Most of us would prefer to be investors instead of traders. Investors, with an intermediate to long-term time horizon, must be aligned with a positive trend in order to make money. This is true even for value investors who focus on a company’s valuation rather than a trend that can be seen on a chart. For the value investor to make money, eventually the position must turn up.

The chart above is not designed to convey that spotting a trend reversal is easy. It is not, but as more evidence gathers as to the probable legitimacy of the new trend, the less risk you need endure to participate. If the stock or market does not trend upward for a significant period of time, long-term investors do not want to participate. The point is, you can afford to miss the early part of the new trend. Let the traders show us the way while putting their capital at higher risk. The strategies and goals of shorter-term traders are quite different from those of a long-term investor. When you understand this, it becomes clear that many buyers at a "bottom" are traders who have no intention of keeping the stock for a long-term investment, which means they will be happy to sell at the first sign of trouble (creating many false bottoms). Long-term investors do not necessarily want to enter a market at the same time as traders who have much shorter holding periods. This concept currently applies to the ETFs, SPDR S&P 500 (AMEX: SPY, Stock Forum), PowerShares QQQ Trust (NASDAQ: QQQQ, Stock Forum), Diamonds Trust (AMEX: DIA, Stock Forum), SPDR Financial Select Sector (AMEX: XLF, Stock Forum), iShares MSCI Eafe Index Fund (NYSE: EFA, Stock Forum), and the list goes on.

Volatility and risk management while capturing a trend

Depending on how you manage it, volatility can be your friend or your enemy when attempting to make money in financial markets. Fear is an investor’s biggest enemy and volatility is what drives fear. To remind everyone of what could be at stake here and what can happen in bear markets, below are the devastating losses suffered in the SPY and QQQQ during the 2000-2002 bear market.

It is evident above that volatility should be respected since losses can wipe out years of hard work if a portfolio manager does not adopt proper risk-management measures. How can volatility be our friend? Those who study and understand the volatility characteristics of any investment or market will have a much better chance of staying with and capturing the gains available in long-term trending markets. As illustrated in Chart A below, any investor would have loved to ride the Nasdaq’s meteoric rise from 1995 through the first quarter of 2000. I have removed the volatility from Chart A to illustrate a trending market without the gut-wrenching and emotional effects of the market’s inevitable ups and downs within the context of the primary trend. Our goal is to stay in an upward trending market long enough to profit, while not staying invested too long during what appears to be more than a "normal" correction (see Chart C).

Chart A

Chart B

Chart C

Chart D (below) shows both the current uptrend in oil – the United States Oil Fund (AMEX: USO, Stock Forum) – and recent corrections within the context of the uptrend. The percentage drop in the large pink circle from peak to trough was 34%, but those who held even a reduced position were able to profit from the remainder of the trend. The percentage drop in the green circle was 13%, but those who held on through the correction were able to profit. If oil dropped 12% from its recent peak of $145 it would fall to $127.50. If oil dropped 34% from its recent peak, it would fall to $95.95. In a form more simple than how we would actually make decisions, an investor in oil should not get too concerned until $127.50 is taken out on the downside. Based on your risk tolerance, you may decide to cut back on your holdings below $127.50. If $95.95 is violated on the downside, it is possible you would exit the entire position or at least make a significant reduction in your exposure.

Chart D

In the real world, a portfolio manager would use several factors to make calls on when to cut back or exit a position. If trend lines are broken, that adds to the negative evidence. If an investment has had an extended run, like oil, the manager may be more inclined to cut back earlier rather than later. Fundamental factors come in to play as well. The cons for oil are the reduction in demand that comes during periods of economic weakness and the aforementioned long-in-the-tooth trend. The pros for oil are well known; questions about supply and increased demand from China, India, etc.