Module 3 – Trend Concepts

Introduction

Now that we have reviewed the fundamental ideas of technical analysis and the basics of charting, it is time to introduce you to some tools that you will use as you develop your knowledge and abilities. By the time you finish this module, you will start to see the power of technical analysis, and will be looking at charts in a new light.

In this module, I will show you the basics of

  • support and resistance, which are simple concepts with far-reaching outcomes;
  • trend lines, sloping lines with similarly powerful applications;
  • retracement expectations, and where we expect the price to halt its slide;
  • other straight line guides

All these concepts will be built upon in later modules, which will draw upon the tools that you are learning about here.

I am illustrating the concepts using simple hand drawn charts to introduce the ideas, with some actual share price charts to show you how it works out in practice. The simple charts are drawn as line charts for clarity, and the real case studies are presented on candlestick charts, such as you would probably be using for your trading.

We’ll discuss later why these things work. They are not magic formulas, but applied correctly can appear to be. For a start, we’ll just look at what works, and get into the reasons for that once you have grasped the concept.

 

What Is a Trend?

This module is called trend concepts, and the idea of a trend is what underlies pretty much all of technical analysis. Most of the time you want to be trading to take advantage of a trend, particularly when starting out, although I will mention exceptions from time to time. Generally, you stack the odds in your favor if you stick with trading with the trend. The trading world recognizes this in the popular sayings, ‘Let the trend be your friend’ and ‘Don’t buck the trend’.

Defining an Uptrend

Downtrends and Range Trading Markets

A trend is something that many people think they can recognize intuitively, but for the purposes of analysis we have to pin it down more clearly than that. We have to be objective and take the guesswork out of it in order for our work to be repeatable and produce the same effective results each time. Very roughly, the trend is just the direction of the stock price, as in ‘uptrend’ or ‘downtrend’, and sometimes we can just look at the chart and be pretty sure that we know the trend.

One of the problems, though, is that price charts don’t move in straight lines, at least not for very long. Whether going up, down, or sideways in overall terms, you can practically guarantee that the price will zigzag up and down. You can look on these zigzags as being the cycles of the market, with many different time frames of cycles superimposed on each other. But if you cut through the clutter, what you’re looking for with an uptrend is successively higher peaks and higher low points, or troughs. Here’s an example –

trend
  

A downtrend is defined in a similar way, with successively lower peaks and troughs, such as simply illustrated here –

trend

And, although many people think of markets as usually being in an uptrend or a downtrend, about 40% of the time they are neither. The price instead goes in a sideways direction, moving up and down a little but generally staying in a limited price range. You may remember that Dow called this a ‘line’. It can also be referred to as a ‘trendless’ price activity. Here’s the simple form of that chart –

trend
 

Much of the time, you will find you want to stay away from this sort of price chart. It can be traded if you are confident of the limits that the price will change direction at, but it still has limited potential. As a trader, you can choose to do one of three things. You can take a long position, which is buying shares, and this works best with an uptrend. You may decide to go short if there is a downtrend. Your third choice is to stay out of the market altogether, and if the market is trading sideways this may be the best decision.

Just as most trading systems are trend following, they usually don’t work very well if you try and apply them to a sideways or trendless share chart. The trends you want for a trend following system are either up or down, and not sideways.

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