Arguably, the cornerstone of technical analysis is the trend. A trend in technical analysis refers to a share moving in a clear distinct direction for a reasonable period of time. Shares very rarely move in the same direction day after day for weeks. Even shares that increase significantly over a month or so will have a few days in that month where the share price will fall. The underlying trend or direction is up, however.
When a share trends effectively, there will often be small movements against the overall direction. These small movements are often referred to as ‘noise’. Unfortunately, noise can sometimes distract from the underlying trend. It is important to always stay focused on the trend, however.
One of the time tested trading rules is to follow the trend. One of the aims of trading is to buy shares at one price and then sell them later at a higher price. In order to do this, you should try to identify shares that have a high probability of going up. Those shares presently trending up are showing a tendency to head in the right direction and therefore are candidates for purchase. This is one of the simplest rules, is very effective and should underpin your trading methodology.
Conversely, we can draw conclusions about shares that are trending down. If you want to buy shares and sell them at a higher price, buying shares that are showing a tendency to head down is not doing much to help you achieve your aim.
How do you identify the trend? There are a number of various ways of identifying the trend including using moving averages and analysing the different points where the share price plotted on a chart appears to form peaks and troughs.
When identifying trends, it is important to consider one of the principles of trends. A trend is said to exist until there is absolute evidence that it has changed. For example, should you identify an up trend, that chart is in an up trend until a down trend establishes itself. In other words, should the up trend falter slightly, unless a down trend is formed, you are still in an up trend.
Shares go up for one reason. There is more demand than supply for those shares. The buyers are being more aggressive and there is not enough selling pressure to hold them back. For a share to continue to go up and therefore trend up, there must be a continuous flow of new money, otherwise the trend will falter. The opposite is true for shares that go down.
When you think of the emotions behind people when they buy shares; it is normally of anticipation, some excitement and hope that the price will rise. It is generally positive thoughts. Similarly, think of the emotions associated with the decision to sell shares. It may be frustration, a lack of patience, however it is often fear and panic. It is normally not positive. There is the feeling that the odds are against you and that it is wise to get out from the situation and move on. Simply put, there is the anticipation that the share price is going to fall.
Always Consider the Trend
The most important thing you can do when purchasing shares is to consider the trend and follow it. You will never be profitable, over the long run, if you consistently trade against the trend. Therefore, the trend should always be an underlying factor in a company before you consider buying it.
One of the important things we do when preparing ourselves and our trading plan is to consider how much time we have available to trade. This will often dictate what sort of time frame we consider trends.
For more information on this area, please read the article on How Much Time do you Have? It is a thought provoking look at what is a finite resource.
After a considering of time, you will then be able to determine what type of trends you are interested in trading. Whilst there are no set definitions that delineate between short-, medium- and long-term trends, I will use the following definitions:
- Short-term trends—from three days to between two and three weeks
- Medium-term trends—from three weeks to between three and four months
- Long-term trends—from between four to six months and beyond
Note that, even in my definitions, there is no clear delineation between the different timeframes. Nonetheless, they do give you a general guide.
Consider that it is quite feasible that you can be looking at a chart of a stock with two fellow traders and your opinions of the prevailing trend can all be different. However, you may all be right! Do you know how?
Even though the three of you are looking at the same chart, you all draw a different conclusion. The reason why you can all be right yet all different is because you are all looking at the chart in a different way – you are looking at the chart over different time frames.
You have the chart of a stock which has been moving up for the last 12 months, although trading in a trading range (moving back and forth between two different price levels over a period of time) for the last few months. Over the last couple of weeks, it has been moving down from the top of the prevailing trading range.
In this instance, the first person looking at the chart might conclude that the stock is going up. They would be right based on the fact that they consider very long term trends (the stock has been moving up for the last 12 months). The next person concludes that the price is going nowhere – in other words, it is neither moving up or down as it is moving sideways. Again, they would be right too because they consider medium term trends (trading in a trading range for the last few months).
Finally, the third person concludes that the stock is going down, and they view trends over the short term. This person is also right.
I strongly believe that the emotions in a person to buy shares are not as strong an influence as the emotions in a person to sell shares. Therefore, downtrends can be a lot stronger and sharper than uptrends because of the emotions involved.
Consider what has happened in the markets with regards to strong one-day moves. The most significant example, in recent times, was on Monday 19 October 1987 in the USA when the Dow Jones Industrial Average dropped from a value of 2,246 points on the previous Friday’s close to close at 1,738 points— a drop of 22.6 per cent after being down 25.3 per cent earlier in the day. Do you think that, when the market opened 200 points lower on that day, an amount of panic and fear swept through many market participants?
More recent examples include the events on Monday 17 April 2000, when the All Ordinaries Index (Australia’s general market index) dropped from a value of 3,096 to 2,920, representing a 5.6 per cent drop, after being down 6.8 per cent at the low for the day. More recently on Wednesday 12 September 2001, when the All Ordinaries Index dropped from a value of 3,183 to 3,051, representing a 4.1 per cent drop, after being down 4.7 per cent at the low for the day.
You will rarely see moves to the upside as significant as the moves you see to the downside. Always consider the trend and never stand in its way. If you buy a stock that is in a solid downtrend, then you will just get run over on its way down.
Picture a large solid boulder weighing several tonnes on the top of a hill. The boulder has been given a nudge and is now heading down the side of the hill, gathering momentum as it goes. That boulder is representative of a share price in a downtrend. Buying a company that is in a downtrend, is like running out from behind the bushes and jumping in front of the boulder to stop it as it approaches. It is obvious what is going to happen—the boulder will not skip a beat as it continues along its way having just knocked the life out of you.
A Final Thought
There is an interesting observation to be made about trends. You may often hear yourself say that a stock is too expensive to purchase. You start to think that you have missed the boat; you have missed out on its run; you will get in too late if you buy now. These feelings are quite common but are not necessarily well founded.
An example may have you watching a price that has just moved from $3 to $4.50 over the last few months. Looking at the solid move, you comment that purchasing now would be foolish. “I have missed the boat”, you say to yourself. Then as the price moves from $4.50 to $5.50 over the next couple of months, you remark, “Well, I have definitely missed the boat now!” Sadly, the price continues to rise and several months later, it is over $7.00, at which point you concede, “Well, I was wrong the last couple of times but now it has absolutely had its run!”
This happens all the time. Never underestimate how long a well established trend can continue for.
Over the last few years, there have been a large number of stocks that have enjoyed significant gains with little rest along the way.
This is just one example of an Australian company that moved from around $3 to greater than $50 in less than 5 years. There are many more …
In the above situation, instead of thinking you have missed the boat, you would be better thinking that the price is clearly in a well established up trend and therefore is adding to the probability that it will continue to go up. We want to purchase shares that are going up and then sell them when they have stopped going up. One of the most important trading rules comes into play here – Follow the Trend. Generally speaking, I don’t believe you will trade well consistently trading against the trend.