Discovering a trend in anything is never easy until it has happened. So that begs the question, why use this for investing? Well, trend analysis can be the foundation for any type of entry or exit strategy. Discovering an investment worth taking also has the pitfall of knowing when to apply the funds and when to take them "off the table". Trend analysis is used by some market participants in order to satisfy these goals. One of the explanations of trends is in the Dow Theory. Let's take a look:

There are six rules to Dow Theory; however, we are going to focus on the Market Trend rule. In the Dow Theory there are three stages to the Market Trend rule. The Accumulation phase is the beginning period of a new trend and the ending of the previous trend. The Body of the trend is when other investors catch on to the new trend in progress and the trend continues. Finally, the Distribution phase comes at the end of any trend and has the first comers distributing their investment to those late to the party.

The Accumulation phase begins a new trend and has late comers and capitulators transferring the supply of asset to the "smart money", which is accumulating the asset from "the herd". This phase is at the beginning of a trend. This phase can have smaller price swings because the "smart money" has a large amount of supply ("the herd") from which to accumulate an investment without having to pay higher prices for the asset. Warren Buffett has a saying that has been repeated frequently, "Be fearful when others are greedy, and be greedy when others are fearful." Another applicable quote comes from Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family: "The time to buy is when there's blood in the streets." What are these two astute investors trying to say? They are explaining that in order for them to invest as contrarians, they need to be at the beginning (or end) of the trend.

The second phase, the Body of the trend, is the period of a sustainable run where there are higher highs and higher lows in a bull case and lower lows and lower highs in a bear case. Let's take a look at two equity charts from ScottradeELITE to explain these runs.

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This chart shows the Dow Jones Industrial Average (DJIA) has a bear channel running currently in a Phase 2 (Body) trend. With each successive peak to trough (A to A, B to B, C to C) in the channel, we can see that each time the DJIA reaches the bottom portion of the channel, this new low is lower than the previous low made earlier in the trend, and subsequently, each successive high is lower than the previous high. I have illustrated with the red arrows.

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The Body of the trend is the longest portion for a trend, and the earlier an investor can spot a trend the more profitable it could prove to be. The Body is where most investors either purchase or sell their equity positions. Whether it is a bull or bear channel, knowing how to spot the trend and then creating a strategy around the trend can give you an advantage.

Let's take a look at the third and final phase. The Distribution phase is the same as the first phase, yet in reverse. Huh? Confusing? Well, the Dow Theory says at this phase we can see the "smart money" decide valuations have reached a point that the risk versus reward does not make sense, so they begin to distribute their holdings to the crowd that has now formed on the end of this trend.

These phases hold true for up markets (bull trend) and down markets (bear trend).

Why is this information important? What this information can help you do is spot trends. These trends can give you a guide for what is expensive and what is cheap compared to the trend. If we have a security in the upper part of a downtrend, then we maybe wait and see if the price can trade toward the bottom of the channel before we decide to commit our funds. Conversely, if we are in an uptrend, we know that being too patient may have us missing the opportunity to purchase a growing asset.

We can also use these trends for when we decide to let go of our investments by using the same criteria in reverse. Selling our investments at the top of the channel in a down trend may help us miss a long, slow, painful bear market. Using stops/trailing stops to sell an asset when the trend is confirmed may also limit risk. Selling investments into the strength of a bull trend may help to maximize your short-term selling potential, and using stops/trailing stops at the bottom of a channel in an uptrend to protect a long-term profit also helps to protect your hard-fought gains.

Finally, I thought I would share a terrific chart on trends and the psychology behind them:

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Looking at this chart, we can see the irrational tops and bottoms of trends. You also may ask why were there no charts showing the Accumulation/Distribution phases (euphoria) or the Accumulation/Distribution phases (depression)? Well, I would have to say picking the bottom and top is anybody's guess. I could show you after the fact the starts and stops of trends, but the real success in trend investing is not picking the absolute lows and highs, but rather recognizing the trends and their pressure points or trend lines. No investment approach is perfect, but most investors like having more tools in their toolboxes to help make educated choices.

Any securities, analytical tools, or strategies described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision.