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Do You Have an Embarassing Gap in Your Investor Knowledge?

Posted
12/14/2012 12:37:00 PM
By: Teeka Tiwari
Referenced Stocks:XHB

The year was 1989. I was 18 years old and had just started working for Lehman Brothers. To say I was intimidated would be an understatement. The truth was I didn’t understand a word that anybody was saying around me.

As a new investor, and even as a seasoned pro, it can be hard to keep up with the latest Wall Street lingo. One phrase I heard a lot and didn’t understand when I was starting out was, “The trend is your friend until it isn’t.”

Have you ever heard that saying?

It is one of the few Wall Street aphorisms that is actually extremely valuable. So valuable, in fact, that I used it to rebuild my own wealth after disastrously losing it all back in 1998, but that’s a story for another day.

What exactly is a trend?

A trend is an ongoing move in a specific direction.  Being able to identify trends can be highly profitable if you trade in the direction of a trend. For instance, below is a chart of the homebuilder ETF XHB, you can see that it has been in an uptrend since late 2011.

 

The key to making money in an uptrend is to buy in at the bottom of the trading range while adjusting your stop loss level slightly higher after each successive wave of movement so you can catch as much of the trend as possible.

Looking at this chart we can see that XHB is squarely in the middle of its trading range. If we look at the long-term chart we can see that this ETF is right up at its 2008 levels.

 

It doesn’t mean that this ETF can’t go higher but it does mean that it has failed our test of wanting to buy in at the low end of the trading range. As such, we would avoid this one for now.

Does that make sense?

Trends come in different flavors, including short-term trend, long-term trend, intermediate-term trend and trendless (otherwise known as mean reverting). What adds to the confusion is that you can sometimes see different trends at work at the same time.

Let me explain…

A stock or a stock index can be in a long term up-trend but still experience periods of short-term down trends, intermediate-term down trends, and even extended periods of sideways action, all while being in a long-term up-trend.

The S&P 500 is a prime example.

 

We’ve been in a long-term (usually measured in months and years) uptrend since 2009. But along the way we’ve seen a lot of other smaller trends.

Mean Reversion

 

For instance, for the whole of 2011 the S&P 500 went nowhere. It traded in a very wide range but ended the year pretty much where it started. This is called a sideways or mean reverting market.

Mean reversion just means that the stock or index is trading sideways; usually 1 or 2 standard deviations from its mean price. In a mean reverting market, we want to be very short-term in our trading, buying at the bottom, selling at the top.

 

Intermediate Term

 

You can see from this chart that the S&P 500 experienced an intermediate term (usually measured in weeks and months) down trend when it dropped about 16% from April through July 2010.  So here we have an index that was in a long-term up trend, but still experiencing an intermediate term down trend.

You may have heard the term “Buy the Dips.” The only time it makes sense to buy the dips is if a long-term uptrend is in place. In this instance a long-term uptrend was in place and this market period represented an excellent buying opportunity.

In future articles I’ll talk more about how to determine what type of trend is in place. But you can see that if you have a way of being able to tell what type of trend is in place it gives you a huge edge in your trading and investing. So when people say, “The trend is your friend until it isn’t,” what they really mean is to go along with the trend until the trend changes.

You don’t have to be blessed with second sight to do this. All you have to do is attach a stop loss on your trades and adjust it as the trend progresses. When the trend turns you’ll be automatically taken out of your position.

Looking at the S&P 500, we can see that it is in the middle of its trading range. Again, it doesn’t mean it can’t go higher, but if we really want to put ourselves in the best position to win we are much better off buying in at the low end of the trading range rather than in the middle or at the very top (which is what many, many individual investors do!).

So, remember if you are looking to take advantage of an up-trend buy at the bottom of the range not in the middle and certainly not at the top!