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Tuesday, February 3, 2009

Some Thoughts on Trends

One of my deep beliefs about financial markets is that trends exist all the time.

As a trader, trends are very important. Ideally, you want to identify trends "early" (and this definition of "early" might not be what you think), jump on it, and hopefully, the trend will continue in the same direction, allowing you to profit from it "before it bends".

But do trends exist all the time?

In my opinion, yes. But it doesn't mean that all trends are exploitable profitably to you as an individual, and we'll come to that later. But trends do exist everywhere and all the time - the secret to understanding lies in the time-frame selected, and finding the right instruments with large enough volatility and liquidity to make it good odds to trade.

For example, in forex, there is bound to be some currency pairs that will exhibit bull market characteristics -- if the currency pair you happen to be looking is bearish, simply invert that pair and you now have a bullish price *grin*.

Similarly, if the trend is going down, there are financial instruments overseas that will allow you to invert that, turning it into a bull market.

Even if the price appears range-bound -- say, moving in between trading channels -- if you split it into shorter time-frames, then, you have a smaller trend that goes up before it hits the upper part of the channel, and then, another smaller trend that goes down before it hits the lower end of the channel. In other words, trends do exist if you drill down deeper.

Whilst trends always exist, it is a completely different question on whether - YOU - as a trader - can profitably exploit it. If you have been trading for some time, I'm sure you understand what I mean.

But this article is NOT about reasons why one CANNOT exploit trends profitably. Actually, I believe this is an extremely important question - one which every trader must personally answer that question for him/herself. For me, it's too complex, and too long an answer to answer here, and it's not my reason for writing this article *grin*.

But a simpler question is do you know how to identify trends in prices? Actually, that's a possible trick question. If you see a price/volume chart, and you cannot tell from a quick visual inspection whether the price is trending or not, then, chances are there is NO trend in the time-frame given to you. (of course, if you drill down, there will be mini-trends as mentioned above).

One successful trader apparently decides whether to enter a trade or not by quick visual inspection of the charts. He used to say that he made his final decision -- after analysis -- by posting the chart at the other end of the room, and then, taking a quick look at the chart for confirmation. More often than not, that quick visual inspection turns out correct. Of course, he is a close student of the markets, and has personally examined millions of price charts over his lifetime.

So, if you're experienced, you can easily tell whether a stock / index is trending or not by quick visual inspection of the price/volume chart. But what if you're not? How do you tell?

Well, a simple rule is to look at the "lows" and "highs" of the price chart. When a stock is making a lower "low", and a lower "high", it suggests that price is trending down. And vice versa. That's one quick way. And in fact, when an experienced trader looks at the charts, he no longer need to consciously look for these lower / higher lows/highs - he merely, with a quick glance, subconsciously absorb whether the stock price is making a higher or lower "lows"/"highs", and is able to quickly determine - in a split second - whether the stock price is trending up or down.

But sometimes, when you look at a given time-frame on the screen -- prices might not fit in more than 3 to 6 months prices. Most traders use short-cuts, by plotting longer-term Moving Averages. Typically 200 day and 50 day Moving Averages or EMAs. When a stock is trading below the 200 day MA, it's generally regarded as bearish because the price is below the average of the last 200 day prices. Whilst these are short-cuts, they obviously have their limitations too. Ultimately, these Moving Averages are just tools created to assist one in deciding whether a stock has been trending in the past or not. These tools should be your servant, not your master.

Other traders uses Multiple Screens or Triple Screen approach, which is to consciously examine a longer-time frame chart such as weekly or monthly candles instead of daily. This would allow one a wider view, and you can see the last 5 or 10 years data in just one screen, to view the trend better.

And then, in the world of Technical Analysis, there are many people who thought a lot about this problem about finding trends "early", and have developed a large variety of technical indicators, generally classed as "trend following indicators". The Moving Average and EMAs are just one small example of a "trend following indicator". Another common one is MACD. You can google stockcharts.com to learn more about it. There are literally dozens (or hundreds of smaller variations) of such trend following indicators in the TA universe.

Personally, I - and a million other traders - like Trend Lines. These are lines drawn that connects the higher lows in a bull market (I call it Up Trend Line or UTL), and the lower highs in a bear market (I call it DTL for Down Trend Line). Trend Lines are a fascinating topic, where the breadth and depth are actually very interesting. For example, Bulkowski has done a lot of work studying this and many other fascinating topic. Not all trend lines are the same, some - with certain characteristics - are more reliable than others, and have more profitable impact than others. However, as a general comment, bear in mind that in recent times, there have been studies overseas done that shows that they have not worked as well as they used to work say 20 years ago. However, they still work enough time and to an extent large enough that it is still generally profitable for a disciplined trader to trade using these tools.

In practice, I use a variety of methods to establish trends, and whether trends is likely to continue or not. A visual inspection of the charts across various time-frames, Trend Lines, EMAs, MACD, Bollinger Bands -- these are the more common ones, and for me, it's more important to develop an excellent understanding on how these works over time. I don't necessarily always look at default parameters, the choice of parameters depends on the actual situation, usually in reference to what works in the past, or what works similarly, but not always.

Naturally, I also fuse what I observe and synthesized from the charts with what I know from the market/stock fundamentals, news, sentiment, etc. The ideal situation is of course when all these analysis matches. Even the risks/price falls should match as well. This is much harder to do in real life, and whenever I'm wrong, hindsight will show me that I've missed something. This is the learning process which I find thoroughly enjoyable.

As I alluded to earlier, knowing if a stock is trending in the past doesn't necessarily mean that the trend will continue. The general rule is that momentum will tend to push prices in the same direction, but this is only a general rule -- exceptions exist all the time, and blind adherence to this rule can be expensive.

So, say you're able to see past trends occuring. The key question is how likely will this trend continue in future, where the future is always an uncertain question?

This is where nothing beats personal and close observation of prices in my experience. You have support and resistance studies, and supports and resistance have many forms - such as past peaks, past valleys, trend line supports, fibonacci levels (and there are always more than 1 fibonacci levels usually), pivot calculations, etc. etc. etc. In fact, the entire study of support and resistance is a fascinating topic in itself too. A deep understanding and observation of how prices behave around these critical areas will tell you much about how prices are likely to develop later, although not in as reliable a way as an exact science. Sometimes, price reversals can happen faster too.

But at the end of the day, trends -- the ones that have happened in the past, and the ones that are "likely" or not continue in future -- means nothing to a trader, unless his money is in the trade.

And when he puts his money in the trade, his opinions cease to matter. What's more important is how prices behaves after he enters the trade. And he obviously must have clear ideas on how to exit the trade when it goes right and when it goes wrong, BEFORE he enters the trade. Trade long enough, and some will go right, and others will go wrong. It's not a matter of if, but when.

So ... what are your thoughts on trends? Is the KLCI going to go up, down or sideways? *grin*

Actually, this is probably one of the less useful but more common questions I've heard, because much depends on the time-frame. And even if KLCI is going to be higher/lower than today in a months time, it doesn't mean it won't go down lower/higher first. And of course, stocks and markets are 2 completely different things -- when markets go up, it doesn't mean your stock will go up by as much or if at all, and vice versa.

But it won't stop those who doesn't know from telling, and it won't stop those who knows from keeping it to themselves *grin*

And ultimately, to a trader, what's far more important is that his equity actually grows, rather than being right publicly or privately. *grin*

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