Jim’s Blog – The Trend is Your Friend

How many times have we read, “the trend is your friend”? How many times have we said it to ourselves? One¬†of the first rules of technical analysis deals with trends and determining if the market or stock is in an uptrend, downtrend or sideways trend. In other words, it is one of the¬†fundamental¬†topics¬†within¬†technical or market analysis. Unfortunately this easy topic or strategy within technical analysis has been lost in the more advanced studies or signal generating strategies. For that reason I believe we should review, refresh, or replenish our appreciation of trend analysis.

How Webster defines the word Trend is; “to extend in a general direction.” If we look at a chart of a stock or index¬†we could define the direction/trend to¬†be up, down or sideways. Because we are recording the price of the stock or index in a specific time interval it takes multiple data points to define a trend. That would relegate time as key variable in determining the trend of a stock or index. Thus we could have short term, intermediate ¬†and long term trends. If we connect the sequence of periods (time line) on a chart based on the closing price over a period of intervals¬†we would be able to draw a trendline by connecting the interval points at there lowest or highest points on a bar chart. The trendline would take on the characteristic of up, down or sideways. By¬†defining the trend it allows us to participate in the bias of the market during those periods moving higher and equally to avoid markets when the trend is moving down. Maybe that lends credence to the term, “the trend is your friend.”

Looking at a chart of the historical price of a stock or index allows you and I to see visually where the stock has been and what course of action it took to arrive at the current price. It can also be implied in simple terms to state what the trend of the chart is by looking at direction reading left to right. If the price on the chart from left to right is moving higher it would be defined as an uptrend. Likewise falling from left to right defines a downtrend and if the price is essentially unchanged looking left to right it defines a sideways trend. Simple, straight forward, and a universal principle. If you want to make it more difficult by adding additional indicators or parameters you are welcome to do so, but remember each indicator or benchmark you add increases the complexity of determining the trend and in response your action(s) to be taken toward that stock or index. Simple is better, but if you must add more do so with extreme caution and understanding.

For some this simple explanation of a trendline may seem old hat or mundane, but is is such a key fundamental part of market analysis. Too often investors and traders will get caught up in the more technical or analytic indicators to predict directional movement going forward and forget about this simple tool that¬†shows visually what is happening. It also dismisses inadvertently the fact, “the trend is your friend”. Take the time to refresh you understanding and use of trendlines in your analysis regardless of how complex you want it to be, trendlines will always show you what is happening now on the chart.

To put this in perspective currently the chart below is the SPDR S&P 500 Index ETF (SPY). SP500The trend over the 20 month period is rising from left to right which would indicate an uptrend in the index. The current test is the eighth during this timeline which would also give some indication of the strength of the trend currently in play. At the end of the chart we see yet another test of the trendline and another bounce off the trendline. Based on the strength of the trend we would want to see the trendline broken and the downside confirmed before we would make any significant adjustments to our positions. How you treat the break of the trendline gets into the money management or risk management side of trading and is equally important to understand or have a predefined strategy for when the event occurs. But, for our purposes here we will just focus on the trendline itself. This is a perfect example of a long term uptrend in a chart.

The next step is where we develop a strategy around how to use the trendline in trading or managing money. Finding the trend is simple and straight forward. Managing our money in conjunction with the trendline is what we refer to as a trading strategy. There are many theories and philosophies of how the asset will respond relative to the trendline given a specific set of variables. The key is to find what works for your style of investing or trading. Test them with paper trading or trading small dollar amounts to gain an understanding and appreciation of the risk of the strategy you would like to implement before putting your portfolio at undue risk.

We are going to post several strategies over the coming days to put this trendline idea into practice. The objective is to define the trend and the trendline, look at some entry, exit (stops) and target setting ideas using the trendline based on a specific time interval. The goal is to find the best opportunities based on the current market environment and timeline. This will teach you to believe in the concept that the trend really is our friend.