We Are All Trend Traders!

Since following the trend is one of the core principles of natural selection investing, it is important to elaborate on the intuition behind it and explain why it is such a critical element of successful investing. Although it is not widely acknowledged in the investing world, the objective of all traders and investors is to buy an emerging upward trend and stay in the trade until the trend shows signs of ending. There is simply no other way to make money being long the market than to buy something low and sell it at a higher price, regardless of the investment style or time-frame that one is trading. The sooner the price of a holding begins to trend upwards, the sooner the investor begins earning a positive return. The greater the proportion of holdings that are in a upward trend, the greater the total return will be.  While this concept seems simple, it is in stark contrast to conventional investing strategies where no effort is made to time the market and it is not uncommon to have as many of your holdings trending down as are trending up.

 

Much like buy-and-hold, value and fundamental investing are often touted as alternative strategies to trend trading, however, it must be noted that these strategies are also seeking to catch a trend. The only difference in these cases is that fundamental analysis is trusted to predict an imminent trend rather than waiting for visible evidence that one is occurring. While this is great in theory, I believe it is a mistake. There are many examples of seemingly sound fundamental investments sitting flat for years, or worse, declining.  As the saying goes “the market can remain irrational longer than you can remain solvent". Having even a few holdings like this can be extremely damaging to a portfolio’s ability to earn a positive return. The same principle holds true when investors choose to stay in an investment even after it has given a clear indication that the trend is about to turn negative. Staying in a trade too long results in giving back prior earnings and delivers results similar to the buy and hold strategy that we discussed earlier.

 

In light of the evidence presented here, investors need to ask themselves whether they would prefer to buy a basket of high cost mutual funds and hope for multiple trends to appear, or instead commit those resources only to investments where signs of a trend have already emerged. This is not to say that investors should not pay attention to fundamentals – I certainly do! Rather it simply acknowledges that good fundamentals alone mean very little without corresponding price action.  In today’s stimulus driven markets where fundamental distortions are the norm, adhering to this concept is more important than ever.

 

The discussion here makes trend trading sound easy and it certainly is achievable with the right methodology. It’s important to understand that trends can be broken down into three distinct phases; emerging trend, established trend, and ageing trend. Successful trend trading requires high probability indicators to provide us with as much edge as possible in identifying each of these stages, and then successfully rotating from ageing trends into emerging and established trends to maintain a constant state of growth within our portfolios. Consider the following chart of a stock that has gone through the complete trend life-cycle.

In this chart you can clearly see the three stages of a trend. There are obvious indicators during each stage that inform us of what is happening. In the first stage we have a clear break above important moving averages (after a period of flat price action) to a new high, accompanied by heavy volume. This is a strong indication that there is buying interest in this stock. The stock begins to trend upwards and stays above our moving averages for over a year, making higher highs and higher lows along the way. At this point it has become an established trend. In the final stage you can see a clear breakdown developing, which is characterized by lower highs and lower lows, a flattening slope on our key moving averages, and finally selling pressure on heavy volume. Depending on the sell signal used, this stock gained close to 85% in approximately a year and a half.  Having a whole portfolio of similarly trending stocks can obviously be very rewarding. In this context, it becomes clear that investors should not spend time waiting for their favourite sector to begin to trend, rather they should seek to hold stocks that are already moving. The net effect of doing so is a portfolio that is in a constant state of growth.

 

It is important to remember that not all stocks trend in the manner shown above. Some stay flat, bounce around, or trend down for years. Strong investments may trend up for five or more years with little correction. With the proper trend identification indicators and appropriate buy and sell signals, it is possible to be on the right side of these trades most of the time. Let’s move on and take a closer look at how the Natural Selection Trading System accomplishes this.   NEXT

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