Sunday, June 25, 2006

Trading Trends

"The trend is your friend." Certainly that is one of the many stock market adages. Generally, I think a saying becomes an adage through repetition over time. Those sayings don't seem likely to be repeated unless there is some truth to them. Trend trading as we try to practice it is a form of momentum trading. We prefer to try to capture profit out of the middle of the trend rather than try to catch reversal at bottoms and tops. A wise man (maybe a 'wise guy') once said that a trader only catches one top and one bottom in a lifetime.

One of the positives about trend trading is that it is relatively easy to find an entry and to set an exit without letting emotion creep into the decision making process. While there is never any guarantee of profit, this trend trading method can keep losses relatively small in many cases when the stock turns against the investor or trader. Once the trend is broken, it is time for the trend trader to exit the position. As long as the trend is continuing, the trader can see the value of his position increase. If he holds the position until the trend is broken, he is much less likely to cut his profits short.

There are many ways to define a trend. Since I am talking about bullish (up) trends in this article, I look for stocks that may be faithful to a moving average (e.g. 18 day, 20 day, 40 day, 50 day, 200 day or whatever) or one whose line chart may be traced by its retracements touching a straight diagonal line. Trend breaks are seen whenever the moving average or trend line (whatever the trader is using) is broken. Of course, until that break happens, the stock remains in the trend.

I am convinced that emotion is one of the greatest enemies of the average person who trades or invests. Many times the unsuccessful investor buys near the top and sells near the bottom -- exactly the opposite of what the successful trader does. I think that occurs because the unsuccessful person wait until the chatter about a stock reaches a crescendo, an emotional fever pitch. He sees, for example, a positive magazine article about a stock after he has heard the 'talking heads' on TV talk up the stock. Maybe he has friends who have 'gotten in.' By the time the magazine article comes out, it may be the last of many positive statements. As the stock was 'talked up' it may have run up. Our poor trader (pun intended) loses sight of the fact that it may take quite some time to develop and article and bring it to print in a national magazine. By the time the magazine hits the streets, the move may have run most, if not all, of its' course. Now our trader is excited and makes his buy, but almost everyone else has already bought their shares and there is little demand left. The stock turns over. Rather than realize his mistake and get out quickly with a small loss, our trader falls into the trap of talking himself into the belief that "it's coming back." He watches and anguishes as the stock falls and falls and makes little arguments to himself like: "If it just comes back to 'x' dollars, I'll sell." Forgetting, or perhaps not knowing, that the first loss is often the best loss, our trader hangs on until finally he despairs, just gives up and takes a big loss. Do you know anyone to whom that has happened?

The trader who trades the trend can avoid that kind of emotionalism; avoid staying in the position as the stock drops farther and farther. Instead of kidding himself that "it'll come back," the trend trader can exit on the objective evidence that the trend has broken. So, too, the trend trader can enter on the objective evidence that the trend has been tested and has held. The "it'll come back" investor (and all of us) needs to remember that in order to recover from a 50% drop in price the stock must make a 100% gain just to break even! For example, if a $100 stock drops to $50 (50% drop), it must double in price (100% gain) just to get back to $100. I sincerely believe it is much better not to hold through that 50% drop. "What if it turns back up," the trader says. Well, there is no law that says you can't get back into the position. As an aside, if a loss was taken, the trader might want to consult with her tax advisor about the "wash rule."

Trend trading can enable an investor to cut losses and let profits run. As Warren Buffet once reputedly said when asked how to make money in the stock market: "Don't lose." While using a break in the trend as an exit won't necessarily avoid losing, in many cases, it will keep losses small and let profits run. It can help remove the emotionalism that has been the downfall of so many traders.

Some investors like to be in the market all the time and are concerned that they will be left out if they are trading trends. The truth is that some sector, some stocks are almost always in an uptrend even if the overall market is not. Of course, there is nothing to prevent one from trading the down trends as well, but that is a subject for another day.

Trading the trends,

Bill Kraft, Editor
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Bill Kraft is the editor of the Trend Trader Service at

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