I wrote a few posts earlier that I had checked out a couple of books from the library. The first one that I decided to go into was “How Technical Analysis Works
“by Bruce M. Kamich. I’m about a third of the way into the book and it has been fairly interesting so far. The main points that Kamich has discussed are trend lines. Trend lines seem to be a promising way to predict the movement of a particular stock over a large period of time. Many of his examples show trends over the course of ten years. He used three years as well. He even had a couple of examples where the trend line was drawn over a time period of a year or less.
The purpose of a trend line is to show the investor the general direction a stock is headed based on past movements. The key to this is that it is based on past movements. Price movements that occurred in the past were based on news and expectations from the past. These expectations could change dramatically in the present day. Another important thing to consider is that trend lines are solely based on opinion. There is typically no one correct trendline to draw. This can prove to be especially difficult in short periods of time or with a very volatile stock.
In the book, Kamich suggests that if the price should fall below the upward trendline by a certain amount it may be a good idea to get out. He suggests that while some people use a 1% drop below the trendline as their signal to get out, many others will let it drop as much as 5% below the trend line before getting out in fear of missing out on a reversal. Kamich suggests that the best trend line trading strategy is to pre-determine your exit strategy so that you are not caught up in the emotion of trading.
Trend lines should be used as one of many tools to evaluate a stock. While they can be a helpful tool, the predictions that they may seem to make may not always come to fruition.
Below are a few examples of how one might trade using trend lines. If you click on the small images of the charts, they will open in their full size version in a new window.
This first example is your classic trend line example. The chart shows a one year chart for financial institution Horizon Bank (HRZB). The initial point starts in mid-June at roughly $23.75 and hits the next peak around mid-September at about $21.50. That is a drop of approximately$2.25 according to my guesstimates. If you believed that this trend line would hold true in the future, one would take a bearish position on the stock and short it. If you had shorted in mid-September at $21.50 you could have rode that price all the way down to the current levels of around $13 where you could have covered. This would be a 65% return over the course of about six months. Not too shabby. Below is the chart for HRZB. Notice that over the time period of the trend line the price of the stock never rises above it. Kamich suggests to always maintain your position in a given security as long as it is trading in favor with the particular trend line.
The next example shows a bit different of a story. As I’m sure you have already gathered, not all price charts fit this model as nicely as HRZB. Take Netflix (NFLX) for example. Their price chart over the last year has been a bit more volatile. Notice in this chart there are both downward and upward trend lines. The lines are numbered in order of when they would be chronologically drawn (ex: it would be impossible to draw U3 chronologically before U2). Between April and May the stock develops a downward trend line (D1) which extends all the way into mid-September when it is broken by an upswing in price. At this point in time NFLX is trading at about $19/share. Using the 1% rule, you would not cover your short shares until the price had reached $19.19, which we can see it quickly does. Following the 5% rule, one would wait until the price reached $19.95/share before repurchasing. As we can see, this happens only a few days later. Take not though that the $19 intersection should not be used for the 1%/5% rule, but instead the price of the trend line should be used. The day after the $19 intersection, the trend line may be at $18.90/share. Using the 5% rule, the stock would only need to be trading at $19.85 to warrant a buyback.
You will also notice on this chart that the stock reaches a low of about $16 in late July. In hindsight this would have been the best spot to cover the shares, but since the trend line goes all the way to zero we must assume that the price will continue to decline until the trend line has been broken. It is at this low where the price starts to rise ever so slightly. By choosing that late July low and combining it with another low in mid-September, we have created a new upward trend line (U1). Had a new investor noticed this new trend line, they could have bought in mid-September at $17/share and ridden the rise all the way up to current trading levels of about $33/share. That is a nice 94% gain over six months! Notice that the price never falls below U1 during this time period.
Take a look at U2. From mid-September to early November, the stock realized considerable appreciation. U2 is created by using the dip in mid-September and the dip in mid-October. Had you bought in mid-October at $23/share, the trend line would have suggested selling it at around $24.70 using the 5% rule. Using this trend line the investor would have only realized a gain of only 7.3%. This is a far cry from the 94% gain using U1.
You can see from U3 and U4 that an investor could potentially find a number of different trend lines for a stock depending on what date it was being analyzed and where they felt the most accurate dips in the market were to put a trend line through. As you can see from the Netflix example, using trend lines is an imperfect art that should be used as one of many tools to analyze a stock. U1 and U2 show how drastically an investors returns will be depending simply on what lines are drawn.
I am including three additional charts to look at and analyze to get a little more understanding on the art of using trend lines. I won’t go into too much analysis on these ones. Trend lines are a fairly simple subject, so after seeing the first two examples these next three should appear fairly straightforward.
- Jones Soda (JSDA): U1 gives investors a false hope in early December. Using this strategy wouldn’t have netted much if any profit for a speculator who bought in mid-December and would have sold at the very beginning of January. D2 seems to show the most accurate trend line, but is also based off more data than D1. This chart was created over a six month period of time
- Cemex (CX): Cemex faced downward pressures from mid-October through mid-January. This can be seen from D1, D2 and D3. These downtrends show how difficult it can be to correctly choose a trend line. U1 shows promise for a speculative investor. This chart was also created over a six month period of time.
- Ford (F): This stock has been all over the map as far as trend lines are concerned. U1 would have shown little or no gain. If you shorted using D1 you may have seen a loss. A short using D2 would have experienced the best gains.
As a final note: of these five stocks, the only one I own is JSDA as of 3/12/2008 (the time of this writing).
