Word for the day: Basic concepts of trends

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George Dorsey
6 years ago
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1 Word for the day: Basic concepts of trends The concept of trend is the cornerstone of the technical approach of analyzing financial markets. The purpose of the tools used by a chartist (trend lines, support and resistance levels, price patterns, moving averages etc.) is to measure the trend of the market for the purpose of participating in that trend. Remember that in the first part of this series we noted the saying the trend is your friend. We often hear familiar expressions such as always trade in the direction of the trend or never go against the trend. So let s spend a little time to define what a trend is and to classify trends into a few categories. Definition of trend In a general sense, the trend is simply the direction of the market, the way it is moving. Nevertheless, we need a more precise definition to work with. First of all, no financial market moves in a straight line. Market moves are characterized by a series of zigzags. These zigzags print a series of successive peaks and troughs. It is the general direction of these peaks and troughs that constitutes a market trend. Three types of trends Uptrend Downtrend Sideways An uptrend would be defined as a series of successive higher peaks and higher troughs. Each new top created by the price action is higher than the previous one. Also, each new low would also be higher than the previous low. A downtrend is just the opposite, a series of declining peaks and troughs. A lot of people tend to think of markets as being always either in an uptrend or a downtrend. However, the fact is that markets actually move in three directions. It is important to be aware of this distinction because markets spend a significant amount of their time moving in flat, horizontal patterns that are referred to as a sideways paths or a trading range. Although we ve defined a flat market as having a sideways trend, we usually say that this market is trendless. There are three decisions a trader can make: buy a market (go long), sell a market (go short), or do nothing (stand aside). When a market is in an uptrend mode, buying is the preferred strategy. When prices are trending down, the second approach would be correct, while when the market is moving sideways, the third choice to stay out of the market is usually the wisest.

2 Figure 1: Type of trends Trends have three main classifications In addition to having three directions, trends are usually broken down into three categories: Major or long-term trend Intermediate or medium-term trend Near-term or short-term trend In reality there are almost an infinite number of trends interacting with one another, from the very shortterm trends covering minutes and hours to super-long trends lasting several decades. But most analysts limit these classifications to three. Generally, in theory, a major trend is defined as one lasting longer than a year, while an intermediate one is considered to last from one month to less than a year. A near-term trend is anything less than a month. However, different analysts define each trend differently and so the definitions are quite vague. Each trend becomes a portion of its next larger trend. For example, an intermediate downtrend could be a correction of a major uptrend. Subsequently, that medium-term trend would consist of shorter waves that could be identified as near-term paths. Look at Figure 2 to get a sense of how these three trend lengths might look like.

3 Figure 2: Trend classifications S&P500 futures: Daily chart (September 2011 April 2013) Support and resistance A support is a level or area on the chart under the current price level where demand is thought to be strong enough to prevent the price from declining further. Logic dictates that as the price declines towards a support barrier and the asset gets cheaper, buyers become more willing to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below that hurdle. Usually a support level is identified beforehand by a previous low. Resistance is the mirror image of a support level. It is a price level or area over the current market price at which selling pressure is thought to be strong enough to prevent the price from rising further. The logic behind resistance is that as price advances towards a resistance barrier, the bears become more willing to sell and buyers become less willing to buy. Usually a resistance level is identified by a previous peak.

4 Figure 3: Support and resistance areas AUD/USD: Daily chart (July 2012 April 2013) There is also a tendency for round numbers to stop advances and declines. Traders tend to think in terms of important round numbers, such as 10, 20, 25, 50, 100, also multiples of 1000, as price objectives and act accordingly. These round numbers will often act as psychological support or resistance levels. (The fear of round numbers is colloquially referred to in the market as roundophobia. ) A trader can use this information and begin taking profits as an important round number is approaching. As a first stage we've defined support levels marked by previous lows and resistance levels marked by previous highs. However, this is not always the case. This leads up to one of the most interesting and lesser known aspects of support and resistance levels: their reversal of roles. Whenever the price penetrates a support or a resistance level significantly, the levels reverse their roles and become the opposite: a resistance level becomes a support and a support level becomes a resistance.

5 Figure 4: Reversal of roles GBP/USD: Daily chart (April 2011 May 2014) On the daily chart of GBP/USD, we can easily see that the barrier was a strong resistance from back in April 2012 until November Each time the bulls pushed the price towards that zone, the advance was halted and turned down. In November 2013, the longs found the strength to overcome that hurdle and thereafter the zone acted as a strong support area. A solid grasp of the support and resistance concept is necessary for a full understanding of the concept of trend. For an uptrend to continue, each successive low, or a support level, must be higher than the one preceding it and each peak or resistance level must be higher than the one before it. The resistance levels represent pauses in the uptrend and are usually exceeded at some point. Each time a previous resistance peak is tested, the uptrend is in an especially critical phase. Failure to exceed a previous peak in an uptrend is usually the first warning that the existing trend is running out of strength. If the forthcoming corrective dip comes all the way down to the previous low, it may be an early indication that the uptrend is ending. If that support level is violated, then a trend reversal from up to down is likely. The exact opposite scenario holds for downtrends.

6 Figure 5: Support and resistance during an uptrend EUR/USD: Daily chart (May 2013 May 2014) Trend lines The trend line is one of the simplest but also one of the most important tools in technical analysis for both trend identification and trend confirmation. A trend line is a straight line on the chart that connects two or more successive lows or highs and is extended in the future to act as a line of support or resistance. Many principles that apply to support and resistance levels described above can be applied to trend lines as well. It is important to fully understand support and resistance before you continue. An uptrend line is a straight line drawn under rising lows. It acts as support and marks an uptrend. If the line connects two successive higher troughs, it is only tentative, since we can connect any two points on the chart with a straight line. A third point is needed to make the trend line valid and more significant. The more touches we have, the stronger the trend line is. As long as the price stays above the trend line, the line is considered solid and intact. A break below the trend line is a sign of weakness, a sign that the trend is running out of momentum. For some analysts, a trend line violation is a trend reversal signal. FOR ME? IT ISN T! As I said, it is just a sign of weakness. A trend reversal from an uptrend to a downtrend, or at least to a sideways trend, comes when the definition of the uptrend is not valid any more. (See figure 5). Similarly, a downtrend line is a line used to mark a downtrend. This time we connect the successive lower highs and consequently the trend line provides resistance to the price action.

7 Figure 6: Valid uptrend line USD/CAD: Weekly chart (November 2011 January 2014) *Remember that during an uptrend we always connect the lows and during a downtrend we take the highs. If we take a line connecting the highs during an uptrend or the lows during a downtrend, then that line is called the return line. It is a line where we expect the price to find resistance or support and return towards the trend line. How to adjust trend lines Sometimes trend lines have to be adjusted to fit a slowing or an accelerating trend. For example, if a steep uptrend line is broken, a slower one might have to be drawn (See Figure 7 below). On the other hand, if the original line is too flat and the trend accelerates higher, we may have to redraw an uptrend line at a steeper angle (See Figure 8 below). A trend line that is too far away from the price action is obviously of little use in tracking the trend.

8 Figure 7: Steep trend line is broken Slower trend line is drawn Silver: 4-hour chart (November 2014 January 2015) Figure 8: Trend accelerates higher Steeper trend line is drawn USD/NOK: Daily chart (October 2013 January 2015)

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