The price chart of a stock or commodity may appear to be a random distribution, but it is not. Looking for trends in security prices is an important part of technical analysis. Identifying trends has been used since Charles Dow wrote about his observations regarding stock prices in The Wall Street Journal. His basic beliefs are often collectively referred to as “Dow Theory”. One of his basic beliefs was that security prices trend.
A stock or commodity will be in a definite trend about a third of the time. The rest of the time prices will trade mostly in a sideways range. To use trends to make money you want to be able to recognize trends as early as possible, preferably just as they emerge from a non-trending period. Likewise, you need to be able to recognize reversals of previous trends so that you can adjust or close your trade. You want to go long or short (as appropriate) early in new trends and exit the trade profitably when the trend ends.
Trend breakouts or reversals are often used as trading signals, but the most critical thing is to understand the time factor being used. An intra-day price chart may display a significant trend that happens to be the opposite of the trend shown on a daily price chart, which may itself be contrary to the trend on the weekly chart.
While trends may be termed either bull or bear trends, changes in the stock price are broken into three distinct types based on the time period being used. The primary trend takes place over a long time, often years. Secondary movements take place in the intermediate term, usually months or weeks. Finally, there are the day-to-day price fluctuations. Naturally, these last two are also part of the overall primary trend.
Trends are measured and identified by trend lines. A trend line is simply a sloping line drawn between two or more points on a price chart. They are similar to support and resistance lines, although trend lines are generally diagonal rather than horizontal lines.
Successful trading with trend lines depends on recognizing and trading the appropriate trend. When trading the intermediate trend you should use both daily and weekly charts. Day traders would use daily and intra-day charts. Both methods should also make use of the longer-range chart that is being used to determine the primary trend.
It is the shorter-term charts that are used for timing your trades. I would normally consider a trade when at least the short term and intermediate term trends are in the same direction. While the ideal would be to have all three trends in agreement, that is not always possible, and intermediate trends can be substantial in both time and price.
One question that comes up is which prices to use to draw the trend lines. For example, I often use point and figure charts that are based solely on closing prices. That agrees with Dow Theory since Charles Dow used the closing price as an appropriate price for determining trends since that is the price at which investors are willing to hold a stock overnight.
Let’s think also about how to analyze and interpret trend lines. The basic premise is that up trends identify price support while downtrends identify price resistance. Breaking through a trend line is considered a trend reversal, while touching the trend line is considered confirmation of the trend. Trends differ from support and resistance levels in that trends represent change, while support and resistance levels are barriers to change.
A rising trend is defined by successively higher low-prices and can be thought of as a rising support level. The bulls are in control and pushing prices higher. Draw a straight line from the lowest low of one period to the lowest low before the highest high price. The line will not pass through any other prices between these two points. The slope of the trend line indicates the trend. The figure below shows an example of a rising trend:
A falling trend is defined by successively lower high-prices and can be thought of as a falling resistance level. The bears are in control and pushing prices lower. Draw a straight line from the highest high of the period to the highest high prior to the lowest low (the line will not go through prices between those points. An example of a falling trend:
Trend lines can work with any chart but are normally used with high/low/close bar charts such as I used in the examples above. Just as prices penetrate support and resistance levels when expectations change, prices can penetrate rising and falling trend lines. Boeing’s stock price reversed a short time after the previous chart was made. The illustration below shows how the falling trend line at first acted as resistance, as prices stayed below the trend line, and then how the stock price decisively penetrated the line.
The penetration of the trend line is an example of when you might place a long trade to take advantage of the reversal in trend. Unfortunately, complete confirmation of the reversal is possible only after the fact. You should always set a tight stop loss level when predicting reversals. This will limit your losses if it turns out to not be a decisive reversal of the trend, but rather just noise in the longer-term down trend.
One benefit of using trend lines is that it helps remove emotion from your trading decisions. You simply hold a trade until you hit the technical stop or the current trend line is broken. Another benefit is you should always be on the "right" side of the market. It can be difficult to hold a long position when prices are falling or to be short when prices are rising.
There are some limitations with trend lines as well. Positioning trend lines is subjective and takes practice, and the situations in which you must make decisions are often ambiguous. Trends must be established before they become recognizable, and by then you may have missed much of the price move. Finally, they work the best with consistent, sustained trends and those do not emerge all that frequently.
After a significant price move (either up or down), prices will often retrace a significant percentage (if not all) of the original move. These pullbacks occur because stocks rarely rise or fall in a straight line. In an uptrend prices usually rise, retrace a portion of the rise, then run up again, on and on, repeating the pattern over and over until the uptrend fails.
The longer the time period a trend line holds the more valid it is, especially if price has touched the line several times without penetrating it. When a long-term trend line is broken, it gives an indication that a reversal of the trend has a higher probability of occurring. No trend lasts forever. In a rising trend investor enthusiasm will inevitably outpace the company's fundamentals and the rally will stall.
It can be difficult at the time to differentiate a topping formation signaling the end of the uptrend from a short pause that later leads to even higher prices. Other indicators can be used to help confirm a breakout or reversal. Many look to see if the price has moved through a moving average for a confirmation signal. Penetrating the 50 and 200 day moving averages are often considered very significant. You can also look at trading volume. Increased volume accompanying the penetration of the trend line can be an important confirmation that the previous trend is no longer intact.
Trend lines are a valuable addition to any trading toolbox. They can confirm the rationale for a directional trade. They can be very helpful when choosing the optimal time to enter a trade. And they are invaluable for choosing stop-loss levels to limit those inevitable losses. Once a trend has formed it will remain intact until it is broken. When you trade with the trend, always wait until the trend line is broken before you exit the trade. Once a trend line is broken, consider investing with the new (opposite) trend.