Once identified and understood, cycles can add significant value to the technical analysis toolbox. However, they are not perfect. Some will miss, some will disappear and some will provide a direct hit. This is why it is important to use cycles in conjunction with other aspects of technical analysis. Trend establishes direction, oscillators define momentum and cycles anticipate turning points. Look for confirmation with support or resistance on the price chart or a turn in a key momentum oscillator. It can also help to combine cycles. For example, the stock market is known to have 10-week, 20-week, and 40-week cycles. These cycles can be combined with the Six Month Cycle and Presidential Cycle for added value. Signals are enhanced when multiple cycles nest at a cycle low.
A cycle is an event, such as a price high or low, which repeats itself on a regular basis. Cycles exist in the economy, in nature and in financial markets. The basic business cycle encompasses an economic downturn, bottom, economic upturn, and top. Cycles in nature include the four seasons and solar activity (11 years). Cycles are also part of technical analysis of the financial markets. Cycle theory asserts that cyclical forces, both long and short, drive price movements in the financial markets.
Price and time cycles are used to anticipate turning points. Lows are normally used to define cycle length and then project future cycle lows. Even though there is evidence that cycles do indeed exist, they tend to change over time and can even disappear for a while. While this may sound discouraging, trend is the same way. There is indeed evidence that markets trend, but not all the time. Trend disappears when markets move into a trading range and reverses when prices change direction. Cycles can also disappear and even invert. Do not expect cycle analysis to pinpoint reaction highs or lows. Instead, cycle analysis should be used in conjunction with other aspects of technical analysis to anticipate turning points.
The Perfect Cycle and stock signals
The image below shows a perfect cycle with a length of 100 days. The first peak is at 25 days and the second peak is at 125 days (125 - 25 = 100). The first cycle low is at 75 days and the second cycle low is at 175 days (also 100 days later). Notice that the cycle crosses the X-axis at 50, 100 and 150, which is every 50 points or half a cycle.
Cycle Characteristics and Best Signals
Cycle Length: Lows are usually used to define the length of a cycle and project the cycle into the future. A cycle high can be expected somewhere between the cycle lows.
Translation: Cycles almost never peak at the exact midpoint nor trough at the expected cycle low. Most often, peaks occur before or after the midpoint of the cycle. Right translation is the tendency of prices to peak in the latter part of the cycle during bull markets. Conversely, left translation is the tendency of prices to peak in the front half of the cycle during bear markets. Prices tend to peak later in bull markets and earlier in bear markets.
Harmonics: Larger cycles can be broken down into smaller, and equal, cycles. A 40-week cycle divides into two 20-week cycles. A 20-week cycle divides into two 10-week cycles. Sometimes a larger cycle can divide into three or more parts. The inverse is also true. Small cycles can multiply into larger cycles. A 10-week cycle can be part of a larger 20-week cycle and an even larger 40-week cycle.
Nesting: A cycle low is reinforced when several cycles signal a trough at the same time. The 10-week, 20-week, and 40-week cycles are nesting when they all trough at the same time.
Inversions: Sometimes a cycle high occurs when there should be a cycle low and vice versa. This can happen when a cycle high or low is skipped or is minimal. A cycle low may be short or almost non-existent in a strong uptrend. Similarly, markets can fall fast and skip a cycle high during sharp declines. Inversions are more prominent with shorter cycles and less common with longer cycles. For instance, one could expect more inversions with a 10-week cycle than a 40-week cycle.
The data points on a price chart can be split into three categories: trending, cyclical or random. Trending data points are part of a sustained directional move, usually up or down. Cyclical data points are recurring diversions from the mean. Diversions occur when prices move above or below the mean. Random data points are noise, usually caused by intraday or daily volatility.
Cycles can be found by removing trend and random noise from the price data. Random data points can be removed by smoothing the data with a moving average. The trend can be isolated by de-trending the data. This can be done by focusing on movements above and below a moving average.
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