Following the Trend
“The trend is your friend”. You probably have heard this before. Some traders try to guess exact turn points to enter to a trade. Typical wording for this are “this stock cannot get any lower, it’s time to enter”, “this stock is over valued, let’s shot it”, “this is an emotional peak, cannot get higher, down it goes!”, “it got the lowest 52-week value, it should rebound now!”
This kind of rationale involves a big risk. The markets are not run by computers, but by human beings. And because of that, the crowd psychology works almost all the time. For example, when a stock starts to go lower, stops-off got triggered, and that accelerates the downward process. A non-stopping decay also increases the panic, and some investors with no stops decide to go out. Meanwhile, several people decide also to short, which heads it even lower.
When does this stop? When all sellers are gone, and you start having more buyers than sellers. How do you know that this is the case? You can’t. Nobody can know it for sure.
Fundamental investors probably will get in when the numbers make them think that the price stock is cheaper compared with the future earnings. As you may understand, there can be a big discrepancy of opinions on the future earnings, as they depend on the market demand, the competition, the management, etc. But even if you are right on predicting all variables in the long term, in the short term the market may not react exactly as expected, and can oscillate while the participants agrees on the price. Or maybe there can be unknown events about to happen (a merge, an acquisition, a CEO removal, etc) that may alter the price behaviour. On top of that, there can be also institutional investors deciding to unload that particular security, and because of the size of the movement, the price may immediately down, despite of the good fundamentals.
This means that if you jump in solely based in the fundamental analysis, as a small trader you can be in problems as the error margin is very narrow. You may be right, but the market noise can kill you.
Technical traders will jump in when they see that the price chart indicates that a reversal is coming. There are two problems with this approach: (a) There are tenths of indicators available, and all of them can send fake signals, and (b) some of these indicators can signal contradictory messages. Trying to guess a reversal based on technical indicators is a risky and frustrating game.
You may try to combine both methods, but this doesn’t help neither for you, as a small trader. The main problem is trying to predict a reversal is hard, whatever method you use. As the crowd participates on it, there is a lot of noise during the turning points. It can go sideways or up and down several times before establishing a new trend. A mistake predicting a reversal, or the beginning of a trend, indicates that the previous trend will continue, triggering your stops.
The approach that we recommend is less risky. Wait until the trend is established, and only then jump in. As always, you should have your stops in place, just in case the trade goes wrong. Then continue the trend as much as possible, and move upper your stops as the trade progresses in your favor.
That’s why they say “the trend is your friend”. Do not take profit immediately. Be gentle with your friend. Continue with your new friend as much as possible. It always can go higher. At some point your new friend will look tired and exhausted. Instead of continue “chatting” with you by moving in your trade direction, it will show signals of willing to go to other side. Learn to recognize the signals and then setup an orderly exit, using a trailing stop. If at the end your friend wants to go in other direction, your trailer stop will say good bye to him. But it also can happen that it was just a momentary indecision, and the trend may resume his walking with you.
So, be nice with the trend, and the trend will tend to be with you for a long time. The moral is: don’t be greedy, don’t jump out as soon as you have a profit. Follow the trend as much as possible.
In the following links, we present some practical tactics to take advantage of the trends.