We know that the prices of the securities that we invest in do fluctuate, and can fluctuate quite a bit actually at times, and these movements can occur over long periods of time as well. Charles Dow is credited with introducing investors to the idea of market trends, and his view certainly was that of an investor, not a trader, as he felt that the only trends that were worth paying attention to are the medium and long-term ones, and not the ones of shorter duration.
A century later, we have a much better understanding of the significance and nature of market trends, and especially over the past few decades, the popularity of using trends to track the movement of investments has really grown.
Most investors and those who manage investments still don’t pay much attention to trends, if at all, and instead look to predict future trends, using information apart from the behavior of markets themselves. This is a very difficult task though and there are just so many variables involved that we generally don’t really know that much about what will happen in the long term and even in the shorter-term using data like this.
Trend following is exactly what it sounds like, looking at the direction of a market and seeking to define points where the trend will end. Trend following is still not that simple of a task by any means but is immeasurably simpler than looking at microeconomic and macroeconomic data and analysis to try to predict such things.
The driving rationale behind trend following is that trends create their own momentum, and this momentum will continue until opposing forces gain the upper hand in a market. Whatever forces influence the price of an investment play out in the market, and the net result is these trends in prices.
We can view market momentum in action in any timeframe, from as short as tick-by-tick to charts where a single year is represented by a single bar on the chart. Even the longest-term investors find yearly charts to be too broad for their purposes though, as we do need a certain amount of data to be able to both analyze and predict future trends, but people do use monthly charts for this and monthly charts are actually quite useful for long-term investing purposes.
Interpreting charts is called technical analysis, as opposed to what is called fundamental analysis which does not use price data at all, where technical analysis relies pretty much exclusively on price data, with volume sometimes being factored in as well. In other words, one approach uses the market performance of the investment as its means of predicting future performance, where the other looks to make educated guesses based on other types of data such as earnings growth or interest rates.
How Market Trends Predict Price Movement
When we are looking to decide whether to enter an investment, to continue to hold on to it, or to exit our position in it, this is all based upon what the future may hold for it. The future we’re talking about here is the future price of it, where if the price is more likely to move in our favor, we should buy or stay in, and if it is more likely to move against us over a significant period, we are wiser to exit.
This depends on our being right about our analysis though, and if we are wrong, we will be making the wrong decision. Investment decisions always involve incomplete information though, and all we can do is look to assess the probabilities of certain things happening and act upon these assessments.
Some think that market activity is random, including some otherwise very educated people, although this theory falls on its face when we apply it to the way markets move. There is nothing random about this and trends do clearly have a life of their own and are self-perpetuating to a high enough degree for those with the requisite analytical skills to profit from.
There’s no question that markets move in distinct ways that are far from random, and it’s not hard to imagine how this can occur. To use one simple example of the process, let’s say that the price of something is rising. We know that the forces on the buy side are stronger than the forces on the sell side, and we can call this force the will to buy or sell.
This will is based at least in part on the current direction of the movement. There are computer programs that trade trends of an extremely short duration and their software is programmed to ride these trends even though they may only last less than a second. In highly traded instruments, this is possible, due to the sheer volume of the trading and the very small increments needed for the programs to make this profitable.
Online trading therefore in itself perpetuates trends, not only very short-term ones but longer ones as well, because if a trend is moving a certain way, computer trading will seek to take advantage of it and jump on for the ride so to speak.
Most of the trading on the world’s stock markets is actually of this sort, computers trading against us and against each other, and there is a lot of money that changes hands from this computer trading, in the billions of dollars each day. None of this is concerned with what the price will be in 30 years, next year, tomorrow, or in some cases, a couple minutes from now.
From there, there are trends that emerge on all time scales, and the trick is to be able to predict their reversal points well enough to be right enough to generate a net profit. The same sort of things that happen on a monthly chart happen on a daily one, an hourly one, or a 10 second chart, and our task is to pick the timeframe that is most suitable to our objectives.
People do the same thing, and if we see something going up in price, we’re more likely to buy it and when we see it going down, we’re more likely to sell. When the price goes down, eventually those who are looking to sell move out of their positions and this reduces the downward pressure, and eventually the buying pressure that is always there but has been overwhelmed gets the upper hand, and things start moving in the other direction and that also creates momentum that way.
Investors don’t mess around with short term timeframes, as this requires that we become much more involved in our trades than investors really have time for, but this doesn’t mean that they cannot profit from trend following should they seek to do so. It does take some skill to beat the market with this strategy, but only a fairly minimal amount.
Various people have put forth data that beats the market quite handily and only involves the simplest of strategies such as following simple moving averages, with clear signals and absolutely no decision making needed. It is not really hard at all to beat the market, especially if we are open to taking advantage of both upward and downward trends, which can be accomplished by investors as well.
Of course, the better you are at spotting these pivot points and trading them, the better you will do, and there are various levels of skill that are attainable, even with investing, with rewards proportionate to one’s skill level.
These rewards aren’t guaranteed, and nothing is with investing, but they do seek to put ourselves in a better position than sitting back and doing nothing, but if we can increase the probabilities of a better return than the market and can at the same time manage our risk so that it doesn’t increase and in fact gets reduced, this can be a valuable tool indeed.
Putting Trends to Work for Us
The default view of a trend is that it will continue, until opposing forces overtake it. This overtaking can occur at any time although it does show itself on charts, and the real trick is to come up with a plan that will allow us to get out of positions or even reverse them and profit from doing so.
Nothing moves straight up or straight down, or this would be too easy, and it is not, although still not terribly difficult either. If we just look at line or bar charts, things can look pretty unorganized, with movements both ways of various lengths over various amounts of time.
Provided that we’re not trading in such a way that we will exit on any downtick, which very few human traders would even contemplate, we’re going to have to build in a certain tolerance level of movement against us and stay in the trade or investment until a certain stage is reached.
A simple example of this would be what is called a moving stop, where if the price drops from its highest level while in the trade by a certain amount, the trade gets stopped out, or liquidated. This isn’t necessarily the best way to time trades but some people do use such things. There are many other charting techniques that we can use and all of them involve us using some form of smoothing technique.
Indicators like moving averages and Heiken Ashi bars, which are bars that use averages as well as the usual open, high, low, and close, help us distinguish between movements against us that aren’t significant enough and those that are and should have us wanting to exit the position.
There are a lot of indicators out there, some useful with the right application, and others not really that useful, and there are a number of other things such as certain chart patterns and points of support and resistance, trendlines, and so on that are used in studying charts. This need not be a complex undertaking though and even the simplest of techniques can yield good results if applied correctly.
Investors aren’t traders though, and the successful ones at least approach trading as a profession, and devote a lot of time and effort to improving their craft. Investors just do this as a sideline, and usually do not get involved at all in the management of their investment portfolios.
Many could stand to benefit from being a little involved, even spending as little as a few minutes each month to assess the progress of their investments, using simple rules that can be designed to produce decisions at a glance.
Whenever there is a clear and significant trend, and we don’t follow it, and we could have and done better or even much better, we are missing out on some real opportunities that can make a big difference in our long-term bottom line. Just staying out of the market during bear markets can make a big difference in itself, where most investors are getting hammered but our money is elsewhere, in a more appropriate place.
In order to allow ourselves these opportunities, we need to rid ourselves of all of the myths and faulty thinking that pervades the investment world generally. Markets are certainly not random, and there are trends that emerge all the time, in all timeframes, from the shortest conceivable to the longest anyone would ever use.
The very fact that we invest implies quite clearly that there are trends, and we’re actually counting on the prospects of the trend we’re hoping for being valid, even if we’re looking 30 or 40 years ahead.
There may be nothing as important to investors as understanding that trends do exist, we must trade on trends, and getting better at managing trends will make us better investors. Ignoring trends, on the other hand, might have us coming out OK in the end, but there’s too much at stake to not bother with even looking at trends and see ourselves not put ourselves in the best position or anything close to it to achieving the true potential of our investments.