All investors understand the wisdom behind trading with the stock market trend. After all, few would drive their car the wrong way down a one-way street, so why try to trade against persistent market movements?
Simple to understand, but questions remain over how to determine when a series of price movements represents a true trend versus a one-off anomaly. By following these five rules, we can ensure that the stock trend is valid:
1. Three data points needed – Only when we have three or more points of contact is a trend considered valid. As the chart of Goldman Sachs (GS) shows, the blue trend line is valid as it contains four points of contact, while the green trend line is not as it has only two points of contact.
2. Direction – Trends can move in three directions—up, down, and sideways. As the chart of Apple (APPL) shows, studying prices over long periods of time often allows for the appearance of all three types of trends on the same chart.
3. Watch the slope – The slope of a trend indicates how much the price should move each day. Bank of America (BAC) shows a trend with an extremely steep slope (blue line) which will be unsustainable and eventually correct, while the one that is too flat (green line) calls into question both the validity of the trend and its predictive powers.
4. Time matters – The time measurement used speaks to the validity of a trend. Generally, monthly time series carry greater importance than weekly prices, which supersede daily prices.
5. Long lasting – The longer a trend remains in force, the greater the weight it carries. The downtrend on Sears Holdings (SHLD) has been in existence for nearly two years as compared to six months for Zale (ZLC). SHLD’s downtrend will provide harsher resistance to rallies than ZLC’s downtrend.
Stock market trends are one of the most powerful technical tools we have. Learn how to apply them to your analysis and positive results will follow as you begin predicting stock trends.
Sean Hannon, CFA, CFP is a professional fund manager.
Further Education, Technical Analysis: