The last two weeks, I have introduced some high level technical trading concepts. My hope is that these articles have put some new weapons in the advanced investors trading arsenal. I do recognize that there are others who are very new to stock trading and the higher level concepts can confuse and intimidate. This week I want to take a step back to the basics.
After all, before Michael Jordan amazed us with his inhuman ability to put a basketball through a hoop, he first had to learn how to dribble. In the same way, the future Warren Buffet stock trader also needs to learn some basics in order to reach his or her hidden potential.
This week we are going to talk about the one basic element where I feel all prosperity begins in the stock market: knowing when a trend has reversed.
We have all heard clichés such as “The trend is your friend” or “Don’t fight against the trend” or “trend reversals”. These statements are true and anyone who has bought a stock in a raging Bull market can verify the thrill of seeing their portfolio value rise. Many also know the feeling of despair as they try to buy a stock and the following failure in a bad Bear market.
A friend at my work, who wanted someone to share in their pain of losing over 50% of their 401K in the bear market of ’08, asked me what percentage I lost in my retirement account the same year. They were amazed and almost angry when I explained that I had not lost money in ’08, but actually made money. How did I do that? One of the things that helped make me successful was to understand that the Bull market that started in July ’06 was over because the market trend, from my analysis, had reversed and would soon head down.
Once the trend changed, I knew it was time to move all my money out of the S&P 500 Index fund into the safe funds offered to my retirement account. I will share with you my exact analysis at the end of this article, but for now lets take a look at the elements that help the trader to identify a change in the trend.
If you want to make money fast in the most risk-free way in the stock market you have to identify a change in trend as early as possible, then take a Long or Short position and follow the trend until exiting shortly after the trend reverses.
Forget about trying to buy at the extreme Low or sell at the extreme High points. That practice is for the amateur. Instead, recognize a trend has changed and catch 50, 60, 70 or even 80% of the new trend move. To do this, the trader must pull out their most effective weapon, the trend line. The problem with the trend line is that 90% of traders draw the trend line incorrectly.
Here is a simple method that can be used to draw any trend line in any market:
1. Determine what time frame you want to use. Do you want to use Weekly, Monthly, Daily or intraday charts? Once selected you must use that time frame to trade because there are often multiple trends going on at the same time and they are not always in the same direction.
2. For an uptrend, draw a line from the extreme low of the bar that starts the trend, up and to the highest minor low point preceding the highest price on the same trend. The key here is that the line you draw must not pass through prices in between the two low points. See Figure 1 and Figure 2 below. Then extend the line upwards past the highest high point.
3. A Downtrend is drawn by taking a line from the high point of the bar that starts the Downtrend to the lowest minor high point preceding the lowest price of the trend. Again the line can not pass through prices as the line is drawn. Extend the line past the lowest high point downward. (Figures 3 and 4).
These steps are quite easy but accurate. If you follow them, you won’t find yourself drawing a trend line that will fit your personal bias on what the market is doing. Drawn correctly, you now have the ability to make a decision on when a trend change has occurred.
Indentify a change of trend: Easy as 1, 2, 3
1. A trend line is broken.
2. The trend no longer makes a higher high in an uptrend or lower low in a downtrend. For example, in an uptrend the market sells off but when prices rise again they do not make a higher high.
3. Prices go below the previous sell-off in an uptrend or go above a previous rally in a downtrend.
1. The trend line on Dryships Inc. was broken 2. When prices rebounded they could not make a new high. 3. The price drops below the previous sell-off low. Was the uptrend really broken after these three things happened? Let look at Figure 6. Figure 6 Trend Change Confirmed.
After the previous sell off low was broken prices quickly retreated from the $102 price range to the $70 price range. Start practicing the drawing of trend lines and following the trend change rules above and there is a good chance that you will soon be on your way to making good trading decisions. As promised here is the personal analysis that I did that helped me miss the 2008 bear market.
For those of you who check on the trend line I drew, you will notice that I chose to draw the trend starting at the bottom of the last leg up, which started in July of 2006. There are larger trends but the retracement amount are too large for my taste, so I like to stick with the most recent leg.
As you can see the market topped in October 2007 and the trend line was broken in late December 2007. After the break in trend line, prices started to rise again, but in May 2008 prices could not break through the 50 week moving average and rejected the price there. I knew right then the market was in trouble and I did not wait for the 3rd confirming point of price breaking the previous sell off low. I moved my money to the safe funds and waited for bear market retracements. I stayed in the safe fund for most of the year, but did have the opportunity to make money in November and December 2008.