"A rising tide lifts all boats".
"It is easier to swim downstream than upstream".
All of these sayings have some level of merit for traders when they are considering a stock trade. By definition, a bull market is a period of time when the majority of stocks rise in price. As a result, the potential for finding a profitable stock is greater when the majority of stocks are rising in price.
A rising tide lifts all boats
The definition of a bull market is "a period of time when the majority of stocks rise in price." If you can effectively identify an overall bullish market trend, you increase your likelihood of buying stocks that rise in price.
Yet, in the face of a powerful bull market, there will always be some stocks that decline in price anyway. Some companies experience difficulties which are specific to their own circumstances. Poor sales, uncontrollable expenses or too much debt can be difficult to overcome and result in negative price action in the security’s shares. In these instances, even the most favorable broad market action may not be sufficient to propel a struggling company’s share price higher.
The trend is your friend
This phrase is possibly the oldest in a long line of adages designed to show the value of trend analysis. Many traders experience the fear of ‘buying the top’ and then having to endure a price decline and loss of capital. While most of us are very familiar with the most common saying ‘buy low, sell high’ the art of identifying which prices are considered high and low, respectively, is a challenge for the majority of traders.
In reality, it is easier to identify the trend of a stock in the moment than it is to determine where the stock’s price is going next. With this in mind, it can be argued that the idea of "buying high and selling higher" is more likely to be a successful strategy than one that attempts to "buy low and sell high."
This line of thinking is the crux of an investment approach most commonly referred to as "trend following." As the name implies, this approach to trading and investing makes no attempt to pick tops or bottoms, but instead focuses on simply identifying whether the current trend for a given stock or asset is presently bullish, bearish or neutral. The primary goal of trend following is simply to ride a bullish trend as long as possible and to miss a significant portion of any bearish decline once the trend is discontinued.
It is easier to swim downstream than upstream
This adage is similar in concept to "The Trend is Your Friend." This phrase simply acknowledges that it is generally easier to go with the flow than to predict when a turning point is about to take place. Additionally, making money by selling short in the face of a rising stock market or buying during a bear market can be successful, but it is a much more difficult task than trying to go with the flow and trading in the direction of the major trend.
The potential benefits of identifying a bullish trend
At any given time, a trader might find reasons to be concerned about what unforeseen event might happen next. Whether the concern is economics, politics, stock market specific, company specific or the price of tea in China, there is always some news available to cause a trader doubt. Overcoming these extraneous doubts is at the forefront of creating an objective trading method.
Many traders over the years have been convinced to exit a winning or potentially winning position due to a fear that an existing trend can’t last forever. Frequently, this results in profits left on the table as the trend continues on its merry way for an unexpectedly long period of time. One way to avoid selling too soon is to utilize a trend-following method that has the trader selling their position only when the trend is broken. While this approach may seem counterintuitive to traders from the "buy low, sell high" school of thought, it can be very effective and might allow a trader to ride positions to larger gains.
Identifying a bullish trend
So how does a trader identify a bullish trend? As with many aspects of trading, there is no one best, surefire method to definitively identify a trend as bullish or bearish. There are, however, several useful and simple tools that traders can use in an effort to label the trend at any given point in time as bullish, bearish or neutral.
One of the most common trend-following tools used by traders is the simple moving average. A simple moving average, (SMA), is a technical analysis tool that calculates the average price for a stock or index over a chosen period of time. A trader can compare the current price for the stock or index to its moving average. If the price of the stock or index is above the moving average, a trader can consider the trend as bullish. If the price of the stock or index is below the moving average, a trader can reasonably call the trend bearish.
While there is no one best moving average value, many traders will compare a major stock market index such as the Dow Jones Industrials Average, the S&P 500 Index, the Nasdaq 100 index or the Russell 2000 small-cap index to its own 200-day SMA in order to assess the current trend. An alternative might be a 40-week moving average of weekly closing prices.
If the index in question is presently above its 200-day SMA, the current trend is generally deemed to be bullish, and as a result a trader may continue to hold existing bullish positions and/or continue to look for new buying opportunities. On the other hand, if the index in question is presently below its 200-day SMA, the current trend is deemed bearish, and a trader may consider selling existing bullish positions and/or delay looking for new buying opportunities.
The strength of bullish and bearish trends can also be measured by considering how many of the major market averages are presently above or below their respective moving averages. For example, if all four of the indexes listed earlier are above their 200-day moving averages, it is quite logical to deem the major trend as bullish. If one of the indexes subsequently falls below its moving average this may serves as an early warning sign. If all of the indexes fall below their respective 200-day SMA, then the trend-following trader would consider the trend to be bearish and would likely take some sort of defensive action.
For traders with a shorter investment horizon, the 50-day, 20-day, and 10-day simple moving averages are commonly used to eliminate earlier daily closing prices. Using shorter time frames for the SMA gives the trader signals that are consistent with their strategy’s timeframe. In the chart below, you can see that the value for each of the four indexes shown is above its respective 200-day simple moving average. In light of this, a trader would likely deem the current trend to be bullish and would begin or continue to look for buying opportunities.
Major stock market indexes and their respective 200-day moving averages
No trend lasts forever
Although we have extolled the potential benefits of simply going with the flow, it can also be a mistake to assume that the current trend is destined to continue in perpetuity. One mistake that some traders make is to "fall in love" with a particular trend and to ignore evidence that the trend they prefer is no longer in force. Remember that any trend-following method tells you only what the current trend is and there is never a guarantee that the trend will continue indefinitely.
The overall market trend is important in bullish trading. It can be an extremely useful piece of information to have some idea of whether the current trend of the stock market is presently bullish, bearish or neutral. This piece of information tells a trader if he or she is going with the flow or fighting the trend and attempting to swim upstream prior to entering a bullish trade.