THE BASICS SERIES ON TRADING AND INVESTING How do you find out the trend of a market? They say “the trend is your friend”, meaning that you have to buy a stock only if the trend is bullish, and sell it if the trend is “bearish”. But how do you know precisely what the trend is? What are the tools and the method for a rational qualification of the trend,? First, define the time frame. The trend depends on the time horizon you are willing to consider. A stock can be in a bearish trend in the short term, while being bullish when considered in a longer perspective. Traders and investors commonly look at charts drawn with in a certain time frame. In a so-called “daily chart” each bar or dot represents the stock price for a given day (extreme prices for a bar chart, closing price for a dot). In a weekly chart each piece of data represents the low and high prices for the week (on a bar chart) or the price at the end of the week (dot chart). To know what time frame to study, you must know your objectives and style. If you consider yourself as a long term investor, interested in the fundamentals of a stock or of the economy, you do not care about, and you will not be monitoring, the day-to-day changes in price. You will base your buy and sell decisions on a weekly chart. The underlying trend that makes the backdrop on your analysis is the next superior time frame, the monthly chart. If the monthly chart shows bullishness, you can take advantage of a favorable situation on the weekly to enter. If you want to be an active investor or trader, seeking to follow up and optimize entries and exits on a daily basis, decisions will be made on a daily chart and the underlying trend will be made on a weekly. Generally speaking, if the effective entry and exit decision are to be made when looking at a given time frame, the trend must be assessed by looking at the immediately superior time frame. Next, decide what trend logic you use: “linear” or “punctured” This sounds more complex than it is. Simply put, if you take a linear approach, you look at some data coming from the price series, typically from moving averages. A moving average is simply the average of the stock prices upon a certain period. In that spirit there is still many ways to define the trend. The trend can be given by the position of the price relatively to a selected moving average. For instance if the price is above the 50-day moving average, it means that investors and traders are OK to pay more now than others paid on average during the 50 previous days, and you conclude that the stock has tailwind. Or, the trend can be defined by the relative positions of two moving averages. If the 20-day MA is above the 50-day MA, it means that investors have paid more in the more recent period, so the trend is bullish. You can easily see that each trader/investor has to determine her own particular parameters. There is no universal definition. What is important is to be logical and consistent in time. A different approach is the ‘punctured” one. Instead of relying on a continuous calculation like a moving average, you look at the level of price compared to particular thresholds that are deemed important, like pivot points, swing points, or support or resistance levels. It is the fact that the price crosses over or under such thresholds that modifies the assessment of the trend. In the punctured method, trend qualification has a tendency to change more often, which can be seen as a negative. But on the other hand, there is more rational in comparing the current price to significant price levels in the real world, than in looking at mathematical calculations that always are arbitrary. A base of a method: trend assessment plus entry definition The whole idea of trading and investing is to buy, then to sell higher. The detailed discussion of entry methods will be done in another post. For now, let’s say that once you qualified the trend as bullish, you have to wait for a favorable buying position. According to us, the best method is to look for a pullback that will allow a buy “on the cheap”, taking advantage of the natural oscillations on the market, to enter at a temporary lower price against the backdrop of a bullish trend. If the trend qualification is true, the trend should then carry the price higher in the following days and give us a safety cushion relatively to our entry price. The next posts in this “basics series” will study in more details the qualification methods.
