Knowing the market environment is very important to becoming a successful trader because the current market state will ultimately determine which trading strategy you use. While Fibonacci retracements, extensions, and trend lines are helpful in trending markets, you would be better off with other trading tools in ranging markets. Knowing how to identify trending markets will give you a significant edge over other traders, and with a little practice; the saying “buy low, sell high” will become part of your daily trading routine.
That’s why we will cover the two types of trending markets - the bull market and the bear market - and show you how to identify and trade on them in this article. So, let’s get started!
Bull market vs bear markets – the difference
A bull market is a financial market where prices rise over a certain period of time. Although the term “bull market” was initially used to describe rising prices on the stock market, it can be also applied to other areas such as the foreign exchange or commodities market.
For a market to be described as a bull market, prices don’t have to rise constantly. In fact, prices will correct (or retrace) from time to time, creating a series of higher highs and higher lows. As long as the price pushes higher to create higher highs, and doesn’t fall below the previous low during retracements, the market can be referred to as bullish. Take a look at the image below and take note of the higher highs and higher lows in the price.
A bear market is the opposite of a bull market. Prices fall over a certain period of time, making a series of lower lows and lower highs. Just like in bull markets, the price doesn’t have to constantly fall, but can make several corrections (retracements) on its way down. As long as the price pushes lower to create lower lows, and doesn’t break the previous lower high during retracements, the market can be referred to as bearish. The image below shows what a bearish market environment looks like.
When trading on bull and bear markets, some tools have proven to be very helpful and effective. For example, traders draw the Fibonacci tool when the market is trending to determine where a retracement might end, and where the price might extend. The Fib ratios of 38.2 or 61.8 are often self-fulfilling as many traders and big players watch these levels and place orders at them. Trend lines are another popular technical tool used in trending markets. The lower and upper trend lines act as supports and resistances respectively, and the price will tend to bounce off these levels. Once the price makes a confirming signal, for example, with a reversal candlestick pattern, these trades can become very lucrative.
Examples of a bull and bear market
The best way to learn how to identify bull and bear markets is through examples. Some financial markets, such as the foreign exchange market, are often trending up or down and provide traders with a lot of trading opportunities. Knowing the current market environment is very important in order to avoid trading against the overall trend, and traders can further add to their positions at every peak or trough during the trend.
A trending bull or bear market can also be identified by using the Average Directional Index (ADX) indicator. The value of the indicator will rise above 25 if the market is trending, and will fall below 25 if the market is ranging. The following example shows a bull market, in which the price makes consecutive higher highs and higher lows, and the ADX indicator remains above 25 (green rectangle). The blue rectangles show the end of the bull market, with the price moving into a range-bound environment and the ADX falling below 25.
The next chart shows an example of a bear market on the AUD/USD currency pair. The price makes consecutive lower lows and lower highs and the ADX remains above 25. Once the price makes a higher high and the ADX falls below 25, the downtrend is over.
The difference between retracements and reversals
A retracement, or correction, is a short-lived price movement which goes against the established trend. They give us important signals that bull or bear markets are still intact by forming higher lows during uptrends and lower highs during downtrends. Traders often measure price retracements with Fibonacci tools to identify exactly where a retracement may end.
On the other hand, reversals can occur at any time when the underlying fundamentals of a currency pair change. A higher high during a bear market or a lower low during a bull market give clues that the current trend is about to reverse.
Summary
Bull and bear markets can be easily identified with a little practice. It’s important to remember that even in a trending market, prices can retrace from time to time, while the overall trend remains intact. Knowing that those retracements are only short-lived, and that the currency fundamentals haven’t changed, traders can add to their positions at the end of a retracement or even trade on the retracement itself against the trend (although this can be risky). Once a trend has been established, it will continue as long as there is no major shift in market sentiment or a change in the underlying fundamentals of a currency pair. When the price decides to reverse by breaking the previous higher low (during a bull market) or lower high (during a bear market), the safest bet is to stay away from the market until a new trend has been established. Although there are trading strategies for ranging markets as well, riding the trend is one of the most profitable trading strategies when done right.