By Dave Goodboy
Michael Marcus turned an $30,000 investment into $80 million. He loves the technique I'm about to share with you. And he's not alone. Bruce Kovner manages a $4 billion fund. He swears by this, too. So does Kenneth Tropin, who earned $120 million in 2008.
Do they all invest in the same type of stocks or commodities? Do they share a secret investing trick known only to the ultra-rich? Well, the answer to both guesses is no.
What these multimillionaire and billionaire investors have in common is that they all practice the same investing technique. And here's the best part: The technique is neither difficult nor only limited to the largest money managers. In fact, it's a common and easy-to-use investing method that anyone can replicate.
If you haven't already guessed, the investing tactic I'm talking about is called trend following.
What Is Trend Following?
This is an investing method that takes advantage of long-term moves in stocks and commodities. It can be used effectively on the long and short side of any market or instrument. Think of buy and hold, but with rules on when to buy and sell.
Trend followers wait for a distinct uptrend or downtrend to appear on the price chart, then they enter in the direction of the trend. An uptrend is defined as a series of consecutively higher highs and higher lows. Whereas a downtrend is defined by a series of lower highs and lower lows on a price chart. In most cases, trend followers use a daily price chart and either buy into an uptrend or short into a downtrend. New highs or new lows are often the trigger to enter the investment.
But other investors (including myself) prefer to wait for a pullback from the highs to enter in the same direction of the longer-term trend. The reasoning is that the lower price of a strong stock will attract institutional buying interest. Trend followers believe that the price momentum will continue either higher or lower after a breakout or pullback.
The Key To Protecting Profits
The old saying "the trend is your friend until it bends in the end" is apropos for trend following.
The facts are that even the most skilled and knowledgeable trend-following investors don't know whether the trend will continue after the investment is entered. The trend could end immediately after you buy or short. The short-term pullback from the strong upward trend could, in fact, be the start of a new downtrend rather than a short-term pullback.
This unknown is why stop orders are a must when trend following. Unlike buy and hold investing -- which trend followers call "buy and hope" -- trend following requires the use of stop orders to prevent excessive losses. Where the stop orders are placed is a personal choice. Placement is a function of your personal risk tolerance. In other words, how much of a loss will you accept before closing the position and trying again?
I like setting stops very close to the entry level. Then, if I'm stopped out, I try as many as three times to catch the trend before looking at other opportunities. The big-time trend followers do this across a variety of stocks, commodities and currencies at any one time. Basically, they enter positions, close the ones that do not profit, and let the profitable ones move higher or lower depending on the position being long or short.
Many profitable trend followers use trailing stops to protect profits as they accumulate. A trailing stop automatically remains a certain distance behind the advancing price and will close the position should the price change direction, in an effort to protect the profits.
This is just a brief introduction to the trend-following investing method. I recommend Michael Covel's best-selling book "Trend Following" for a comprehensive explanation of this investing method.
Here are three stocks in strong upward trends, along with illustrations of how a trend-following investor would likely enter the position.
1. Coca-Cola Co. (NYSE: KO)
2. LinkedIn Corp. (NYSE: LNKD)
3. PowerShares DB US Dollar Index Bullish Fund (NYSE Arca: UUP)
Risks to Consider: Although a proven and highly effective investing method, trend following can also be frustrating and risky. Buying on breakouts can easily fail, as no one knows how long a trend will last. In addition, buying pullbacks from a trend also has risk since the pullback may be the start of a new trend.
Locating strongly trending stocks and buying on breakouts or pullbacks is the core of trend following. Always use stops and be ready to close out a position if it goes against you. Remember, sometimes it takes several entries at a level to catch the move.