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Trend following in bearish trading

Trend-Following in Bearish Trading

“The trend is your friend” may be one of the oldest and most often repeated adages in trading. Some would suggest that it is one of the most useful. Often, new traders are ruled by the idea of buying low and selling high. They attempt to buy bottoms and sell tops, which is a difficult, if not impossible task. Fortunately, many traders come to realize that riding existing trends and acting decisively when the trend changes can be a very effective trading strategy.

Using trend-following tools as a catalyst to enter bearish trades

Veteran traders understand the strengths and limitations of trend-following indicators and use them when establishing positions on either side of the market. The primary advantage to using these methods for bearish trading is to help the trader limit losses in these very risky trades. These tools can also allow the trader to stay in a winning position longer than they may have otherwise. Sometimes trends take a long time to play out and their move can exceed the time and price range the trader expected. The bearish trader can stick with a particular trade longer than anticipated because the stock’s trend shows its slide continuing rather than reversing. The primary limitation of trend-following indicators is that they are not predictive in nature. That is, they tell you what is happening, not what is about to happen. Understanding this nuance is key to using these tools successfully.

No trend continues in perpetuity. A stock or index that is bearish today may not be bearish tomorrow. Because trend following tools can’t tell you with certainty what tomorrow holds, traders who use them accept this drawback and employ risk management techniques to protect themselves. It should be noted that strongly bearish trending stocks are susceptible to sharp upside reversals, leaving the short-seller at substantial risk. The implications of these limitations are that a trend-following trader must:

  • Be vigilant in employing risk controls in order to limit losses on those trades where the trend fails to follow through.
  • Be prepared psychologically to deal with sharp countertrend rallies as well as the inevitable losing trades.

 

Trend-following catalyst example: Moving averages

The moving average is among the most commonly used trend-following tools. A Simple Moving Average (SMA) calculates the average closing price for a given security over a specific number of trading days.

Source: StreetSmart Edge®

For example, a 50-day simple moving average represents the average closing price over the last 50 trading days while a 200-day simple moving average represents the average closing price over the last 200 trading days.

Source: StreetSmart Edge®

Many traders apply the 50-day and 200-day moving averages to major stock market indexes such as the Dow Jones Industrials average and the S&P 500 index to identify the current trend of the overall market. In a nutshell, when the 50-day moving average is above the 200-day moving average the overall market is deemed to be “bullish” and when the 50-day moving average is below the 200-day moving average then the overall market is deemed to be “bearish.” 

The moving averages employed, however, can give very different signals. The shorter the time frame the more sensitive to smaller price movement, the longer the time frame, the less sensitive to smaller price movement and smoother the line. For example, a chart that has 10-day and 30-day moving averages generates differing buy and sell signals than one that has a 50-day and 200-day moving averages.

Source: StreetSmart Edge®

Many moving averages exist and it is important to note that there is no “one best” moving average or combination of moving averages to use. Their usefulness and importance lies in how they complement your trading strategy and match your trading time frame.

Trend-following catalyst example: ADX (DMI+ and DMI-)

The Average Directional Index (ADX) uses the entire price action in a given period, from low to high, to measure the strength and persistency with which a security moves up or down. It is displayed on a scale from 0 to 100 and is designed to rise when a trend is strengthening and to decline when a trend is weakening. This holds true, regardless of the direction of the trend.

The Average Directional Index may appear differently across charting services, but is primarily made of four indicators. Among those is a pair of trend-following indicators known as DI+ and DI-. DI+ measures the percentage of positive price movement while DI- measures the percentage of negative price movement.

Traders look for DI+ and DI- “crossovers” for indications to the trend’s strength and potential changes in trend. There are two types of DI crossovers. When the DI+ line crosses above the DI- line it signals a potential change of trend to the upside. When the DI+ line crosses below the DI- line it signals a potential change of trend to the downside.

The default window for the ADX indicator is 14-days. However, for trend-following purposes, traders will often look at longer day windows in order to identify the longer-term trends. Some traders will look at the overall market first before looking at individual stocks.

For example, the indicator is considered to be bullish when DI+ is greater than DI- and bearish when DI+ is less than DI-. If DI+ for a market index such as the S&P 500 is greater than DI- then some traders will treat this as a bullish sign for the overall market and may focus on buying individual stocks. If the DI+ for a market index like the S&P 500 is less than DI- then some traders will either stand aside or consider trading the short side of the market.

Source: StreetSmart Edge®

Traders might also consider applying this method to individual securities. For example, when DI+ is greater than DI- on the chart for XYZ, the trend is deemed to be bullish and then the DI+ is less than DI- the trend is deemed to be bearish.

Source: StreetSmart Edge®

Combining trend-following indicators

Rather than relying on one indicator, some bearish traders will combine two or more trend-following indicators in hopes of identifying strong trends more clearly. A trader might combine DI+ and DI- with a moving average and sell short only when both indicators are bearish.

For example, when $SPX’s, price is above the 200-day moving average and the net DMI value is greater than 0, then the trend is deemed to be bullish. A bearish trader might consider a strategy of looking for bearish opportunities only when both of these trend-following indicators are bearish.

Source: StreetSmart Edge®

Traders might also consider applying this method to individual securities. For example, when XYZ’s price is above the 200-day moving average and the DI+ value is greater than DI- the trend is deemed to be bullish. When XYZ’s price is below the 200-day moving average and the DI+ value is less than the DI- value the trend is deemed to be bearish. A bearish trader might consider selling short shares when the trend is bearish and closing a position when the trend is bullish.

Source: StreetSmart Edge®

Summary

Trend-following is among the most time-tested and potentially useful approaches to trading. Trading against the trend can be mentally taxing and difficult. By using trend following techniques, a trader can identify the major trend, trade with it, and stay protected with risk management tools.      

Traders who rely on trend-following should remember that not every newly emerging trend will play out as a big price move. Short-term reversals will inevitably occur and can be frustrating so establishing a trading strategy and sticking to it can be helpful. While trend-following methods can never buy at the bottom, nor sell at the top, traders typically find that trading in the direction of the major trend offers many long term advantages.

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Schwab does not recommend the use of technical analysis as a sole means of investment research.

The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern or investment strategy.

Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.

Past performance is no guarantee of future results.

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