Jul 29, 2024
Written by:
John McDowell
If the stock market were a rock song, a power trend would be the epic riff near the end of the song. It's like buying on margin toward the end of Skynard's Free Bird, then jamming out and head bobbing with a beer in your hand for the next three minutes while the guitarist keeps jamming. And just when you thought the end was near, he somehow adds another minute of electric ecstasy.
That's what a power trend in the market is like. When the chop has subsided and the market finally decides to take off, you pull all your buying power together and find the best stocks in the market to ride the trend for as long as the guitarist wants to play it out. These trends can often last a lot longer than anyone imagines, and trying to guess the top without good criteria is a fool's practice.
Stock markets tend to follow one of three general directions: up, down, or sideways. This is a general rule of thumb, as most markets are continually bouncing up and down depending on the time frame. Yet, with a broader view, say, with a daily or weekly chart, the market will generally follow an upward trend, a downward trend, or find itself in a consolidation period.
Trend traders will wait for a breakout from a consolidation and ride a wave of momentum. However, not all trends are created equally. Some trends are shorter-term; some are longer-term. The slope of a shorter-term trend may be steeper than the longer-term trend. Here is an example of a few different trends in the SPY from 2024:
Notice that the longer-term trend can remain intact despite the breakdown of a shorter trend. You need to understand your time frame for investing when analyzing trends in the market. There are some helpful tips for spotting trends in the market, and careful consideration will keep you in these trends longer.
Market uptrends generally follow certain indicators. For example, moving averages will often smooth out the chop of markets and let you know when the market is trending upward. As we show you in the examples below, these indicators, like the 10 moving average, 20 moving average, and 50 moving average, are all near-to-long-term indicators. If the market is moving upward, they are stacked on top of each other and trending at an upward angle.
Notice in the chart above that the 10 simple moving average in blue, 20 exponential moving average in purple, and 50 simple moving average in orange are all in alignment during the upward trend. Before that, they cross each other during consolidation phases.
Other useful indicators can confirm stock market uptrends, like the Investors Business Daily model for follow-through days. According to Investor's Business Daily (IBD), a follow-through day (FTD) is a strong gain in volume on the Nasdaq or S&P 500 on or after the fourth day of a rally attempt. This gain confirms that a new uptrend is underway. An FTD is defined as a gain of at least 1.25% with a larger trading volume than the previous day. However, the volume doesn't need to be above average, just higher than the previous day.
Follow through day examples on the SPY chart.
Bill O'Neil developed the FTD as a signal to identify potential shifts from downtrends. While an FTD can't predict the exact day a market will bottom, it can help investors get close to the bottom. However, not every FTD is successful, and over 90% of rallies fail or become whipsaws. For example, if the market closes below the low of the FTD within the first 15 days, that's a better indicator that the rally may fail.
Together with the combination of FTDs and moving averages, traders and investors can judge when to put on risk versus when to sit out.
Moving averages are a versatile tool. Just as the moving averages trend upward during an uptrend, they do the same during downtrends. Or, when markets are consolidating, the moving averages will go in a sideways direction, often overlapping during the choppy phase. These should be signals to either take off risk or to adjust your strategies and become more tactical in your approach.
As you can see in the image above, markets in a sideways trend will often frustrate "buy and hold" investors who are hoping for a solid trend to ride the wave of profits. It's during these choppy markets that shorter-term swing trades can be profitable.
One of William O'Neil's proteges, Mike Webster, has done an amazing job of data mining in his time with O'Neil Capital Management and Investor's Business Daily. Webster is credited with codifying a lot of the important tools that the faithful IBD and CANSLIM investors use regularly, like the Relative Strength Indicator. Among his many accomplishments, Webster has also determined the rules for power trends.
In the podcast below, Webster discusses the journey he took to find the rules for power trends. It's worth a watch if you have 15 minutes or so.
Webster essentially studied the NASDAQ from the time of its inception. He looked at all the uptrends during its history to see if he could define the moments that led to major market uptrends -- times when buyers should be aggressive and riding long-term trends.
When Mike Webster studied every NASDAQ trend throughout its history, he found that the biggest trends began when four criteria were met. These qualified the index for what he dubbed a "power trend." Here are the four elements that must be satisfied on a daily chart before a power trend will begin:
1. The 21-Day EMA: The 21-day exponential moving average must remain below the low of the Nasdaq trading price for at least 10 days. In other words, the price of the Nasdaq must remain above this trendline for at least 10 days, never dipping below it.
2. The 21-Day EMA: Additionally, the 21-day ema on the daily chart must be trending above the 50-day moving average for at least 5 consecutive days.
3. The 50-Day SMA: The 50-day simple moving average (sma) must be trending upward. This moving average is a longer-term indicator. For it to be trending upward often signals that a market is moving out of a sideways or downward correction.
4. Closing Up: As long as the above three criteria are met, the market must also close higher than it opened for the day. If that day is a "green" close, then the markets have initiated a power trend.
When these criteria are met, the savvy investor will understand that the environment has become very risk-oriented. This is the time, according to Webster, to use your leverage strategies. Obviously, you want to employ good stock-picking strategies and manage your risk in case the market reverses. However, it is time to use strategies like pyramiding into positions and holding them until the trend ends.
Here is an example from 2023 of two great power trends that Mike Webster called, plus a bonus of when he called out the 2020 Covid low with a power trend confirmation.
There are at least two "rare cases" that can negate a power trend in the early stages of development. One is called a circuit breaker rule, the other is a follow-through day failure. These are both IBD-explained events.
The Circuit Breaker rule comes into play when the price of the index breaks the 50-day line while the Nasdaq is more than 10% off the most recent high. A failed follow-through, on the other hand, is when the index closes below the IBD designated follow-through day's low.
Aside from premature failures like these, a successful power trend will typically end when the 21-day EMA crosses below the 50-day SMA. As you can see below, this happens when the market has had a good run and is likely headed into bear-market territory.
As of publishing, there is at least one power trend indicator that has been written for a popular charting software platform. John Muchow is a pine script developer who follows the methods of IBD, Bill O'Neil, and Mike Webster closely. He has coded a simple indicator that highlights when a power trend begins and ends.
However, there isn't much need for an indicator for a power trend if you have moving averages enabled on your trading charts. All you need to know is when the market is beginning to trend upward again. Perhaps you've seen the market create a recent bottom. From that point, you apply the four rules that Webster has outlined and that we mentioned above, then follow the trend.
A power trendline in the stock market is more or less a set of trendlines that follow the highs and lows of the advancing stock or index after a power trend is initiated. Once the power trend is confirmed, you can establish the lows of the new trend and the highs of the new trend. After some time, the market will naturally undulate, usually defining the highs and lows of a trend.
Once this is established, you can visually see the points on a chart where price is respecting the highs and lows of the trend. From there, you can draw your power trendline. See the image below for an example:
Once a power trend is established or confirmed, many of the tried and true trading strategies for trend trading will come into play. For example, you could screen for stocks that match the criteria for a cup-and-handle pattern. Or you can look for the Minervini Volatility Contraction Pattern that often plays out as a wedge or triangle pattern.
These basing patterns reveal themselves over and over again in the markets. Once you enter a power trend, it simply becomes a matter of screening for the most powerful stocks in the market -- the true market leaders. Once you identify these, you look for the basing pattern and enter at the best time for low risk.
For example, during the powerful trend from November 1st 2023 until summer of 2024, many of the tech stocks like NVDA and SMCI led strong surges in the market. Let's take a look at the patterns these stocks had before breakout out.
Notice in this example of NVDA that the stock experienced a strong advance off its lows in November of 2023, just as the indices were confirming a new uptrend using the "follow through" rule. From there, in December and January it consolidated with a cup and handle pattern, otherwise known as a VCP from Mark Minervini. Then in January of 2024 the stock emerged from a powerful base breakout and advanced all the way to $1000 in just a few short months.
SMCI was another big winner and closely connected with NVDA. Notice a similar pattern, the volatility contraction patterns leading into a huge base breakout in mid-January. These are the type of patterns you want to have on your radar as the general stock market is entering a power trending phase.
The risk management for power trends is no different than for any other stock trading strategy. You must consider that trading is risky and that not all power trends will be successful. At some point, the trend will end. This could be prematurely or after a year or more of solid up-trending.
Either way, you want to always have a plan in place for when to take profits and when to cut your losses. As Bill O'Neil was famous for saying, let your winners run and cut your losers quickly. Successful trading and investing is a matter of numbers. You can't win them all. In fact, you'll likely lose more than you win. So compound your gains and cut your losses quickly to keep the odds in your favor.
TradingSim offers an online trading simulator that allows you to go back in time and study historical charts and markets. Like Mike Webster, you can search for historical examples of power trends in order to identify your own criteria for entries and exits and fine-tune your approach.
Simulators like TradingSim also give you the ability to replay markets in a life-like environment. This allows you to trade without the risk of real money while honing your chart-eye. Take advantage of our free seven-day trial and study the power trends of the past.
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