Is the Stock Trend Really Your Friend?

By on May 5, 2013

Is the Stock Trend Really Your Friend

There is a saying amongst active traders in most every financial market that goes "The trend is your friend," but I wonder if that is strictly true.  Does it make sense to make investments based on a current trend and will it really remain your friend?

The Birth of a Trend

Unless you are prescient there is no way that you can tell when a trend is beginning.  However, you really don't need to get in at the very beginning of a trend.  While it would be nice to get in at the bottom of a trend and get out at the top (assuming you are trading long), the reality is that you will almost never be that lucky.

Fortunately you don't have to be that lucky.  Even if you only catch 50% of an established trend you can make money.  That leaves plenty of room at the bottom to verify that a trend truly is taking shape and plenty of room at the top to get out before exhaustion hits the markets and your investment drops (sometimes like the proverbial stone).

Trend following traders are smart enough to know that they can't catch an entire trend from bottom to top (or top to bottom) without being lucky.  Rather than relying on luck, they rely on signals and indicators to tell them when a trend might be starting.  These indicators can be something as simple as a cross of a shorter moving average over a longer moving average or they can be complex computer driven systems based on advanced mathematical principles.

The Death of a Trend

In a similar fashion, there is no way to reliably know when a trend is going to end.  Some trends are short lived, lasting just weeks, while others continue onward for years.  Because there are always retracements (periods when price moves in the opposite direction from the trend), many traders end up getting out of a trade, only to see it continue in their direction for months after.

Rather than trying to predict when a trend is ending, savvy trend traders wait for the market to tell them the trend has finished.  This inevitably leads to some loss of paper profits, but is significantly more profitable than getting out of trades to early in the long run.

Trends Off of All Time Highs

A common market misconception is that you have to buy low and sell high to make money.  That is all well and good, but what do you do when a stock or other financial asset is trading at an all time high?  In such a case there is no chance to buy low as the price is already higher than it has ever been before.  Yet, many assets making all time highs continue upwards for months or years afterwards.

Consider the blue chip company IBM for example.  Its stock made an all time high of $130.90 in October 2009 by climbing from the low of $84.16 set in October 2008.  That's a gain of over 50% in just 12 months.  You might think that the trend is finished for the stock once it climbs so rapidly in such a short period of time.  Indeed, after hitting that high the stock did sell off, but only briefly.  It dropped to $123.48 by April 2010 and then took off and hasn't looked back since.  As I write this it is trading at $212.38 in April 2013.

In fact, Cole Wilcox and Eric Crittenden of Blackstar Funds created a hypothetical portfolio that traded only stocks closing at a new all time high.  Their findings were that from January 1991 through December 2004 such a system would have returned 19.3% with a maximum drawdown of 20.8%.  In contrast, the S&P 500 during the same time period would have returned 12.0% with a maximum drawdown of 44.7%.  It seems that the trend was indeed their friend in both returns and safety of capital.

Closing Thoughts

The truth is that when trend following, the trend is neither your friend nor your enemy.  It simply is what it is.  That being said, once started, trends tend to remain in place.  Just like the people behind the scenes, markets do not like to change.

The trend can be your friend if you are willing to devote the time to learn how trends emerge and more importantly how to recognize them when they do.  Combine that with the patience to remain in a trending stock even when it retraces and the wisdom to get out of a stock when it moves against you and you have a winning friend for life.


 
Steve Walters
Steve Walters
Contributing Writer at ExcelLiving.com
Steve blogs about personal finance at his site Money Infant. After paying off over $40,000 in debt in less than 3 years, he and his wife sold all their stuff and moved across the world to Thailand with their 1 year old in tow. Needless to say it's been an adventure. He is also available for freelance writing assignments and can be contacted here
Steve Walters

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