Before buying or selling a stock, you will first need to evaluate the current trend.
The best way to start the analysis is simply to quantify the current trend objectively.
Many traders skip this step by going directly to the signals expressed by the indicators.
Many traders don’t understand that some of the most popular indicators work well when a trend is consolidated.
When you have a stock chart in front of you, where do you start?
Do your eyes immediately fall on the indicators?
Maybe there are too many, so you don’t know where to start.
We face the infinity of information that the technical analyst can discover.
Often the newbie trader does not know which way to start.
Sometimes it could be useful to eliminate the indicators and focus only on the price.
Technical analysis is an art rather than a science.
Every time you analyze a chart, you can be guided by widely tested principles.
We start from the foundation of technical analysis: the trend.
What is the Trend?
The trend is a sequence of price swings that travel in the same direction over the considered time frame.
Most traders evaluate the strength of upward trends to find buying opportunities.
During a prevailing upward trend, traders open new positions by taking advantage of the pullback.
Long Term – Medium Term – Short Term
In the stock market, trends are often divided into long-term, medium-term, and short-term trends.
The up-trend is a sequence of relative highs and lows (bullish swing) during a period.
The down-trend is a sequence of decreasing relative max and min (bearish swing) during a period.
The art of technical analysis consists of identifying changes in the trend well in advance.
The trend, once consolidated, is more likely to continue than to reverse.
So, the most profitable opportunities will come from trades based on retracements during a strong trend.
Many new traders are continually looking for the highs and lows, but they operate against consolidated trends.
The trend reversal
All traders want to be the first to identify market reversals.
For every correctly identified maximum or minimum share, there are dozens of incorrect assessments.
Some traders accumulate huge losses when they persist in countering a trend.
Traders lose money when they go counter the prevailing trends, and they risk suffering significant losses.
A trend cannot last forever. The bearish trends transform over time into bullish trends. The bullish trend in the maturity phase must turn into bearish trends.
Your goal should always be to identify the structure of the trend.
You must be able to grasp the signs of reversal of a mature trend.
We will need to change your expectations when the price chart appears to indicate a reversal of the trend.
You will need to prepare to liquidate your position when the upward trend declines.
Remember that it takes courage to buy after a prolonged waning trend.
Those who know how to identify an effective reversal of the trend as far in advance as possible will do better than other traders.
As I mentioned before, you cannot consistently bet on the reversal of a trend. This strategy would lead to numerous losses and unnecessary frustration.
Most of the simplest operations derive from the choice to position oneself in line with a prevailing trend.
The traders generally can open trade during the correction (pullback) phases.
In these terms, most trades will be similar to a bet on the continuation of a prevailing trend.
There is no perfect method, nor can any way ever define the maximum and minimum of a market.
Methods for defining trends
Dow noted that to be valid, a bullish trend had to have a higher high and a higher minimum, just as a bearish trend had to have a lower high and a lower low.
The volume confirmed the trend.
In an upward trend, the volume increased in the price increase phases and decreased during the correction.
In a downward trend, it increased in the price decrease phases and decreased in the fazes upward correction.
This is the pure price method and one of the most accurate and objective methods for defining a trend.
Besides the pure price method, traders use the moving average process to evaluate the structure of a trend.
The best method combines pure price and moving average methods.
The pure price method
Let’s start with the most straightforward concept, then move on to more detailed definitions.
The pure price method, by removing all the indicators from the graphs, bases the analysis on the price only.
This method is concerned only with identifying the relative highs and lows.
You can compare the previous highs with the most recent highs and the previous lows with the most recent lows.
To define the trend with this method, you can use a candlestick chart or a simple linear graph.
The linear graph can be the best starting point for an objective analysis of the structure of the trend.
The goal is to remove cognitive biases and get a clear picture of the ascending or descending rate of the price.
An ascending trend is defined as a sequence of increasing max and min, while a descending trend is defined as a sequence of decreasing max and min.
We focus only on the most essential relative highs and lows to develop our definition of the trend.
Any change in the sequence of the rising highs and lows could signal an imminent turnaround.
Until we see the price form a decreasing min or max, assume that the current upward trend persists.
What is a Swing
Can a bar (daily or weekly) be a swing?
Does the price have to change a certain percentage to cause a swing?
Does the swing have to extend to some bars?
There is a balance to be achieved when defining what is meant by price swing.
If your definition is too restrictive, you will identify too many swings and arrive at erroneous conclusions.
If your definition is too extensive, you will not identify enough swings and detecting the trend changing too late.
Here the eye can deceive us, while simple mathematical models can help us clarify.
What is meant by swing depends on the time horizon being analyzed?
Five-minute intraday chart, a single swing could last from 30 minutes to over two hours.
Daily chart, however, a single swing could last from weeks to months.
Weekly chart a single swing could last from a few months to a year.
The chosen time horizon can, therefore, help to evaluate the time component in defining what a swing represents.
When making your final decision, consider the number of time bars in the graph and the percentage change.
For the weekly timeframe, you should have more extensive parameters in all categories.
For intraday timeframes, you should have more restrictive parameters in all categories.
The next task is to find the specific price level at which an ascending trend becomes descending.
The trend reversal with the pure price method occurs in two ways.
The most common outcome is that the price interrupts the sequence of rising highs and lows, creating a new relative low, breaking below a previous relative low and then rising to form a lower high, below the recently high relative format.
The reversal is confirmed only when the price drops and breaks below the new low.
The alternative occurs when the price is continuously rising, and for the first time, it gives a lower maximum at a price lower than a recent peak.
This method allows a trend reversal to be detected more quickly.
It can lead to a high probability that the price movement will immediately go in the opposite direction.
The signal occurs when the price reaches the new lower low and start of a new bearish trend.
It will be better to wait for a confirmation, rather than to speculate immediately on the highs and lows.
But when the price actually forms a lower high and then breaks below the previous low, we can believe knowing that the trend has reversed.
The moving average method
Many traders take some moving average on their charts to define trends and highlight the price structure.
To understand if the current price is higher or lower than the simple 200-day moving average.
The price is in a bullish trend if the current price remains consistently above the 200-day simple moving average.
The price is in a bearish trend if the current price remains always below the 200 days SMA.
As a short-term moving average, consider using a period 20 average.
The period 20 average is a widespread choice because it approximates the price changes that occur during a single month.
As a medium-term moving average, consider using a period 50 moving average.
As a long-term moving average, on daily charts, it uses the classic simple 200-day moving average.
Simple and exponential moving averages
Most traders use simple moving averages; others prefer to resort to exponential averages.
The simple moving average attributes the same weight to each day, making the price of 20 days ago equal to yesterday’s price in calculating a 20 day moving average.
The simple moving average is more linear and represents a real average of price changes.
The exponential moving average gives greater importance to recent bars and less importance to the past.
The exponential moving averages can also be weighted exponential moving averages, which consider recent changes in price faster than simple moving averages.
EMA, therefore, react faster to sudden changes in the price.
Exponential averages react faster to recent changes, but they could lead to a higher possibility of price movements in one direction followed immediately by movements in the opposite direction than simple averages.
Although the difference between an exponential moving average of period 20 and a simple moving average of the similar period is relatively small, it is amplified with the lengthening of the period considered.
Using the moving average method to identify a bearish trend on a daily chart, these conditions must occur:
- the price must first drop below the 20-day moving average and then below the 50-day moving average;
- the 20-day moving average must cross the 50-day moving average downwards;
- the price must cross the 200-day moving average downwards;
- the 20-day and 50-day averages must then cross the 200-day average downwards;
- the price officially enters a downward trend when all the criteria have been met.
To confirm a reversal of the trend on the weekly chart, it is often only necessary to detect a bearish crossing of the 20-week average with the 50-week average while the price remains below these averages.
You risk waiting too long if you wait for the price and shorter-term averages to drop below the 200-week moving average.
Although the price swing classifications differ little by using the pure price method on daily or weekly charts.
You can get a positive or negative time lag by using the moving average method on daily rather than weekly charts, but, the detachment is reduced to a few months.