signal becomes strong. Since making this revelation I have been able to improve my success rate dramatically. Now, instead of blindly making those longer term trades with the hope the market would move in time I change tactic with the secondary trend and capture more, profitable, trades.

A Look at Primary and Secondary Markets

The word “market” can have many different meanings, but it is used most often as a catch-all term to denote both the primary market and the secondary market. In fact, “primary market” and “secondary market” are both distinct terms; the primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors.

Knowing how the primary and secondary markets work is key to understanding how stocks, bonds, and other securities trade. Without them, the capital markets would be much harder to navigate and much less profitable. We’ll help you understand how these markets work and how they relate to individual investors.

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Key Takeaways

  • The primary market is where securities are created, while the secondary market is where those securities are traded by investors.
  • In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public offering (IPO).
  • The secondary market is basically the stock market and refers to the New York Stock Exchange, the Nasdaq, and other exchanges worldwide.

Primary Market

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example of a primary market. These trades provide an opportunity for investors to buy securities from the bank that did the initial underwriting for a particular stock. An IPO occurs when a private company issues stock to the public for the first time.

For example, company ABCWXYZ Inc. hires five underwriting firms to determine the financial details of its IPO. The underwriters detail that the issue price of the stock will be $15. Investors can then buy the IPO at this price directly from the issuing company.

This is the first opportunity that investors have to contribute capital to a company through the purchase of its stock. A company’s equity capital is comprised of the funds generated by the sale of stock on the primary market.

A rights offering (issue) permits companies to raise additional equity through the primary market after already having securities enter the secondary market. Current investors are offered prorated rights based on the shares they currently own, and others can invest anew in newly minted shares.

Other types of primary market offerings for stocks include private placement and preferential allotment. Private placement allows companies to sell directly to more significant investors such as hedge funds and banks without making shares publicly available. While preferential allotment offers shares to select investors (usually hedge funds, banks, and mutual funds) at a special price not available to the general public.

Similarly, businesses and governments that want to generate debt capital can choose to issue new short- and long-term bonds on the primary market. New bonds are issued with coupon rates that correspond to the current interest rates at the time of issuance, which may be higher or lower than pre-existing bonds.

The important thing to understand about the primary market is that securities are purchased directly from an issuer.

Primary Market

Secondary Market

For buying equities, the secondary market is commonly referred to as the “stock market.” This includes the New York Stock Exchange (NYSE), Nasdaq, and all major exchanges around the world. The defining characteristic of the secondary market is that investors trade among themselves.

That is, in the secondary market, investors trade previously issued securities without the issuing companies’ involvement. For example, if you go to buy Amazon (AMZN) stock, you are dealing only with another investor who owns shares in Amazon. Amazon is not directly involved with the transaction.

In the debt markets, while a bond is guaranteed to pay its owner the full par value at maturity, this date is often many years down the road. Instead, bondholders can sell bonds on the secondary market for a tidy profit if interest rates have decreased since the issuance of their bond, making it more valuable to other investors due to its relatively higher coupon rate.

The secondary market can be further broken down into two specialized categories:

Auction Market

In the auction market, all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. Thus, theoretically, the best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually agreeable prices to emerge. The best example of an auction market is the New York Stock Exchange (NYSE).

Dealer Market

In contrast, a dealer market does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. The dealers hold an inventory of security, then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. An example of a dealer market is the Nasdaq, in which the dealers, who are known as market makers, provide firm bid and ask prices at which they are willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for investors.

The so-called “third” and “fourth” markets relate to deals between broker-dealers and institutions through over-the-counter electronic networks and are therefore not as relevant to individual investors.

The OTC Market

Sometimes you’ll hear a dealer market referred to as an over-the-counter (OTC) market. The term originally meant a relatively unorganized system where trading did not occur at a physical place, as we described above, but rather through dealer networks. The term was most likely derived from the off-Wall Street trading that boomed during the great bull market of the 1920s, in which shares were sold “over-the-counter” in stock shops. In other words, the stocks were not listed on a stock exchange, they were “unlisted.”

Over time, however, the meaning of OTC began to change. The Nasdaq was created in 1971 by the National Association of Securities Dealers (NASD) to bring liquidity to the companies that were trading through dealer networks. At the time, few regulations were placed on shares trading over-the-counter, something the NASD sought to improve. As the Nasdaq has evolved over time to become a major exchange, the meaning of over-the-counter has become fuzzier. Today, the Nasdaq is still considered a dealer market and, technically, an OTC. However, today’s Nasdaq is a stock exchange and, therefore, it is inaccurate to say that it trades in unlisted securities.

Nowadays, the term “over-the-counter” refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE, or American Stock Exchange (AMEX). This generally means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies.

$13.4 trillion

The market cap of the New York Stock Exchange, the largest stock exchange in the world. Stock exchanges are considered to be part of the “secondary” market.

Third and Fourth Markets

You might also hear the terms “third” and “fourth” markets. These don’t concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions. The main reason these third- and fourth-market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor.

The Bottom Line

Although not all of the activities that take place in the markets we have discussed affect individual investors, it’s good to have a general understanding of the market’s structure. The way in which securities are brought to the market and traded on various exchanges is central to the market’s function. Just imagine if organized secondary markets did not exist; you’d have to personally track down other investors just to buy or sell a stock, which would not be an easy task.

In fact, many investment scams revolve around securities that have no secondary market, because unsuspecting investors can be swindled into buying them. The importance of markets and the ability to sell a security (liquidity) is often taken for granted, but without a market, investors have few options and can get stuck with big losses. When it comes to the markets, therefore, what you don’t know can hurt you and, in the long run, a little education might just save you some money.

Dow Theory and the Primary Trend

There’s been a lot of talk about equity market breadth both in the U.S. and globally, but one thing I’ve not seen mentioned throughout the debate is Dow Theory. While there are five tenets of Dow Theory, today I want to focus on the aspect regarding confirmation among the three averages – the Dow Jones Industrial Average, Dow Jones Transportation Average and Dow Jones Utility Average – by assessing their primary trends.

Let’s start off with the Dow Jones Industrial Average, which is trading at five-month highs and 4.20% below its all-time highs. From a structural perspective, momentum remains in a bullish range, the 200-week moving average is rising, and prices are still advancing in a series of higher highs and higher lows. There’s not a whole lot of evidence that this is anything other than a secondary downtrend within a primary uptrend. (See also: Dow Theory.)

The Dow Jones Transportation Average is also hitting six-month highs and is just 2.30% below its all-time highs. Again, from a structural perspective, we’re seeing much of the same that we saw in the Dow Jones Industrial Average. Prices hit an upside objective in January and have been consolidating since, now pushing back toward their highs. Again, a secondary trend followed by a continuation of the primary trend is very normal behavior.

The third relevant index is the Dow Jones Utility Average, which is hitting seven-month highs and is trading roughly 6.25% below its all-time highs. Last year, prices broke above the upside objective hit in July 2020 and failed to hold higher, confirming a failed breakout and correcting roughly 17%. This secondary trend was met with buying at the uptrend line from its 2002 lows as momentum diverged positively. Despite this initial weakness and several-month divergence from the other two indexes, utilities have recovered and appear to be continuing their primary trend higher. One final note here is that the Dow Jones Utility Average is not traditionally part of Dow Theory, but we still find value in monitoring it, as the three tend to move in tandem over the long term.

The last chart I want to highlight is an overlay of the Dow Jones Industrial Average and the Dow Jones Transportation Average over the past 20 years. In red, we’ve highlighted negative divergences between the indexes that led to significant secondary trends to the downside, and in green is a divergence that preceded the beginning of a new primary move to the upside. And if you look all the way to the right, you’ll see that there’s no divergence at the moment. In fact, both indexes are at five- and six-month highs.

The Bottom Line

While Dow Theory isn’t necessarily a great tool to generate precise buy or sell signals, it is a good indicator to identify potential divergences that often precede a change in the broader market’s primary trend. As of now, we’re seeing confirmation from all three of these indexes resolving their year-to-date ranges to the upside. If the market was nearing a major turning point, we’d expect to see some sort of negative divergence in at least one of these indexes, but there aren’t any as of yet.

When there’s a lot of noise, it sometimes helps to take a step back and use simple exercises like the one above to get an objective view of the broader market’s primary trend. For now, it looks like the market is headed for higher prices, but we’ll continue to monitor these charts for any changes that might affect that thesis.

If you enjoyed this post and want updates on how these charts develop, consider joining the All Star Charts community by starting a 30-day risk-free trial or signing up for our “Free Chart of the Week”.

Thanks for reading, and let us know if you have any questions!

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