The ability to analyse the trend of a stock is an essential first step in being able to pick trades. Although it is a simple process, it is often overlooked. Master the concept, and you are well set up to be able to start with momentum trading, or as an options trader, you have all the basic information that you need for selling credit spreads and naked puts. While it is a powerful tool, its downside is that many traders do not trust its simplicity, and end up over analysing and getting too much information. There are two major steps to finding the trend of a stock, using four indicators.
“The Trend is your Friend”
Step One: Find the trend of the market
Unless you have a contrarian stock that often goes against the market trend, most stocks will follow a market trend pretty safely. Many traders make the mistake of setting up a trade, only to find that they have bet against the market (I did that once!). While almost any of the major indexes will serve, I prefer to use the S&P500, simply because it is most representative of the general market. You may want to find the trend of the sector of your stock as well, as a back up. Essentially, you need one tool to find the trend, and one tool to measure the strength of the trend. You then use two other indicators to make sure that a reversal is not imminent.
To find the direction of a trend, use the balance of moving averages. For medium term, you may wish to use the 10ma and the 30 ma. These show whether the market is trending upwards, sideways or downwards. If the 10ma line is ABOVE the 30ma line, it means that over the last 10 days, the stock has been trading higher (on average) than for the last 30 day period, and this means that you are in uptrend. The further the two lines are apart, the stronger the trend. However, there is a more objective way of measuring the strength of the trend, by using the Wilder’s DMI, also known as the ADX. If the ADX is above 25, you have a strong trend, irrespective of whether the trend is up or down. ADX does not show direction – it only shows the strength of the direction.
Once you have established the direction of the trend, and its strength, you need to check on the RSI and the VIX. If the RSI is below 30 or above 70, you have an indication that the trend has run for a while, and that a reversal may be about to happen – therefore, be cautious. The VIX gives a similar picture. Fibonacci lines can also help you decide when a reversal is close.
Step Two: Find the trend of your stock
Once you have the market trend established, you then focus on your chosen stock. You simply use exactly the same indicators, but this time in a more narrow sense. The balance of the moving averages will tell you the direction of the trend, and the ADX will tell you the strength of the trend. RSI will again help you decide how close you are to a reversal, and you can also look at Fibonacci or support/resistance lines to see how far the trend is likely to go.
Once you have established that your stock is in a trend, you are immediately set up to do a momentum trade, or to to sell credit spreads. If the trend is positive, and you have enough money to cover your margin requirements, you can sell naked puts. Or you can use the fluctuations within the band of the trend to do some short term swing trades, either directly on the stock or by using options. By trading options, you get a much better return for the same investment.