If you follow my blog for some time, you know that the gist of my investment philosophy is to follow the market trends and manage the risk rigorously. This way of momentum investing has worked well in the past few years and it has been demonstrated by my Global Momentum Compass (GMC) Portfolio.
Very often, people ask me how I identify trends. I use both technical analysis (through the charts) and fundamental analysis (through my understanding about current market events). In this article, I will explain some basic ideas about how I use technical analysis to find investment opportunities.
Momentum investing is less known and understood among retail investors. However, “trend-following” is a widely adopted and proven technique used by professional investors. Not only it can be used for short term trading, it is effective for long term investing too. As legendary trader Jesse Livermore said,
Big money is not in the individual fluctuations, but in sizing up the entire market and its trend… Prices are never too high to begin buying or too low to begin selling.
Momentum investing is akin to sailing with the wind at your back. The technique can be applied to many markets. As trends are found on every timeframe, it can be used by both short-term and longer-term investors.
The concept of trend-following is not to catch the entire move but to join an existing trend and ride it until it ends. For example, in early July, I allocated 25% of the GMC portfolio to China stocks. At that time, some of my clients questioned this move as the price might seem to be too high to enter the trade. On hindsight, you can see that we have made some handsome profit from this decision.
Now I am going to explain how to identify and trade with a trend. The charts used below are generated by CFD trading service IG.com. The charts are based on some past time frames but they are good examples.
Identifying a trend
There are 3 different ways which prices can trend:
- Upwards
- Downwards
- Sideways
You can get a clear understanding of these 3 types of trends from the USD to SGD forex movement chart below.
Chart Source: Adopted from IG.com
We want to focus our attention on upwards and downwards trends as this is where the greatest opportunities lie for trend-followers. I will ignore sideways trends, as the price is range-bound with no significant increases or decreases to take advantage of.
You can use the following tools and techniques to help you identify a trends direction on a chart.
Look at the highs and lows
This is very simple yet effective. A market in an uptrend will consist of higher highs and higher lows and a market in a downtrend will consist of lower highs and lower lows.
Use moving averages
Moving averages use past prices to calculate what the average price has been over a given time period. Some of the more commonly used include the 20, 50, 100 and 200-day moving averages. You want to use moving averages that are relevant to your trading time frame and strategy. Generally, the bigger the trend that you want to catch, the longer days you need to use.
In July 2010, I wrote an inconspicuous post about US and Europe stock markets were breaking through 200-day moving average. Fast forward 7 years till now, if you have followed this indicator, you would have made huge profits.
Draw channels and trend-lines
Channels and trend lines can be drawn onto charts using simple tools that should be included with any quality charting service. When drawing these you need at least 2 points where price touches to validate the channel or trend-line.
Chart Source: Adopted from IG.com
However, I seldom use this as this is typically for short term entry and exit.
Trading the trend
Once we have identified a trend, the next step is putting a plan in place to trade it. You want to know beforehand what your entry and exit points will be. That is why I always emphasize that you need a systematic way when it comes to investing.
Entry points
Entry points are where you start buying. To illustrate using the chart below, possible entry points come in the form of breakouts and pullbacks.
Chart Source: Adopted from IG.com
To enter on a breakout, you are looking for price to breakthrough recent swing highs (uptrend) or swing lows (downtrend). You can identify these areas by drawing support and resistance lines on your charts.
Professionals also trade pullbacks, they want to use moving averages or trend lines which the price has found support or resistance at previously, they will then look to enter a trade if price retraces near to these areas. Personally, I do not use this as it increases the difficulty for my portfolio risk management.
Exit points
I mentioned that I do not buy at pullbacks, but I often use it as an exit point.
If we catch an uptrend. we can position our stop losses just near the most recent higher low. In this way, we can keep trailing it as new higher lows will be the point where we lock-in our profits.
By now I have given you a glimpse of how I use basic technical analysis to help identify and make profits from trends. It may be simple if you have learned technical analysis, or it may not be clear if you haven’t tried it by yourself.
Momentum investing is just so simple but easy. It is simple to identify a trend on hindsight, but you need experience, courage and discipline to put your money into it and most importantly, make a profit.
If you like the way I invest, you can find out more about my professional investment management services here.
Thanks for your comment about how technical analysis can help you discover new trends. I like how you said that it can also be beneficial in finding opportunities to invest. If someone with a business was interested in learning more about technical analysis, I would assume that they would keep these tips in mind.