Understanding a stock’s trend is one of the most important things to do before considering a position. You need to know what you are getting yourself into. Recently, because of the medical marijuana stock bubble, I’ve encountered a lot of people who are surprised at just how low a stock can go. While it’s always unfortunate to watch one of your stock pick’s drop exponentially, you should be aware that the stock is following a trend. If you are looking to catch a bottom during a downtrend, you are playing with fire. It’s much easier for a trend to continue than it is for it to reverse.
Identifying a trend
Identifying a trend is fairly simple. Uptrends are classified by higher highs and higher lows (the stock is moving up in price). Downtrends are classified by lower lows and lower highs (the stock is moving down in price). It’s as simple as that. Sometimes, there will be no clear trend present and the stock is considered to be trading or consolidating instead of trending. More often than not, you can identify a trend simply by looking at a stock chart. It’s important to understand that stocks have different trends for different time frames.
Trends Across Different Time Frames
Different traders have different goals and trading styles. Some will hold stocks for a day, while some will hold for months or years. It’s important to pay attention to the trends that affect your trading style as well as the other trends. According to Dow Theory, there are three main trends that may affect a stock: primary, secondary, and short term.
Primary Trend – The primary trend usually accounts for a stock’s price action over the past year or few years. Based on my style of trading, I’ll usually look at 200-Day chart to see the long term trend. Primary trends are of most interest to investors who will hold a stock for months of years.
Secondary Trends – The secondary trend usually accounts for a stock’s price action over the past few weeks or months. Based on my style of trading, I’ll usually look at a 50-Day chart with a stronger focus on the past 20 days. Secondary trends are of most interest to swing traders who plan to hold a stocks for a few weeks.
Short Term Trends – Short term trends account for a stock’s price action over the past few hours or days. I usually look at a 30/60-Minute chart for the past 10 days, as well as intraday charts on 1,2, and 5-minute scales. Short term trends are of most interest to day traders looking to get in and out of a position within the day or a few days.
Below is a 2-year chart of AMBS showing the primary, secondary, and short term trends. (This chart was chosen at random based on a stock I was playing today. In no way is this post intended to influence you to buy or sell this security. This is for analysis only) Notice that the primary trend is an uptrend. The stock has been rising off of its lows since November 2012, consistently setting higher highs and higher lows. That being said, the secondary trends varied. The stock experienced a downtrend during the first 6 months of 2013. During that secondary downtrend, the stock experienced some great short term uptrends. AMBS ran up nearly 100% during the first 10 days of April 2013.
Clearly, it is important to align your trading goals with a stock’s trend. If you bought AMBS in November 2012 and planned to hold for years (which I never recommend doing with penny stocks), you would have experienced a nice 3700% as the stock ran off its lows of about .005 to highs around .19. If you bought in January 2013 and planned to hold for a few months or weeks, you would have been disappointed as the stock dropped from highs of about .19 to lows of around .027. The point being that the trend you follow should match your trading style. If you went long AMBS anytime between January-June of 2013 for a swing trade, you were fighting the secondary trend. If you were looking to invest in AMBS during that period with plans to hold for over a year, you had less of a reason to worry, as the stock did not break the primary uptrend.
Let me make this clear, DO NOT FIGHT THE TREND. Trends are more likely to continue than they are to reverse. As mentioned above, if you are trying to catch the bottom of a stock, you are playing with fire. It’s easy to rationalize a purchase like that. You don’t want to miss the big move. You figure the stock has been dropping for days and is due for a bounce. The stock seems undervalued at these prices. It’s better to miss a big move upward than to jump into a big move downward. Sure, the stock may bounce soon, but you should be prepared to stomach the losses if it does not. Know that by the time the stock does bounce it may not even bounce high enough for you to break even, as you are in a stock where a lot of people are looking for the first chance to get out (causing lower highs).
Let’s look at the AMBS chart from before and see how you can spot trend reversals. I like finding trend reversals so I can initiate a swing trade. I’m looking for reversals in a stock’s secondary trend. I don’t care about the primary trend because I don’t hold stocks for that long. I’m not focusing on a short-term uptrend during a secondary downtrend, because that’s a different kind of strategy. Here are a few ways I spot trend reversals.
Look at the Chart – AMBS was dropping from January 2013 to June 2013. Eventually, the chart started to bottom out. Keep in mind that charts don’t bottom out over night. It can take months. AMBS started a period of sideways trading between June 2013 and August 2013. It formed a clear level of support, and volume started to slow down. There was also a clear level of resistance forming. This represents a period of indecision in the market. There’s no reason to expect any big moves during this period. You can scalp trade and play the volatility, but that can be risky. In hindsight, you can see that the stock consolidated at these levels and made its way higher, but that’s not always the case. Think of this period of indecision as a battle between the bulls and the bears. The bears keep pushing the stock down and the bulls keep pushing it back up (neither of them shifting the trend in their favor). If the support line is broken, the bears win. If the resistance line is broken, the bulls win. In this particular case, the bulls won and the stock continued to run for about 2 weeks. This breakout was eluded to by higher highs and higher lows being formed on the chart. When the stock broke through resistance, it went parabolic and the price went up almost 100%. You should also pay attention to the increased volume, as it shows you that the stock was getting the interest of traders as it ran up and traders tried to catch the move.
This kind of move is best understood when you think about the psychology behind it. Follow along on the chart to understand. AMBS ran from lows of about .005-.006 in October/November of 2012 to highs of about .19 in January 2013, during which time the stock had huge volume. This means that most of the shareholders bought the stock in the price range of .005-.19. What would you do if you bought at .19 and the stock started plummeting? Chances are, you’d look to get out of the stock asap in order to cut your losses. So, the selling begins. What would you do if you bought at .005 and the stock was dropping? Chances are, you would sell your shares to lock in profits. So, the selling continues. During this time, other traders are buying those shares. As the stock continues to drop, a lot of those traders will start to sell their shares, realizing the downtrend is not over yet. So, the selling continues. All of these people stuck holding the stock are looking for a way out. This explains the psychology behind the formation of lower highs. Every time the stock bounces a new group of stuck shareholders decides to sell either for profit or to minimize losses. This goes on for awhile until an equilibrium price is reached. Everyone who wanted out of the stock got out, so the selling slows. Supply of the stock has now dwindled (remember the market is all about supply and demand). That being said, demand hasn’t increased quite yet. New buyers recognize that the stock has been downtrending for awhile and are not quick to jump into a position. Volume is slow during this period. Shares are exchanging hands within a tight price range (a period of trading). This period is like a refresh/filtration of the stock’s shareholders. Now, instead of having a bunch of shareholders who bought in between .005-.19, there are a bunch of shareholders who bought in between .03-.045 (look at the chart). These shareholders have way better entry points than their predecessors. They have less reason to impulsively sell their shares to cut losses or take big gains, so they hold shares. This period of trading is also known as accumulation. During this period of indecision, these new shareholders are looking for a big move in either direction. Eventually, the stock starts making it’s way upward, setting higher highs and higher lows as supply decreases and demand increases. AMBS has a history of huge breakouts, so this catches the attention of even more traders who believe a breakout may be coming. This breakout could be triggered by a news-related catalyst, short squeeze, or it could just be a technical breakout. The point being that demand for the stock has increased, as shown by the increased volume.
Trend Lines – Trend lines can be drawn on a chart to give you an idea as to the stocks general movement. Sometimes you will have to draw multiple trend lines and choose which one is in play at the moment. Drawing trendlines is an art, not a science. Trend line crossovers can signal a change in trend. It’s much easier to see which trend lines are in play in hindsight, however, this is just one of many tools you will use to spot reversals. Here is an example of AMBS trend reversals using trend lines.
Moving Averages – Moving averages help to smooth out price action, which can be helpful for spotting trends. I use simple moving averages for the most part, however, I will sometimes use exponential moving averages when a stock has been making faster moves. These are the moving averages I use for trend spotting on a daily chart:
200 Day Simple Moving Average – Primary trend
50 Day Simple Moving Average – Secondary trend
10 or 20 Day Moving Average – Short term trend
Let’s look at these moving averages on the AMBS chart.
200 Day Simply Moving Average – This MA reacts the slowest to recent price action.
- Notice that the 200 DMA starts to flatten out and curve up towards the beginning of 2013
- Then the 200 DMA starts to curve down a bit in October 2013, signaling a potential reversal in the primary trend
- The stock sets higher lows and the primary uptrend continues as reflected by the 200 DMA in December 2013
50 Day Simple Moving Average – This MA reacts to price action faster than the 200DMA but not as fast as the 20DMA. Notice that it can foreshadow trend reversals, however, it is a bit slow. It also ignores random price fluctuations such as short lived breakouts.
- Notice that the 50 DMA starts to flatten out during the end of 2012 and starts to curve up around the beginning of November 2012. The 50DMA eludes to the major breakout much before the 200DMA does.
- Notice that the 50 DMA curves downward in the beginning of March 2013. It eludes to the upcoming drop when the stock is trading at around .07 and doesn’t curve up again until the stock hits .03
- The 50DMA flattens during the period of consolidation discussed above and starts to curve up as the trend reverses.
- The 50 DMA starts to curve down again as the breakout was short lived
- The 50 DMA curves back up and continues the upward momentum
- The 50DMA curves back down as price starts to drop further
- the 50 DMA curves back up as another run starts to happen.
20 Day Simple Moving Average – This MA reacts pretty fast to price action. This is both good and bad, as you’ll see below.
- The 20 DMA eludes to the breakout almost right away. It only uses 20 days of data so it reacts fast to sharp moves.
- The 20 DMA starts to flatten out and dip, giving somewhat of a false warning. This is a good sign for short term traders, however, as we see, the breakout continues.
- The 20 DMA warns of the upcoming drop when the stock is still in the .9-.10 range, giving traders a lot of time to get out before the stock bottoms around .03
- The 20 DMA reacts to the bounce during the downtrend. Unfortunately, by the time it curves up, the breakout is almost over. Yet another false signal.
- The 20 DMA starts flattening and eludes to the upcoming breakout before the majority of the move occurs.
- The 20 DMA starts to curve down at when the price is at .06-.067 before the drop to .04
- The 20 DMA curves back up eluding to yet another breakout
- The 20 DMA curves down eluding to a breakdown
- The 20 DMA curves up eluding to a breakout (Hopefully this is getting redundant by now)
Other important things to note about moving averages
- Trending stocks will often find support and resistance at their appropriate moving averages. (eg: long term support should be at the 200DMA when the stock is trading above it). Notice how the 20DMA acts as support during up trends and resistance during downtrends in our AMBS example.
- Trading below longer terms MAs (50/200) is a bearish sign. Trading above can be bullish.
- Trending stocks tend to have MA crossovers. In a strong uptrend you’d expect the 20 DMA to be above the 50 DMA and the 50DMA to be above the 200DMA, although this won’t always be the case. Look at the most recent uptrend in the AMBS example to see this.
- Keep in mind that there is no magic formula for using moving averages. They are simply a tool to help smooth out price action. The analyses I made above were done in hindsight, which is much easier. Every stock will react differently to their moving averages. For example, a lot of people expect the 200DMA to hold as support (as mentioned above). This is speculation, and not a rule. Anyone can sell below the 200DMA very easily. Use different MAs to help spot trends, but don’t trade solely off of MAs. There are a lot of other tools that you can use.