“The trend is your friend” is one of the best known investing sayings, although it’s message is incomplete. The full version should be:
“The trend is your friend, until the end when it bends.”
Often attributed to Marty Zweig (read more)
The trick with buying stocks is to to be patient through the small changes in price until you can identify the point when the trend makes a change in direction or bends.
In this article, we’ll define how to identify a trend and what has to happen for a trend to change. Before we get started, please note that the trend-following methodology should only be applied to stocks with strong fundamental metrics, like strong and improving revenues (sales) and earnings.
You can read more about fundamental analysis to learn how to analyze the fundamentals of business.
What’s a downtrend?
A downtrend is a series of lower highs. At each of those points, sellers are deciding that they have had enough and it is time to get out of the stock. When these sellers perhaps urgently accept lower prices to dispose of their stock, the number (supply) of stocks pressures the price lower and helps the trend to continue lower.
When I refer to a “lower high,” I mean that each time the stock attempts to rally and increase in price, it fails to reach the same level as the previous high. Instead, it turns lower. This pattern is evident in the chart, where the price line spikes upward, but not as high as the previous spike, as it falls.
A Downtrend in Action
If an investor were to buy this stock during the period shown in the chart, they would be entering a market in a downward trend. Buying a stock in a downtrend is one of the most common ways to lose money. However, a trader who wants to be successful and make a profit will wait for a change in the trend. This change is indicated by a new high price on the chart, signaling a shift from a downward to an upward trend.
What’s an uptrend?
A clear uptrend can be identified by a chart with consistently higher lows. At each higher low, traders recognize the pullback in price as an opportunity to buy more of the stock. As more investors make this decision, the buying pressure increases, driving up demand and, in turn, the stock price. This pattern can be visualized on the chart below as the stock continues to trend upward.
A Change in Trend in Action
When a stock is stuck in a downtrend, traders can look back and identify the most recent interim high price where the sellers turned the price lower. At this point, I recommend buying the stock only if it breaks above that most recent high price. This signifies that the trend in price may have changed from down to up.
Key Points
- Trend is the second most important technical tool, next to Volume, in understanding a stock’s overall direction.
- It’s when a trend changes that traders should consider entering or exiting a trade.
- To identify a potential change in trend, focus on the stock’s Volume and Price Direction, the most important technical tool in my opinion.
In summary, identifying a change in trend is crucial for investors. By recognizing the most recent high price and looking for a breakout above it, you can potentially enter a new trend. Remember that a trend is a key indicator, and changes in trend can signal potential investing opportunities.
