Section 2:
Objectively Identifying Trends
Trends exist in the market. There are upward, or bullish, trends. There are downward, or bearish, trends. A lot of attention is paid to trends, but not much detail is given to how to identify trends. That’s because it’s a difficult task.
It’s easy, with the benefit of hindsight, to look over the past year of a stock price and conclude if it moved higher or lower. It’s another matter entirely to look at a stock chart today and determine if a stock is in a bullish or bearish trend.
Determining the trend of a stock today doesn’t necessarily guarantee that the stock is going to trend in the same direction tomorrow, next week, or next month. Put another way, the future is unknown. There’s no way around it. It’s impossible to know with certainty what’s going to happen tomorrow.
It is, however, possible to forecast the probable path of a stock over the next day, week, or month. The process of aligning probabilities starts with consistently and objectively identifying the forces of supply and demand. The collective buying and selling of traders can be organized in such a way that trends are defined.
Time and Price Method
The quickest and dirtiest means of identifying a trend is to pick a set period of time over which to examine the price of the stock, and then run an if-then test. A one year period is the best timeframe with which to start. (One month, three month, or six month are alternative periods with which to work.)
The Time and Price Method is simple:
A stock is in a bullish trend if it is higher today than it was one year ago.
A stock is in a bearish trend if it is lower today than it was one year ago.
The Time and Price Method is simple but effective. Most importantly, it’s consistent and objective.
An obvious example of a bullish trend using the Time and Price Method is shown with Potash (POT) in Figure 2.1. The stock is measurably higher today than it was one year ago.
Figure 2.1
An obvious example of a bearish trend using the Time and Price Method is shown with Advanced Micro Devices (AMD) in Figure 2.2. The stock is substantially lower today than it was one year ago.
Figure 2.2
Don’t immediately discount the Time and Price Method. It was extremely profitable in the two examples above. But it has its flaws.
Confusion occurs when using the Time and Price Method when a stock is flat over the past year. Take the one year period in Dell Inc. (DELL) as an example show in Figure 2.3. The stock is trading today right where it was one year ago.
Figure 2.3
Is DELL in a bullish or bearish trend? It’s tough to know based on the Time and Price Method. The easy thing to do is not trade the stock.
Time and Price Method Summary
Advantages:
Simple – A common sense approach to identifying trends.
Quick – A glance of the one year chart reveals the trend.
Consistent – Offers a degree of precision when identifying trends.
Objective – It’s an either-or proposition most of the time.
Disadvantages:
Static – Short-term trends conflict with one year trend.
Possibly Confusing – Problems occur when today equals one year ago.