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Trading
Trend or Countertrend
Jeff Cartridge - August 28, 2008
 The traditional approach to trading with technical analysis is to follow the trend. The old adage the trend is your friend applies in the stock market. But is that always true! There is certainly a time when it is safer to move with the crowd, but at times it is essential to break free from that crowd and do the opposite. When the crowd is going where you want it to go then follow the crowd like a sheep. If the crowd is headed for greener pastures then tag along, but at times it pays to break free from the crowd. There is no point in being a sheep following the crowd to the slaughterhouse.
So how do we determine when to trade with the trend and when to change direction and do the opposite? The best time to get on board a trend is at the start, because there is no way of knowing how long a trend will continue. So how does a trader determine the start of a new trend? There are many tools and techniques that can be used to determine when a new trend is beginning.
The definition of a trend, was created by Charles Dow in the early 1900’s. An up trend is defined as a series of higher highs and higher lows, while a downtrend is defined as a series of lower highs and lower lows. The change in trend can be determined when there is a shift from one trend to another.
Looking at the chart of the Materials sector below it was clearly in a down trend through June and July. Around the middle of August the Materials sector reached a higher high which was then followed by a higher low. The higher low is necessary to confirm the start of a new trend because a higher high on its own is not a new trend. The Materials sector is now in an up trend and any position is beginning to show a good profit. How long this up trend will continue is unknown, but once again watch for signs of a change in trend.
There are other ways to determine a change in trend with the most popular being the moving average crossover, or the MACD which is a derivation of the moving averages. In the chart of the Materials sector shown below the market is moving into an up trend with the MACD already crossed over and the moving averages approaching each other.
The two moving averages are shown overlaid on the price candles and may cross in the next few days. The MACD is shown at the top of the chart and provides a signal of a change in trend before the moving average crossover.
All of these tools can be used to identify trends, but how do we know when a trend is likely to end. Remember a trend is only your friend until it ends.
Were there any signs the Materials sector may be about to turn around before the trend change occurred?
An indicator I like to use is the Price Rate of Change or ROC for short. This indicator looks at how fast the market is moving over a period of time. The indicator shown in the chart above is based on 65 trading days, which is approximately the quarterly rate of change. The rate that the Materials sector was falling in late July went beyond 15% per quarter and actually peaked at 25% per quarter. Is this sustainable? If the Materials sector continued to fall at 25% per quarter the whole Materials sector will be worth zero within 12 months. This is very unlikely to happen with a probability close to zero, therefore a rebound or reversal in the market is likely.
As you can see from earlier in the chart in late June the Materials sector was rising at a rate of 25% per quarter and in late April and mid November was going up at a rate of 30% per quarter. These rates are once again unsustainable and a reversal occurred. In January the sharp drop in the market was also unsustainable and a rapid reversal followed.
I personally have found this indicator a very powerful setup to determine likely reversal points in the market, or when a trend is likely to end. A word of caution though when using this indicator to trade, sometimes the indicator gives a signal too early, while the market is still falling (or rising rapidly). Always wait for a confirmation of the reversal before entering the trade.
Trading with the trend is a great way to make money, but watch out for the end of a trend as this can cause significant losses if you are still hanging on expecting the trend to continue. The ROC is one indicator you can use to identify when a trend is likely to end.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au. Please note that the views expressed here are those of the author, not of CompareShares. Although all investing has some form of risk, CFD trading strategies are only for experienced traders and risk management strategies must be considered.
Whatever your views, you can discuss this article - or any of Jeff's articles - on our message board Your 2 Cents.
More articles from this edition of CompareShares:
Listed Investment Companies: New playing-field for LICs
Super strategies: Do it yourself check list
Trading: Trend or Countertrend
Companies: AMP's H1 profit falls 22%
Promotion: Perpetual promotes short-selling virtues
Turnover: Nuplex profit soars 84% on restructuring
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