Trend Following, Trend Trading, Momentum Trading, these are names that describe the same trading concept that gets its inspiration from Newton’s first law of motion. An object in motion will stay in motion unless acted upon by a resisting force. The forces that act on a share price, or any asset for that matter, are capital flows. Capital tends to flow into an asset investors believe is undervalued in the market place, causing its price to rise. Capital tends to flow away from an asset when investors believe is expensive, causing its price to fall. Since capital moves in waves, prices often trend.
Somewhere along the line, most investors have been exposed to this concept with sayings like “the trend is your friend” or “don’t fight the tape.” Who knows when these phrases were penned, but we know they must have been around a long time. The stock ticker machine was the first digital electronic communication medium transmitting stock information over a telegraph line. It was in use for 100 years, from 1870 1970.
At some level, we all know that asset prices trend. A review of the chart of an index like the S&P500 shows the market goes through uptrends that can last a decade and down trends that can last a few years. The economy works in cycles. Good news tends to be followed by good news and bad news tends to be followed by bad news as the business cycle plays out. It is not very often that one piece of good news or bad news comes out about a company or the economy.
We think one of the most important trading rules to follow is “always trade with the trend.” When a share price is rising, surprise events tend to be bullish. When a share price is falling, surprises tend to be bearish. Investors do not always act monolithically. Some get in early, some investors act later. This behavior contributes to a larger trend. It is tempting to buy a stock that has been smashed, hoping to “pick the bottom.” But often times a cheap stock gets cheaper, leaving the bottom fisher with painful losses. The principal of trend flowing tells us gains are flowed by gains and losses are followed by losses until the trend changes. It is better to wait for a new uptrend to start, before buying. You will not buy the bottom, but you lower the risk of positioning yourself too early.
Remember, “always trade with the trend.” A corollary to that principle is “stop yourself out when the trend turns against you.” Do not let small losses turn into big ones.
Our method of stock selection is based in part on this concept. Our price action algorithm is an expert system that categorizes stocks into three buckets by examining their price behavior.
- Those that are in up trends
- Those in down trends
- Those not trending at all.
Interestingly, most stocks fall into the “not trending at all” category most of the time. This is just a first step in our investment process. We look at macroeconomic factors, industry and company fundamentals, valuation, potential catalysts, block trades and investor sentiment to handicap the probability that a trend will continue. Only the ideas that pass all these tests get a buy or sell recommendation.
Trend following is a simple and logical concept, but sometimes it is hard to follow. To buy high and sell higher, or sell low and buy lower can be emotionally difficult. But once you incorporate this concept into your trading style, it only takes a few successes to appreciate the benefits of this trading principal. Just as importantly, applying this principal with discipline will help you avoid losses.
Some people do not like the idea of trend following as it smacks of “technical analysis” which most fundamental investors do not understand. But there is no mystery in technical analysis. It is simply telling us what other investors did in the past and what they are doing now in real time. Better to be in sync with the big institutional investors than to get run over as they move in and out of a stock.
Trend Channels
One does not have to get too complex to identify a trend, its characteristics, and its termination. To do this, we construct and examine a trend channel. A trend channel is simply a set of parallel lines defined by the highs and lows of an asset’s price action. (We use log scale charts as this allows us to compare percentage changes in price. We also use charts that include the dividend in historical price. This way we are analyzing returns and not just price action.)
Example of an Uptrend
The chart above shows an example of an uptrend. The classic definition of an uptrend is price action where the asset price is making higher-highs, and higher-lows. All you need is these two elements and you can construct a trend channel. In this case, connecting the low touched in 2009 with the “higher-low” in late 2010 forms the lower trend line. Step two is to draw a parallel line from the point of the first high. This creates a trend channel that will help us trade the shares.
- If you own the stock, you can hold it using the lower trend line as a stop loss for risk management purposes.
- If you do not own the stock, you can wait until it approaches the lower trend line, then buy it using that same line for a stop loss. If the stock breaks the trend line, you will be stopped out at a small loss. If the lower trend line is not broken, you have the potential for large gains as the uptrend continues.
- If you own the stock and it gets up near the upper trend line, you can write a call option against the stock with little risk of the stock getting called away.
Example of a Downtrend
The chart above shows an example of a downtrend. The classic definition of a downtrend is price action where the asset price is making lower-highs, and lower-lows. Like the uptrend channel, all you need is these two elements and you can construct a downtrend channel. In the above example, connecting the high touched in Q2 2-14 with the “lower-high” in Q1 2015 forms the upper trend line. Step two is to draw a parallel line from the point of the first low. This creates a trend channel that will help us trade the shares.
- If you own the stock, you need to sell it.
- If you do not own the stock, you can consider selling it short, buy a put, sell a call, sell a call spread, buy a put spread, or any other bearish options strategy.
- If you are short the stock, you can sell puts when the share price approaches the lower trend line, with low risk that your short position will be taken out.
- If you are holding a bearish position, you should cover that position when the share price breaks the upper trend line.
- If you are interested in buying the stock, trend analysis helps you time your purchase. You should not make buy the stock until it breaks the upper trend line. If you can construct a new uptrend channel, use that to define your risk. Alternatively, use the old downtrend line as a stop loss.
Example of a Sideways Trend
The chart above shows an example of a sideways trend. A sideways trend is sometimes harder to identify early on. In this case, and with some hindsight, the stock made little progress for 5+ years. This chart may be signaling that the stock will trade in a range of $40 on the low side and $67.50 on the high side for years to come. This does not mean one cannot make a buck trading this name. If you believe the stock would be range bound for years to come, you could follow a number of strategies.
- Buy the stock in the low $40s and sell it in the low 60s.
- Sell an iron condor when the stock is trading in the $50 to $55 range as volatility trading strategy.
- If you are interested in buying the stock, you use the lower line as a stop loss and if you sell the stock short, use the upper line as a buy stop.
Final Thoughts
The strategy you ultimately use when trading within trend channels should consider other factors, such as the following.
- When volatility is high, employ strategies that generate premium and capture time decay as you wait for the underlying price to move in the desired direction.
- If volatility is low, consider long debit spreads to implement your ideas, as time decay will be more modest, and you can get more leverage if desired.
- If the stock is trading a discount to the market and its historical levels, have a bullish bias.
- If the stock is trading at a premium to the market and its historical levels, have a bearish bias.
- If your stock is fairly valued and in a sideways pattern, consider volatility selling strategies.
In the final analysis, trend analysis is one tool in your kit. The best way to exercise that tool is to make sure your fundamental and sentiment analysis is consistent with the underlying trend.