Whether you are a short-term trader or a long-term investor, you have probably heard one of the following trend-related expressions: “The trend is your friend”, “Don’t fight the trend”, or “Don’t catch a falling knife”. While I’m not entirely sure who coined these phrases, the reason that they have upheld the test of time is because there seems to be some merit to them. Although trends are fairly easy to identify and the investment concept is a simple one, do not underestimate the potential benefit of trading “with the trend”. In my opinion this is one of the most important guidelines that new traders should at least be aware of and understand. In addition, while trends fall into the realm of technical analysis, I believe fundamental investors could benefit from paying attention to what the charts might be conveying about the underlying business.
Let’s start by defining what a trend is and then highlight some of the underlying factors that may be supporting the continuity of a trend. Then we can discuss how to identify potential entry and exit points within an overall trend.
What is a trend?
A trend can be defined as “a general direction in which something is moving or developing”. Within the world of finance, stock prices tend to move in one of three general trends over a defined period of time: up, down, or sideways. While a stock price never goes straight up or straight down, it is common to see a general direction emerge over a given period of time. In other words, looking from left to right on a chart, trending stock prices generally move higher, lower, or within some type of a sideways range. If you pull up a chart of any stock over any time frame, it should be fairly easy to place it into one of these three high level categories. Below are example illustrations of what these trends might look like:
Source: StreetSmart Edge®
Although there is no way to know how long a trend will continue into the future, what makes a trend a trend is the fact that it has persisted in one general direction for a relatively long period of time. Using history as a guide, technicians typically believe that there is a greater probability that the trend will continue in the same direction rather than not. Therefore, those who want to “trade with the trend” might buy stocks in uptrends and short stocks in downtrends. Typically the position is closed out when a desirable profit is achieved or when the trend breaks (more on exiting a trend trade below).
What sustains a trend?
Generally speaking, technical analysis is the study of past price movement in an effort to forecast future price movement. I place trend trading in the technical analysis category because the belief is that the past trend will continue into the future. Although the debate over whether stock price movement can be forecasted or not remains open, I’ll just state that it is my belief that trends occur more often than what a random walk theory (which suggests that stock price movement is random and cannot be predicted) might suggest. In my personal experience, I’ve had a higher probability of exiting a trade with a profit by going with the trend rather than against it. Trading with a trend doesn’t guarantee success, but I believe it can help put the odds in your favor. To support this thesis, I’d like to propose some explanation as to what might help a trend remain intact:
Factors supporting uptrends:
- An uptrend is typically supported by strengthening fundamentals – A company’s stock chart should be a reflection of the health of the underlying business. A stock price moving in an uptrend generally reflects a company that is becoming more valuable over time because it is executing on its business plan, selling more products/services, and therefore bringing in (or is projected to bring in) more revenue or profit over time. Investors are generally willing to pay higher prices for a share of that company as long as the business is growing over time. What does this have to do with an uptrend in the stock price? Companies generally grow or contract over extended periods of time but not at the same time. It would be unlikely for a company to randomly grow and contract from one quarter to the next without any direction or consistency. Therefore, if public companies typically grow or contract in trends (or business cycles if you prefer), it shouldn’t be surprising to observe stock prices that move in trends to reflect the underlying developments.
- An uptrend is typically supported by technicians – A stock price moves up or down based on the collective actions taken by both buyers and sellers of that stock. From this collective group of buyers and sellers, there is a percentage that utilize technical analysis as part of their decision making process. Because this subset makes technically-based buy and sell decisions, the majority tend to buy or hold onto a stock as long as it’s in an uptrend. Because both of these actions (buying and holding) are bullish for the price of the stock, the uptrend is essentially reinforced by the technicians involved in that stock.
- An uptrend is typically supported by confident shareholders – Every shareholder of a company is a potential seller of the stock. However, as long as the stock price is moving higher, the shareholder’s investment decision is validated, the confidence level remains high, and therefore the incentive to sell remains relatively low. While there may be an incentive for some shareholders to sell and lock in profit as the stock moves higher, the new shareholders will maintain that confidence as long as the price continues to increase from their entry point.
Factors reinforcing downtrends:
- A downtrend is typically reinforced by weakening fundamentals – Just as a stock price in an uptrend typically reflects a company that is executing well, a prolonged downtrend is typically associated with deteriorating fundamentals. For example, perhaps the company’s product or service is going out of style or competitors are stealing market share, or overall demand is falling due to poor economic conditions. This translates into lower revenue/profit to use for expansion, marketing, or to pay back debt, and eventually forces the company to take contractionary measures in an effort to conserve capital. These types of events unfold over time and a stock price can remain in a prolonged downtrend as investors continually attempt to assess a fair value for the share price.
- A downtrend is typically reinforced by technicians – We’ve already discussed how the technical community can help support an uptrend by buying and holding the stock while the trend is in place. The reverse can also be true for a stock in a downtrend. If the majority of the technical community is shorting or selling stocks in downtrends, this is bearish for the stock price and can help reinforce the downtrend over time.
- A downtrend is typically reinforced by fearful shareholders – Have you ever owned a stock that is in a downtrend but have been reluctant to sell your shares and take the loss? From personal experience I can tell you that it is a frustrating situation in which losses continue to mount as you wait for an acceptable counter-trend rally in order to exit the position. Since there are many other shareholders who are experiencing the same frustration and looking for the same opportunity to sell, this reinforces both the dominant emotion (fear) and the downtrend. The trapped shareholders who bought the stock at higher prices are referred to as “overhead supply” in technical analysis and make it difficult for the stock to experience a sustained rally. Another common investing phrase that expresses how a downtrend might be reinforced is “selling begets selling”.
Trend Entry and Exit Point Guidelines
There are multiple ways to approach the market and trading with the trend is just one method that can either be applied as a primary filter (i.e. look for stocks in uptrends to buy as the first step) or as a complement to an alternate method. However, even if you use the trend as a primary filter for a potential trade candidate, it is only the first step in the process. For example, once you have identified a stock in an uptrend, you may want to consider conducting some fundamental analysis on the company. What does the company do? Have they been beating quarterly earnings and revenue estimates? Are they raising guidance? After conducting your due diligence and you feel comfortable with the investment, then it’s time to identify an entry point, or a price which you are comfortable paying.
To simplify the discussion we will only focus on a stock in an uptrend, though the same concepts can be applied toward a stock in a down or even sideways trend. Here are some guidelines to help identify an entry point for a stock in an uptrend:
- Define the trend channel – Generally, an uptrend consists of a stock price that establishes higher lows and higher highs over time. Draw a line on the chart that connects all of the “higher lows” and another line which connects all of the “higher highs”. The lines may not connect every one of the higher highs or higher lows, but the lines will make it fairly easy to identify a parallel up-trending channel (see the blue dotted lines below).
- Potential entry point – Once the up-trending channel has been defined, you can consider entering the trade whenever the stock falls to the bottom of the channel (see green arrows below). The channel should be extended beyond the current price to help you identify a future entry point (see the green circle below).
- Potential exit point – There are essentially two scenarios that may warrant an exit from the position: when the stock hits the top of the channel (see red arrows below) or when the stock falls outside of the channel (i.e. drops below the lower trend line). Similar to the entry point, the upper trend line should be extended into the future to help identify when to exit the trade in the future.
Source: StreetSmart Edge®
And some final considerations:
- Don’t force it – When you trade on technicals, it’s important to respect what is in front of you and not what you want to happen. When it comes to trend trading, try to avoid creating a trend when there isn’t one there. Determine what the stock is reacting to and respect that. Ask yourself, where are buyers stepping in and where are sellers emerging? Then use those points to help draw your channel.
- Exit if fundamentals change – Over the long haul, the technicals generally take a backseat to the company’s fundamentals. If something fundamentally changes for the worse while you are in a trend trade, you may want to consider exiting the position regardless of where the stock is in the channel. Regardless of whether you are trading or investing, you are a part owner in that company as a shareholder and should feel comfortable with your investment.