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Editor: Bill Kraft
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"The trend is your friend." Trend trading as we try to practice
it is a form of momentum trading. We prefer to try to capture profit
out of the middle of the trend rather than try to catch reversal at
bottoms and tops.
One of the positives about trend trading is that it is relatively
easy to find an entry and to set an exit without letting emotion creep
into the decision making process. While there is never any guarantee of
profit, this trend trading method can keep losses relatively small in
many cases when the stock turns against the investor or trader. Once
the trend is broken, it is time for the trend trader to exit the
position. As long as the trend is continuing, the trader can see the
value of his position increase. If he holds the position until the
trend is broken, he is much less likely to cut his profits short.
There are many ways to define a trend. With respect to
bullish (up) trends, I look for stocks that may be
faithful to a moving average (e.g. 18 day, 20 day, 40 day, 50 day, 200
day or whatever) or one whose line chart may be traced by its
retracements touching a straight diagonal line. Trend breaks are seen
whenever the moving average or trend line (whatever the trader is using)
is broken. Of course, until that break happens, the stock remains in
I am convinced that emotion is one of the greatest enemies of the
average person who trades or invests. Many times the unsuccessful
investor buys near the top and sells near the bottom -- exactly the
opposite of what the successful trader does. I think that occurs
because the unsuccessful person wait until the chatter about a stock
reaches a crescendo, an emotional fever pitch. He sees, for example, a
positive magazine article about a stock after he has heard the 'talking
heads' on TV talk up the stock. Maybe he has friends who have 'gotten
in.' By the time the magazine article comes out, it may be the last of
many positive statements. As the stock was 'talked up' it may have run
up. Our poor trader (pun intended) loses sight of the fact that it may
take quite some time to develop an article and bring it to print in a
national magazine. By the time the magazine hits the streets, the move
may have run most, if not all, of its' course. Now our trader is
excited and makes his buy, but almost everyone else has already bought
their shares and there is little demand left. The stock turns over.
Rather than realize his mistake and get out quickly with a small loss,
our trader falls into the trap of talking himself into the belief that
"it's coming back." He watches and anguishes as the stock falls and
falls and makes little arguments to himself like: "If it just comes back
to 'x' dollars, I'll sell." Forgetting, or perhaps not knowing, that
the first loss is often the best loss, our trader hangs on until finally
he despairs, just gives up and takes a big loss. Do you know anyone to
whom that has happened?
The trader who trades the trend can avoid that kind of emotionalism;
avoid staying in the position as the stock drops farther and farther.
Instead of kidding himself that "it'll come back," the trend trader can
exit on the objective evidence that the trend has broken. So, too, the
trend trader can enter on the objective evidence that the trend has been
tested and has held. The "it'll come back" investor (and all of us)
needs to remember that in order to recover from a 50% drop in price the
stock must make a 100% gain just to break even! For example, if a $100
stock drops to $50 (50% drop), it must double in price (100% gain) just
to get back to $100. I sincerely believe it is much better not to hold
through that 50% drop. "What if it turns back up," the trader says.
Well, there is no law that says you can't get back into the position.
As an aside, if a loss was taken, the trader might want to consult with
her tax advisor about the "wash rule."
Trend trading can enable an investor to cut losses and let profits
run. As Warren Buffet once reputedly said when asked how to make money
in the stock market: "Don't lose." While using a break in the trend as
an exit won't necessarily avoid losing, in many cases, it will keep
losses small and let profits run. It can help remove the emotionalism
that has been the downfall of so many traders.
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