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Stock Selling Strategies
Sell When the Trend Changes
by Marco den Ouden

"The trend is your friend."

- popular saying

The strategies you employ in selling may depend, to some extent, on the criteria you use in buying. A value investor would look at a stock's changing fundamentals. But if momentum plays any part in your buying decisions, you'll want to look at trends.

I'm not sure who coined the phrase, but there is a lot of truth to the expression "The trend is your friend." It's very popular with newsletter writer James Dines who quotes it in big letters in almost every issue of The Dines Letter. And my former Day Trading colleague at About.com Rob Rak swears by it. As does Ross Jardine, one of the founders of the Investors Online Toolbox. Other ways of expressing this thought are "go with the flow" or "don't swim against the tide".

And the principle is sound. Just as the physical law of momentum says that any object in motion tends to stay in motion in the same direction unless acted upon by some outside force, so too, a stock in a trend (i.e. - a stock with momentum) tends to keep going in that direction until acted upon by some outside force. In the world of stock prices, that outside force can be changing investor psychology, changing fundamentals, or some news. And as so often happens, the stock moves ahead of overt public awareness of such forces.

So you're invested in a stock that is moving up smartly. The trend is up. How do you know when the trend is changing? There are several different approaches.

Ways of Determining Trends

There are several ways of determining trends. The easiest is simply to look at a company's stock chart and see which way it's sloping. But no matter which chart you look at, you'll note that, in spite of an apparent general trend, there can be fluctuations up and down within the trend. There are long term trends and there are short term trends. Look, for example, at the chart for Starbucks from Feb. 1, 2002 to Feb . 1, 2003 below. 

The stock was in an uptrend through to the end of June followed by a sharp downtrend to the end of July, another uptrend through to the end of October and yet another downtrend the third week in January at which point another sharp uptrend was started.

Such a wildly a wildly fluctuating stock demonstrates that trends can run for months or for just weeks.

How can you tell when a trend is changing? We’ll look at several options.

Trendlines

If you join the tops of the approximate peaks of a stock chart in a straight line and the approximate bottoms of the troughs in another, you have two lines running more or less parallel that chart a channel in which the stock is trending. When the stock price breaks below the bottom line, the trend is shifting. Either the stock is slowing in its rate of growth, or worse, the stock is turning and entering a downtrend.

Starbucks broke through uptrend lines in May, again in July and once more in November. The severe downtrend line was broken in August. And another downtrend line was broken in January.  The latter was broken by what is called a gap up – a huge jump in price from one day to the next, usually a good sign.

Moving Averages

The moving average is another way of measuring trends. A moving average is a line plotted by taking the average stock price for a specified time period calculated daily. For example, the thirty day moving average is plotted from day to day by taking the average of a stock’s closing price over the last thirty days.

The simplest way of using moving averages to determine selling points is to simply take a single moving average, say 30 days as shown in the Starbucks chart by the red line, and sell when the stock price dips below its moving average and buy back when it moves back above the average. With our Starbucks example, this would have had you buying and selling the stock rather frequently as it went through several periods without a clearly defined trend. This is a rather costly exercise.

A better way would be to note the slope of the moving average. Sell when the moving average starts to turn down and buy back when it starts to turn up again. You could decide to give the stock a three day leeway - don't sell until the M.A. has been moving downwards for three straight sessions - to avoid excessive fluctuation. In our Starbucks example, this would have had you buy and sell five times. 

Another alternative is to plot two moving averages, one for a short to mid-term period and one for a longer term trend and see how they relate to each other. Stock Trends is a subscription service that plots and analyses the thirteen week and forty week moving averages of stocks.

When the thirteen week moving average is above the forty week average, they consider that bullish. When it is below, they consider it bearish. Important indicators are crossovers - when the thirteen week M.A. crosses the forty week M.A., it may indicate a change in trend. But they also use trading volume as an additional indicator to determine the validity of crossovers. A bullish crossover on strong volume is a good sign, but weak volume negates it.

Many websites such as Globeinvestor, BigCharts or StockCharts.com let readers plot two moving averages against a stock's price. There you can do your own analysis of specific stocks against their moving averages. The use of moving averages is very flexible and the investor can tailor it to her preference by choosing a single moving average or two moving averages and choosing time frames she feels comfortable with. This may vary from stock to stock depending on the stock's history and volatility.

Bollinger Bands

Another method of determining trends was developed by market researcher John Bollinger in the late 70s and early 80s. It combines features of both trendlines and moving averages.

In the 70s some analysts started charting a variation of trendlines by creating a trading channel around a moving average instead of by linking peaks and troughs. But this proved to be less than adequate because they couldn't come up with a distance from the moving average at which to place the channel lines. The optimal distance varied from stock to stock depending on the stock's volatility.

Bollinger came up with the idea of charting two bands around the twenty day moving average that were two standard deviations above and below the M.A.. Standard deviation varies with volatility and this proved to be a very interesting and useful trend indicator as the bands widened during periods of great volatility and narrowed during periods of stability.

As with other indicators mentioned, a break below the lower band would be a selling signal.

Downside to Selling on Trend Reversals

As noted above, using trend indicators can have you trading in and out of stocks excessively if not chosen carefully. You may have to tailor the trend indicators to the stocks you own. But there is great truth in the maxim, "the trend is your friend, and the benefits far outweigh any disadvantages.

Summary of Advantages and Disadvantages
of
Selling on Trend Reversals

Advantages Disadvantages
Preservation of capital. Excessive trading if not careful.
Risk reduction. May have to tailor methods to individual stocks.
Peace of mind  

Links of Interest

Stock Trends - An analytical tool that allows investors to identify trends of stocks on the Toronto Stock Exchange using the resources of The Globe and Mail. The methodology of this subscription service is carefully explained online.


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