We’ve all heard the expression “the trend is your friend.” Well, although it’s a little hackneyed now, the basic premise is true. Trading in the direction of the trend is the most consistently profitable method I’ve seen. The trick is how to identify that a trend is actually in place. Trends can vary in time from minutes on a tick chart to years on a monthly chart.
What Is a Trend?
A trend can be defined as follows:
An uptrend can be described as a sequence of higher lows in conjunction with higher highs.
A downtrend can be described as a sequence of lower highs in conjunction with lower lows.
Some people define an uptrend as the point when the closing price is above the moving average (of a specific period), and a downtrend is when the closing price is below the specific moving average. I don’t use moving averages of price movement to define trend, nor to source trending stocks. There are inherent challenges with only using moving averages, which I discuss next.
In my workshops I ask my students how they unearth trending stocks, and the two most common answers I hear relate to moving averages and fundamental filters. From those two answers I already know that the person concerned doesn’t find trending stocks purely because moving averages and fundamental filters generally don’t lead to trending stocks!
So first things first, let’s look at some trending stocks and clarify why they’re trending (Figure 2.1).
As you can see, the stock is rising and appears to keep bouncing off the imaginary trendline at the points B. This trendline is providing support for the stock. Typically we expect volume to rise as the price hits the trendline and bounces off it, confirming the supporting action. Notice that with an uptrend, we draw the trendline to join up the lows.
Sooner or later the uptrend has to be broken, and the stock will retrace downward. The beauty of using a trendline is that when the price breaks through it, we can define the trend as being over for the time being.
So far so good. Let’s now look at a downtrending stock (Figure 2.2).
Here is the opposite scenario. The stock is falling and appears to keep bouncing off the imaginary trendline at the points B. This trendline is providing resistance for the stock. Typically we expect volume to rise as the price hits the trendline and bounces off it, confirming the resistance action. Notice that with a downtrend, we draw the trendline to join up the highs.
Sooner or later the downtrend has to be broken, and the stock will retrace upward. By using a trendline we know that when the price breaks through it, we can define the trend as being over.
If this sounds easy, the reason is because it is! If you’re looking for something more complex, then I’ll show you moving averages and why they’re more difficult for defining trends. You want your interpretations of trend to be made easily because it helps your decision-making process when it comes to actual trading. If your interpretation of a chart isn’t clear, your trading will be equally as unclear, which will only lead to inconsistent, bad, and unsuccessful trading.
The Challenge with Moving Averages
Moving averages are the most widely known and used technical indicators. A moving average is simply the average closing price of a period of bars on a price chart. On a daily chart, a 20-period moving average is the average of the last 20 days’ prices. Moving averages are useful for the way in which they smooth price action, and they are perceived by many to be good indicators of trend. The challenge, however, is in getting the settings correct, and those may change from stock to stock as different stocks will trend with different smoothness and different timescales.
The most popular way of using moving averages is to have one short term and one longer term. When the short moving average rises up through the longer term moving average, this is a bullish signal. When the short term moving averages fall down through the longer term moving average, this is seen as a bearish sign.
The problem is that this moving average crossover method is only relevant with trending stocks. And if we can’t readily find or identify trending stocks, then there’s no merit in it whatsoever. The other problem with it is that by the time the short Moving Average (MA crosses the longer MA, the stock price may well have plummeted or rocketed ahead of time. In other words, a moving average is a lagging indicator, and if the lag is too long, then the stock moves ahead without you. If the lag is too short, then there are no smoothing benefits to using the moving averages at all.
So what if the stock is rangebound or zig-zagging all over the place? Well, then moving averages aren’t going to be any use to you.
The chart in Figure 2.3 uses moving average crossovers, and the sell signal occurs a full $40.00 below the high of the stock. That’s not exactly very efficient, and in the meantime the stock has been up and down in vicious swings that would send us diving for the Pepto-Bismol. Admittedly the 10-week and 40-week moving average settings here are too slow and therefore inappropriate. However, it’s just as easy to get the moving average settings too fast, which then makes them equally as inappropriate.
So moving averages are best used in the context of trending stocks. In the next example (Figure 2.4) we see how confusing the signals become when the stock is rangebound.
Each “D” stands for “Double Crossover,” whereby the moving average crossovers send a long and short signal (or short then long signal) in quick succession, resulting in losses to your account. If this happens continually, then your accounts can be eroded pretty fast! Do you now see how moving average crossovers could be something of a challenge if not calibrated correctly in each case?
Notice in Figure 2.5 that we’re back into a trending situation. This time the trend is down, there are fewer double crossovers, and the position is a little clearer. But even here, (a) you still have those confusing double crossovers, and (b) you still need to understand how to find trending stocks.
The easiest way to identify a trend is by creating a trendline for the price action. Trendlines are far more reliable and simpler to use than moving averages.
- With an uptrend, the easiest way to trade is to wait for the trendline to be hit and the price bar to bounce upward off it, continuing the uptrend.
- With a downtrend, the easiest way to trade is to wait for the trendline to be hit and the price bar to bounce downward off it, continuing the downtrend.
A break of the trendline, particularly with rising volume, may signify the end of that trend.
If the trendline is broken, particularly with an increase in trading volume, then you know the trend is over, and you can go and find another stock that meets your trending criteria. The advantage is that you exit almost immediately and the rule is very straightforward. If you were using a moving average, you might have to wait several more days until the lines cross over, and by that time you could be sitting on significant losses.
Trending stocks tend to move in steps. These steps involve thrusting moves followed by consolidation. These moves can be referred to as steps or in some cases, flags. A flag is distinguished by the significant thrusting move prior to the flag forming.