In our introduction to technical analysis where we compared technical and fundamental analysis, we mentioned the 3 main principles of technical analysis:
- Price action discounts everything
- Prices move in trends
- History repeats itself
In that article we focused on the idea that price action discounts everything.
Now it’s time to get introduced to trends and trendlines.
Book Recommendation:
Technical Analysis of the Financial Markets is the book that I’ve been using to study technical analysis. I reference it in the video above. You can buy it on Amazon here.
What is a Trend?
In the simplest terms, a trend represents the general direction in which a market or asset’s price is moving. Trends can be categorized into three main types: uptrend, downtrend, and sideways trend. Each type is characterized by the behavior of peaks and troughs on the price chart.
- Uptrend: An uptrend is defined by ascending peaks and troughs. This means that each successive peak and trough is higher than the previous one, indicating that the market is moving upwards. Uptrend lines are drawn along the lowest lows to confirm the upward movement.
- Downtrend: A downtrend is characterized by descending peaks and troughs. In this scenario, each successive peak and trough is lower than the previous one, signifying that the market is trending downwards. Downtrend lines are drawn along the highest highs to illustrate the downward movement.
- Sideways Trend: Also known as a trendless or horizontal trend, a sideways trend occurs when peaks and troughs remain relatively consistent, neither ascending nor descending significantly. This indicates that the market is moving horizontally within a range, and trend lines are drawn along the consistent highs (resistance) and lows (support). Read the support and resistance guide here.
Understanding these trend characteristics is crucial for identifying market direction and making informed trading decisions.
How to Draw Trendlines
Drawing trendlines might seem straightforward, but it’s an art that requires precision.
Here’s something to think about:
Without the consensus of the masses, technical analysis is meaningless.
Hari Seldon – View his video on trendlines here.
The Importance of Consensus in Technical Analysis
Using trendlines effectively means following methods that are widely accepted in technical analysis. This ensures that the lines you draw are recognized by most market participants, including big institutions and individual traders. When many traders agree on the same trendlines, they become more reliable because more people are acting on them. This consensus makes trendlines a powerful tool.
Horizontal Lines
Horizontal lines are a fundamental aspect of technical analysis, used to identify static price points that signify support and resistance levels. Unlike trendlines, which slope and follow the general direction of price movement, horizontal lines remain constant and can cut through candlesticks.
Key Uses:
- Trading Ranges: They help identify the range within which an asset trades, marking the upper and lower bounds.
- Entry and Exit Points: Horizontal lines provide clear signals for where to buy (near support) and sell (near resistance).
- Trend Signals: Breakouts above resistance or breakdowns below support can indicate trend reversals or continuations.
Understanding horizontal lines helps traders make informed decisions by highlighting key price levels and potential future movements.
Here’s how to draw trendlines:
- Identify the Trend: Start by determining whether the market is in an uptrend, downtrend, or sideways trend. Look for a series of higher lows in an uptrend or lower highs in a downtrend.
- Connect the Dots: For an uptrend, connect at least two of the lowest points on the chart without the line cutting through the body of the candlesticks. For a downtrend, do the opposite by connecting the highest points. You can’t go from tops to bottoms or vice versa. You must connect the next natural wick that doesn’t cause the trendline to be too steep.
- Extend the Line: Once connected, extend the line out to the right. This extension helps you visualize potential future support or resistance areas.
- Angle should not be too small: Sharp angles don’t act as real support on a chart.
- The longer the line the more powerful it is: A longer trendline with many touches on it will be more powerful in terms of support and resistance.
The Significance of Trendlines
Trendlines aren’t just lines on a chart—they are reflections of market sentiment. Here’s why they are so significant:
- Support and Resistance: Trendlines can predict areas where prices might find support or face resistance.
- Signal Entries and Exits: They help traders determine optimal points to enter or exit trades, enhancing strategy effectiveness.
- Confirmation of Trends: A trendline provides visual confirmation of the market’s direction, helping traders stick with the trend.
Classification of Trends in Technical Analysis
When analyzing market trends, it’s essential to understand that trends can be classified based on their duration. This classification helps traders determine the potential impact and relevance of a trend on their trading strategy. There are three main types of trends: major, intermediate, and minor.
1. Major Trends
Major trends last for a significant period, typically greater than 6 months to 1 year. These long-term trends reflect the broader market direction and are often influenced by fundamental factors such as economic cycles, company performance, and geopolitical events.
2. Intermediate Trends
Intermediate trends last for several weeks to several months. These trends are often corrections within a major trend, providing opportunities to enter or exit positions based on shorter-term price movements.
3. Minor Trends
Minor trends are short-term movements lasting from a few days to a few weeks. These trends are often caused by market noise, such as news events, economic reports, or short-term investor sentiment.
Why are Day Traders Concerned with Longer Trends?
Longer trends, such as major trends, are important for day traders for several reasons, even though day trading focuses on short-term price movements. Here’s why understanding and considering longer trends can enhance day trading strategies:
Context for Short-Term Movements
Understanding the overall market trend provides context for short-term price movements. If the broader market is in a long-term uptrend, day traders might prioritize long positions, knowing that the general market sentiment is bullish.
Trend Alignment
Trading in the direction of the major trend can increase the probability of success. For example, if a stock is in a long-term uptrend, short-term pullbacks might be seen as buying opportunities. Conversely, in a long-term downtrend, short-term rallies might be selling opportunities. Big high, sell higher.
Risk Management
Knowing the longer trend helps in managing risk. For instance, if the long-term trend is upward, a day trader might avoid taking short positions during short-term pullbacks, reducing the risk of trading against the major trend.
Support and Resistance Levels
Major trends help identify key support and resistance levels. These levels, derived from long-term trends, can act as significant points of price reversal or consolidation, providing valuable information for setting entry and exit points.
Market Sentiment
Longer trends reflect broader market sentiment and underlying economic factors. Day traders who are aware of these trends can better gauge market sentiment, making more informed decisions about the likelihood of certain price movements.
Enhanced Strategy Development
Incorporating longer trends into day trading strategies allows for the development of more robust trading plans. For example, combining trend analysis with other technical indicators that align with the major trend can lead to more effective trade setups.
