Thursday 3rd August 2006

 

Trade with the trends

 
 
 
 
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By Joel Nanton

The one constant about the United States equities markets is its unpredictability. Just when the market slipped below some record low price about three weeks ago and the indices seemed headed for a downtrend a host of earning reports and economic data combined last week to gave the popular Dow Jones Industrial Average, the Nasdaq and the Standard and Poor’s (S&P) 500 indices their first green week in a long time.

In fact the S&P 500 had its best weekly performance since May 2005.

While for the casual observer and perhaps some institutional holders a green week is good by any standards, for the active trader last week’s sudden shift in market direction could have made the going very difficult. In fact, the bulls very well may have been helped in keeping the broader market’s three per cent surge intact, by the number of short sellers that were being stopped out of trades.

Financials and technology stocks in particular posted sharp gains while the pharmaceutical sector made an abrupt about turn and, up to a few days ago, was challenging highs dating back to 2004.

Before last week the market had seemed to have finally signaled a clear trend going into the normally lower volume summer months. After some weeks of tug or war when the market swung from highs to lows, the indices broke some record lows to finally give the bears a lead in the race for control of July/August trading.

Of course the huge sell-off (the Dow shedding more than 400 points) was driven in part by the surge in oil prices and Middle East violence, factors which are still keeping the revitalised bulls in check. But with the earnings of several companies beating analysts expectations and a slowing US economy being taken to mean the Federal Reserve will no longer raise interest rates, investors finally found enough positives to drive the market upward.

If the upward momentum could be maintained over the next few weeks then the bulls would have delivered a surprise knock-out blow to the bears and the market would have begun to develop a clear trend.

And for the active traders, for any trader/investor in fact, a trending market is one of the best in which to trade.

There is power in trading the trend. The trend, simply put, is just the general direction of the market and is often signaled by indices or stocks making higher lows in an uptrend or lower highs in a downtrend over a defined period of time.

Since trading is about playing the odds, with a stop loss as your insurance policy, then the odds are always in your favour when you trade in the direction of the trend. As the saying goes the trend is your friend. Trading against the trend multiplies the risk, lowering the odds regardless of how strong or weak a company may seem.

I had this argument with a friend last week who by all his fundamental assessments of Ebay was certain that it was a classic buying opportunity.

I agreed with him on the fundamentals but in the overall context of the market direction, the sector (Ebay is an internet software company in the technology sector) and the trend the stock has been trading in within the last few months, I couldn’t disagree more that it was an opportune time to buy. The fundamentals may be but the odds were and still are totally against buying Ebay now.

The stock may eventually go up but the current odds favour a further fall for sometime before a move up. Why go in now to endure the pain of losses before seeing gains? Why tie up precious capital in a stock whose odds favour a down move for a while before any turnaround?

In fact with the stock rallying on July 11 it offered a great opportunity for a short. In fact a short seller on that day would have gained at least four dollars on Ebay by last Friday’s market close.

While the market in general remains volatile clearer trends are developing in some sectors in either direction.

Consumer-oriented sectors such as retail and consumer discretionary were slammed a few weeks ago and while they recovered somewhat they are still pointing down. Both are now in major downtrends having undercut several record lows. Telecoms too crashed badly, down continuously for a month, with last week’s rally still not to reverse its downward pattern.

The banking and drug sectors have both turned sharply upwards and are signaling a likely change of direction for some weeks to come. Strength could also be found in the defense sector and oil with prices soaring above $75.

Biotechnology stocks also swung around but not enough so that a few days ago it had already began to come back down keeping it in the downtrend it has been in for more than a month.

The point is that if one trades equities in any of these down sectors one would still be well advised to short stocks not buy. In times such as these it usually takes more than just a good earnings report to bring a sustained rally in a stock. In downtrend markets, rallies are only opportunities to short. Of course if the bulls really take over in the next few weeks then the pullbacks are buying opportunities.

Actively trading the market is not the proverbial David and Goliath scenario. In the stock market the Goliath trend usually wins. Finding and staying on its side regardless of the time frame is the wisest thing to do.

More than that, trend trading assumes that the stock would continue to move in one direction for a longer time and therefore it is closer to the traditional buy and hold strategy, which many investors still cling to. The difference with the active trader in trading the trend however, is the stop. Active traders actively use market timing tools which in trend trading would usually result in the trader having a tighter stop. The first signal of a trend reversal would get the trader out of the trade without giving back much profit.

Again, the trend is your friend. While there are strategies to trade against it, a good rule of thumb in trading developed markets is to make sure you are generally on the side of the indices in as many time frames as you possibly can.

The more you can achieve that the more odds you stack in your favour. Never become an opponent of the market. It destroys with callous force.

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