Trade the Trend

Key Points

  • You may have heard the expression, "Don't fight the trend."
  • Find out why it's important to heed trends and how to identify them.
  • Plus, find out how you can use trend-based strategies.

"Don't fight the trend." "The trend is your friend until the bend in the end." These axioms are often quoted by technical traders. But what do they really mean? Are these statements only relevant for traders who are strictly technical in nature, such as very short-term traders? Or do they hold value for those of us with a slightly longer time horizon? Let's dig a little deeper into trends to see if we might be able to use them to improve our results.

Let me say up front that I'm not a Chartered Market Technician (CMT) but I have used technical analysis in my own trading for years, and I've worked extensively with expert technical analysts over the years. I believe the best approach to trading is to choose your stocks based on fundamental factors and select your entry and exit points based on technical factors.

Don't get trampled

The concept of "don't fight the trend" is rooted in a simple idea: If you're going in one direction while everyone else is going in the other direction, you're likely to get trampled. If you've ever sat at the front of an airplane with your luggage stored in an overhead bin at the back of the plane, you understand this concept.

In technical analysis, an uptrend is defined as a series of higher highs and higher lows. Similarly, a downtrend is a series of lower highs and lower lows. This makes it extremely difficult to buy at the bottom and sell at the top, since it is only after the top has been reached that a stock can begin to decline, and it can only begin to rise after the bottom has been reached. In other words, a trend isn't a trend until there are several days of data and a pattern has been established.

How many occurrences it takes to establish a pattern will vary depending upon your time horizon. Long-term traders may look for trends in weekly or monthly charts, while shorter-term traders may use daily charts.

Consider that the equity markets are driven mostly by supply and demand. Buyers' willingness to pay an increasingly higher price is what causes a stock to rise. If you're a buyer when there are many more sellers, it may be difficult to make a profit. It's not impossible, just difficult. In contrast, the willingness of sellers to accept a decreasingly lower price is what causes stocks to drop.

Example of an Uptrend

Example of an Uptrend

Source: StreetSmart Edge.
Historical data for illustrative purposes only.

Example of a Downtrend

Example of a Downtrend

Source: StreetSmart Edge.
Historical data for illustrative purposes only.

How do you use this information?

It can be very difficult for a trader to trade against his or her opinion about a stock. Trading the trend sometimes requires you to do just that. Even if you're ultimately correct about a stock's direction, it still might not move in that direction right away. Regardless of how extensive your research is, there may still be information you don't know, and that may be what's holding down the price.

Trend trading may help you be patient and wait until a stock begins to rise before you establish a long position. Technical traders use a variety of indicators such as moving averages, breakouts, Bollinger Bands® and momentum to help spot trends. All of these indicators (studies) and many others can be found in the charts available on the various Schwab trading platforms.

Don't worry about missing out. Much research has shown that, at least over relatively short time periods, stocks that are moving up tend to keep moving up, while stocks that are dropping in price will likely continue to drop. While "relatively short time periods" may be fuzzy, most trends will last long enough for you to participate, and there's often profit to be made in the middle of the trend.

Going against the crowd

I'm sure you've heard television pundits say that the obvious trade is getting crowded, or that it's better to be a contra-trader. But before you're tempted to go against the trend, be sure to consider what is most important to you. Would you rather be right and lose money, or would you rather make a profit even though you may not completely understand or agree with the direction?

It's important to consider that the market is a discounting mechanism. As such, it's forward-looking and sometimes anticipates the future far better than we can as individuals. As a result, the market's euphoria during times of economic crisis may be difficult to understand. Similarly, when everything seems great with the economy, the market may already be declining in anticipation of difficult times ahead.

It's tempting to assume that if we do enough research or have enough trading experience we can pick the tops and bottoms of the market. However, it might surprise you to find that even if you could pick the tops and bottoms perfectly on a consistent basis, you wouldn't necessarily perform that much better than if you could simply get close. In fact, if you have a long time horizon, investing immediately has historically performed almost as well as picking exact market tops and bottoms.

If you have a shorter time horizon, a good way to help improve your chances of buying near the bottom and selling near the top is to scale in and out of your positions when you think the market is close to a top or bottom. Keep in mind that this strategy will likely increase commission costs.

Bottom line

Remember, trading isn't about buying at the exact bottom and selling at the exact top; it's about getting close and riding the majority of the trend. Indeed, the trend is your friend. 

 

Next Steps

Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
Not yet a client? Learn more about Schwab Trading Services.

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