Trading the Trends

1. Trend Trading: Capitalizing on Market Cycles

They understand the market does not always go up, they recognize the market moves in trends and cycles, and they capitalize on that knowledge.

Beyond Buy and Hold. Trend trading is a strategy that acknowledges the cyclical nature of the stock market, moving beyond the simplistic "buy and hold" approach. It involves identifying and capitalizing on market trends, whether they are bullish or bearish, to protect capital and generate profits. This approach is particularly valuable during long-term trading range markets where buy-and-hold strategies falter.

Market History Lessons. Market history reveals that long periods of market advances (Secular Bull Markets) are followed by long periods of sideways or declining markets (Secular Bear Markets). Since 1900, there have been 29 bear markets, averaging one every 3.5 years with an average decline of 30%. Understanding these cycles is crucial for making informed investment decisions and avoiding significant losses.

Net Gain Territory. The market is only in net-gain territory 24% of the time. This statistic highlights the importance of actively managing investments and not putting 100% of investment dollars at risk 100% of the time. Trend trading aims to maximize returns during bull markets and minimize losses during bear markets, increasing the overall profitability of an investment portfolio.

2. The Big Picture: Filtering Market Noise

The mistake many people make is ‘not seeing the forest for the trees.’

Beyond Daily Fluctuations. Successful trend trading requires focusing on the "big picture" and filtering out the daily market noise. Daily fluctuations are often inconsequential and can be misleading. Instead, investors should concentrate on identifying and understanding the underlying trends that drive market movements.

Creating a Filter. Developing a filter to distinguish between meaningful news and insignificant noise is essential. This involves focusing on facts rather than opinions, such as Federal Reserve interest rate adjustments or GDP declines, which can signal changes in the economic cycle. Analyst opinions and sensationalized headlines should be disregarded.

Hidden Market Energies. The vast majority of market energies remain hidden from individual investors and traders. Insiders are forever quietly attempting to manipulate news for their own selfish reasons. Realistically, the vast majority of market energies remain hidden from individual investors and traders. Insiders are forever quietly attempting to manipulate news for their own selfish reasons.

3. Predictable Markets: Understanding Dow Theory

All ships rise and fall with the tide.

Dow Theory Foundation. Recognizing market patterns and trends began with Charles H. Dow's editorials, which evolved into Dow Theory. Dow believed the stock market was a reliable measure of overall business conditions and that analyzing the market could accurately gauge those conditions and identify major trends. This theory emphasizes the importance of understanding the overall market movement.

Price and Volume. The information needed to make informed decisions is always price and volume, and this activity shows in the charts. Dow Theory suggests that the market discounts everything, meaning all information, past, present, and future, is reflected in stock and index prices. Therefore, technical analysis, which focuses on price movements and volume, is a valuable tool for trend traders.

Market Confirmation. It becomes a red flag when we see one index continue to advance while another declines. Dow Theory emphasizes the importance of market confirmation, where different market indexes confirm each other's movements. For example, a healthy market during good economic times will experience advances in the technology-heavy NASDAQ, the S&P 500, and the DJIA. Divergence among these indexes can signal trouble ahead.

4. Three-Trend Market: Primary, Secondary, and Minor

Each time the primary trend was broken it was the investor’s early warning the market had changed and the trend was likely changing as well.

Trend Hierarchy. The market operates on three simultaneous trends: primary, secondary, and minor. The primary trend can last from less than a year to several years, while the secondary trend lasts from ten days to three months, and the minor trend varies from hours to a month. Understanding these trends is crucial for making informed trading decisions.

Trend Identification. An advancing trend is recognized by connecting the lows, where each low is higher than the previous low. A declining trend is recognized in the same way, but with each low being lower than the previous low. Trend lines are valuable tools for identifying trend changes and making portfolio adjustments.

Simultaneous Trends. The three trends may be simultaneous. For instance, a bullish but minor reactionary trend can be in a bearish secondary trend that is in a bullish primary movement. In other words, the major primary trend can be an advancing bullish market but have a secondary declining trend that lasts for a few weeks, and can have an advance, or minor trend, that is bullish within the secondary trend.

5. Market Phases: Accumulation, Public Participation, Distribution

Major market trends are composed of three phases: An accumulation phase, A public participation phase, A distribution phase.

Phase Recognition. Major market trends consist of three phases: accumulation, public participation, and distribution. The accumulation phase occurs when informed investors buy stock against the general market opinion. The public participation phase occurs when trend followers and technically oriented investors begin buying. The distribution phase is when informed investors distribute their holdings to the market.

Investor Sentiment. During the accumulation phase, the general market opinion is bad, and most people think it will never go back up. During the public participation phase, the overall sentiment is positive. During the distribution phase, the attitudes and buying interest begin to change once again.

Phase-Specific Strategies. The different markets require different strategies. Sure, a buy-and-hold investor may do well during the public participation phase while a short-term trader may struggle. But these phases don’t last forever. And during the distribution phase, a buy-and-hold investor is entering during the wrong market.

6. Trend and Channel Lines: Visualizing Market Direction

A trend line is one of the most effective weapons in your arsenal.

Trend Line Construction. A trend line is drawn by connecting two lows, and the line can be extended to the infinite. The more times the trend line is tested and holds, the more powerful the trend becomes. The trend line gives you a very good idea as to where the stock price should find support during any corrections or pull-backs.

Channel Line Utility. Channel lines are drawn by connecting the highs, instead of the lows. By drawing a channel line it gives us one more bit of information to work with when analyzing either the overall market or an individual stock. Channel lines help identify potential resistance levels and unsustainable advances.

Trend Sustainability. A healthy advance should never create a trend line that is more than a 45-degree angle. If you are ever holding a stock that goes on a rapid advance of more than a 45-degree angle, you should be looking to unload, not buy. Sharp advances are not sustainable.

7. Support and Resistance: Identifying Key Price Levels

These battlegrounds carry an emotional shadow that truly has lasting influence whenever a price returns to the old level.

Battlegrounds of Bulls and Bears. Support and resistance levels organize the charting landscape into well-marked levels that predict market trends, swings, and breakouts. These levels represent areas where buyers and sellers have historically clashed, creating emotional shadows that influence future price movements.

Horizontal Price Marks. Horizontal price marks the most common form of support and resistance. These important highs and lows reveal scarred battlegrounds between bulls and bears. These battlegrounds carry an emotional shadow that truly has lasting influence whenever a price returns to the old level.

Level Significance. The more times a support level is tested the more powerful it becomes. During the formation of every level of resistance or support, real money was changing hands creating these chart patterns. And logically speaking, the more money that changes hands during the creation of a support or resistance level and subsequent tests of those levels speaks volumes as to their significance.

8. Entering a Trade: Patience and Strategic Timing

Let the market come to you!

The Big Picture First. Before putting a single dollar of investment capital at risk in the market, the wise investor will know which direction the primary trend is headed. If it is headed lower, then the money should either stay in the account until the trend changes directions, or the investor should be looking for opportunities to make money in declines.

Waiting for Confirmation. It is important to wait so it can either return to support and test the support level or trade above the resistance and close above it. A close above resistance is important, especially on higher volume. That would indicate buying interest, strength and momentum.

Low-Risk Opportunities. The safest, lowest risk opportunities are usually found at or near a support or resistance level. The goal is to only put our money at risk when the odds are in our favor. This is done by simple research, knowledge of the market, technical analysis, and letting the market come to us.

9. Managing the Trade: Protecting Profits and Limiting Losses

When in doubt – Get out.

Stop-Loss Importance. The stop loss is one of the most important parts of your trade. Never trade without it, and never invest without it. It ranks up there in the level of importance with analysis of the general market, the primary trend, and finding a good entry point.

Trailing Stop Loss. A trailing stop loss is a stop-loss order set at a percentage level below the market price. The trailing stop price is automatically adjusted as the price fluctuates. Using a trailing stop allows you to let profits run while cutting losses at the same time.

Minimum Losses. Holding losses to a minimum is vital. Many books will tell you to limit your losses to about 8%. But I see that as too much for a couple of reasons. If you enter a trade or investment and it declines by 8%, the chance of it declining further becomes much greater.

10. Trading Sideways: Adapting to Range-Bound Markets

When the market moves into the distribution phase it is once again a different market.

Confirming vs. Predictive. Trading indicators can be classified into confirming and predictive approaches. The confirming approach uses technical analysis and confirmations to validate future market direction. The predictive approach anticipates moves before confirmation, often using recent market movement and technical analysis.

Sideways Market Criteria. During sideways or declining markets, there are four criteria each trade must meet. These trades are buying pullbacks, so in order to buy: Enter only after a decline of at least five days, enter only after signs of support, stop loss must be very close to entry point, and know your target price.

Staying on the Right Side. When trading and investing, timing is everything. No, I am not a proponent of “timing the market” because the market moves when the market decides to move. So using seasonal timing strategies, or guessing when the market might move higher or lower is like throwing darts while blindfolded.

11. Trading the Downtrend: Profiting in Bear Markets

The trend is your friend.

Short Selling Basics. Short selling is selling a stock that the seller doesn't own, anticipating a decrease in share price. The seller borrows shares from a broker, sells them, and then buys them back later at a lower price to return to the broker, profiting from the difference.

Buy Stop Protection. The stop loss for a short sale is a bit different . It’s called a Buy Stop . This means simply in the event the stock trades up to $141, then we would buy the stock back to close the trade.

Early Signs of Decline. The early signs of market weakness and possibly a change in the primary trend are classic. There are five things an investor and trader should always be on the lookout for: Lower volume on advances, higher volume on declines, inability to make higher highs, primary trend line broken, and 200 DMA broken.

12. Options: Leverage and Protection

Charts are the footprint of money.

Call and Put Options. There are two basic types of options: Calls and Puts. Buying Calls is a long position, giving you the right to purchase the stock at the strike price. Buying Puts is a short position, giving you the right to sell the stock at the strike price.

Options as Insurance. Options have many uses. Some hold options as insurance on their investments, some trade options for a living exclusively, while others buy them as lottery tickets. But with all of the options changing hands, someone has to be a seller. The market is a Zero Sum Game. For every buyer, there’s a seller.

Covered Call Strategy. Selling Call Options on stock that you own is what is referred to as selling ‘Covered Calls.’ This is a source of income. This is like the pizza store. In our analogy, if the ‘Pizza Dude’ sold coupons for his pizza, then he would be obligated to honor those coupons at the price listed on the coupon if you held one of his coupons and wanted a pizza at that price.

Last updated: February 28, 2025