investing101

The Trend is Your Friend

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“The trend is your friend” is one of the best known sayings, although it’s message is incomplete. The full version should be, “The trend is your friend, until the end when it bends.” The trick with buying stock is to to be patient through the small changes in price until you can identify the point when the trend makes a change in direction or “bends.”

In this article, we’ll define how to identify a trend and what has to happen for a trend to change. Before we get started, please note that the trend-following methodology should only be applied to stocks with strong fundamental metrics—like strong and improving revenues (sales) and earnings.

What’s a downtrend?

A downtrend is a series of lower highs. At each of those points, sellers are deciding that they have had enough and it is time to get out of the stock. When these sellers perhaps urgently accept lower prices to dispose of their stock, the number (supply) of stocks pressures price lower and helps the trend to continue lower. By a lower high I mean that each new attempt the stock makes to rally and increase in price turns lower before the price gets as high as the previous high.  This is seen in the following chart where the price line spikes upward, but not as high as the prior spike, on the way down.

A Downtrend in Action

If an investor considered to buy this stock during the period shown in the chart, that investor would be buying the stock in a downtrend. There are many ways to lose money in the market, but I think that buying a stock in a down-trending has the highest probability.  Of course the trader wants to be successful in making money.  A smart trader will use trend following as his friend.  He will wait until the trend changes direction with a new higher high price on the chart.  This is the sign of a change from downward to upward trend.

What’s an uptrend?

An uptrend can be defined as a chart with consistently higher lows.  At each higher low, traders are deciding that the pullback in price is a good time to purchase more of the stock. The buying pressure of more and more investors deciding to buy the stock adds more demand and so a higher stock price.  This can be shown on the stock chart as the stock continues to move in an uptrend.

A Change in Trend in Action

As a stock is mired in a downtrend, traders can look back and identify the most recent interim high price where the sellers turned price lower. At this point, I recommend that one consider buying the stock if and only if it goes up above that most recent high price. The current price rising above the most recent high price is what signifies that the trend in price may have changed from down to up.

Key Points

  • Trend—a stock’s overall direction—is the second most important technical tool next to Volume.
  • It’s when a trend changes that traders should consider potentially entering or exiting a trade.
  • To identify a potential change in trend, look to the stock’s Volume and Price Direction —the most important technical tool in my opinion.

 

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