The Importance of Trends
One of the most useful methods of determining which trade will eventually be successful relies on the identification of underlying trends. When we talk about trends in Technical Analysis we really mean nothing more than the general direction of the asset price. Do prices make higher highs and higher lows? That would give us an uptrend:
Lower highs and lower lows would give us a downtrend:
Sideways trading without either of these characteristics would give us a range-bound market:
The charts in the pictures above are relatively clear examples of market direction. But, often, the charts will not be so clear. Additionally, there can be conflicting information, depending on the time frame for a given asset. It is entirely possible to see a clearly defined downtrend on an hourly chart and an uptrend on a daily chart. And while it does not make trading impossible, it does greatly complicate the situation. One important lesson to keep in mind under these circumstances is that we should not go looking for trend direction when it is not there. A technical trader needs to at least attempt to see the market for what it is, not what he or she wants it to be. One of the most common pitfalls, and one that everyone experiences at some points, is allowing too much subjectivity to influence trading decisions. As a general rule: the clearer, the better. If the information available is not completely clear, it is usually better to just stay on the sidelines and out of trades. Patience is a virtue, as many other trading opportunities will present themselves in the future.
To expand on the idea of time frame, we should classify different charts as short, medium and long term. Longer time durations should be looked as being more influential but this does not mean that shorter-term trends should be ignored. For stocks, a long-term trend is generally thought of as lasting longer than one year or more (seen on Weekly or Daily charts). Medium trends last one to three months (seen on Daily and 4-hour charts) and short-term trends last less than one month (usually seen on hourly charts). The longer term trends are composed of smaller, intermediate trends that will either serve as corrections to or continuations of the larger trends. Once the longer-term trends have been identified, correcting shorter-term trends often provide excellent opportunities for entry if the trader is late in anticipating the overall movement.
The drawing of trendlines is the first technique that will be introduced in this series. Below are some examples. Contradictory longer-term and shorter term trends will look something like this:
Drawing trendlines on a chart in this fashion will enable us to look at the chart in a more focused way and allow us to begin forming arguments for which trading bias (Buy or Sell) is most likely to bring positive results. Upward sloping trendlines show uptrends, downward sloping lines show us downtrends. When prices violate these lines, it is a good general indication that the trend is over and a new analysis will need to be completed.
The next charting technique we will look at is the identification of trend channels, which is the formation of parallel trendlines that act as support and resistance. The upper trendline act as resistance and connects the highs, while the bottom trendline provides support and will connect the lows, displaying an upward, downward or range-bound trading environment. When channel eventually breaks, it will be an indication that the previous trend might be ending. Most traders will expect price to continue in the direction of the break.
One of the most common phrases in Technical Analysis is the idea that “the trend is your friend.” What is meant by this is that the dominant trend, for the most part is expected to continue and is not something that should be fought against. There are contrarian traders who look to disagree with this sentiment but even in that case, signals are required in order to enter trades. Examples of these signals would be when trendlines break or when channel resistance or support areas are violated. When this happens, the trend should be thought of as complete, showing the beginning of a reversal. Thus, the identification of trend is one of the clearest and easiest ways to initiate trades or to close them out once the trend appears to be finished.