Stock Selling Strategies
Sell When the Trend Changes

"The trend is your friend."

- popular saying

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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 Day Trading colleague Rob Rak swears by it.

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 of Nortel Networks for the last year (chart will open in a separate window for handy reference), we note that the stock is in a long term uptrend, but had a short term downtrend from around March 20 to May 20, 2000 before resuming the uptrend. And even within the shorter term trends, there are fluctuations.

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. Colleague Rob Rak has an excellent diagram of trendlines for Uniphase stock. 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.

Nortel broke below the bottom trend line near the end of March. An investor paying attention to trends would have sold some or all of her Nortel stock and waited for a clear sign that the stock had not entered a prolonged downturn. She would have bought back into Nortel in late April when the stock started trading sideways or around June 1st when the stock clearly started a new uptrend.

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. See my colleague Mike Griffis's excellent explanation of Moving Averages for more on this technical indicator. I will continue assuming you know what they are.

The simplest way of using moving averages to determine selling points is to simply take a single moving average, say 30 days as shown here, and sell when the stock price dips below its moving average and buy back when it moves back above the average. With our Nortel example, this would have had you sell around April 1 but would have had you buying and selling the stock eight times in the last three months. This is a rather costly exercise. You can alleviate this to a certain extent by picking a different time frame for your moving average.

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 Nortel example, this would have had you sell around $80 and buy it back at approximately the same level. Although it would have cost you the price of two trades, it would have been a good safeguard if a severe and prolonged downturn had occurred. You sacrifice a bit for safety.

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.

Globeinvestor lets readers plot two moving averages against a stock's price. Here is the chart for Nortel plotted against ten week and 40 week moving averages. As you can see, the short term moving average stayed above the long term moving average all through the market decline of April and May. An investor basing strategy on these two averages would have held on through the market turmoil as the stock recovered and hit new highs.

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.

MSN MoneyCentral has a very interesting article explaining the bands and how they helped predict a breakout in Amazon.com stock in November 1998. See the links after this article.

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

Our Nortel example has you selling in early April at around $82 when the price broke below the lower band and buying back in mid April when the stock price went back inside the bands again at around $75 or in early June just below $90 when it broke the upper band if you're more cautious. Allowing some leeway, the one day dips in May and early August would not have you sell. Although the cautious strategy would have cost you a bit between the selling and buying back, excessive trading is avoided and the peace of mind of avoiding a potential rout may have made the small loss worthwhile. It all depends on your risk tolerance.

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 the Cutting Your Losses Short Strategy

Other Links of Interest

Repeat after me: "The Trend is Your Friend" - Article by Jim Jubak at MSN Money Central.

Whether Buying or Selling, the Trend is your Friend - Article by Colin Nicholson in Australia's Shares magazine.

How Bollinger Bands Predicted Amazon's Moonshoot - Article by Randy Myers at MSN Central explains Bollinger Bands and gives a solid example of using the method with Amazon.com as an example.

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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