The trend is your friend is a very common expression in financial markets, and especially when it comes to trading. But what is the meaning behind this extremely common expression? Well, this expression comes from the common knowledge that you should let your winners roll, and cut your losses. The idea is that a given asset trading in a certain direction will continue to move in that direction during the foreseeable future.
Part of the meaning behind “the trend is your friend” is the basis for momentum investing. Momentum investing focuses on finding patterns and directions in pricing for different assets. Based on the belief that if a certain asset is appreciating at price it will continue to do so. Conversely, the same applies to assets whose price is decreasing.
Why the trend is your friend
Although some traders deeply believe that the trend is your friend, and build their strategies around this concept. Some are not familiar with the reasoning behind this common trading expression. The trend is your friend has its origins in the momentum effect. The momentum effect dictates that a stock is likely to continue its upward or downward movement.
This is intrinsically related to how technical stock analysis dictates whether a stock will go up or down.
Technical analysis and the trend is your friend
Technical analysis is widely used by most traders and even investors. The ability to identify patterns on a chart can prove to be extremely profitable for some of them. One of the key aspects of technical analysis is to identify trends. Trends define the direction that a certain price of an asset is taking at a given time.
This is directly related to the origins of the expression “the trend is your friend”. As stocks and other assets’ prices tend to continue to move in the same direction. However, over the years a new expression has also become popular - “the trend is your friend until it ends”.
This is something every trader and investor should be aware of. Trends eventually revert, and you have to be aware of this in order to avoid falling into this trap. Mark Carhart, a well-known financial researcher, proposed an addition to the Fama-French model that included an analysis of the momentum.
Carhart introduced the momentum effect
According to Carhart, asset pricing should take into consideration the momentum. Given that a stock has a tendency to continue to move in the direction it is already in. Hence the expression “the trend is your friend”. Carhart advocated that an asset pricing model should consider the momentum of an asset. Where momentum could be mathematically defined by the velocity at which a price of a certain asset changes.
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