CHAPTER 1

Introduction to Trend Analysis

Markets move in trends. This phenomenon is one of the major organizing principles of market behavior and one of the tenets of the Dow Theory. Some well-known axioms have been coined over the decades regarding market trends, such as “The trend is your friend” and “Don't fight the trend.” Numerous trading and investment strategies have been developed around the fact that markets move in trends. Most traders find it easier to profit when a market is trending than while it is in a period of prolonged consolidation.

■ What Is a Market Trend?

A simplistic definition of a market trend is a directional price move—either up or down. An uptrend is a price move that starts from a specific low point. A downtrend is a price move starting from a certain high point.

Traders ask many questions about the trend, such as the following:

• Which direction is it moving?
• How long might it last?
• How strong is it?
• How can I spot opportunities to participate in a trend's movement?
• What signs should I look for that suggest the trend may be weakening or changing direction?
• Is this a good time to get aboard the trend?
• When should I exit the trend?

My answers to these questions fill the chapters of this book. The charting tools and techniques described herein are intended for the purpose of identifying and participating in a trend, gauging its strength, and responding to changes in its direction. In my opinion, these trend analysis tasks are among the most important activities an active trader or investor will perform.

Trends are an integral part of market analysis, whether it is technical analysis, fundamental analysis, or analyzing market breadth. Although the primary focus of this book is analyzing price trends, in market analysis the word “trend” is not limited to describing price movement. It may also be used to refer to other analysis concepts. Following are some examples where an analyst may notice an upward or downward trend, or a change in trend direction:

• A trend in volume.
• A trend in the market internals. For example, the number of stocks making new highs versus new lows.
• A trend in the number of stocks meeting the criteria of a specific filter (e.g., the number of stocks trading above or below their 200-period moving average).
• A trend in the quarterly earnings growth rate of a company.
• A trend in the growth rate of the economy or the employment numbers.

■ It's All About the Trend

A common challenge for aspiring traders is that they don't fully understand the essential constructs of technical analysis (charting) before attempting to move on to more advanced study and practice. I fell into that trap myself early in my trading career. When I first began my charting studies many years ago, I felt a bit overwhelmed. I found I was spinning my wheels and feeling that there was so much to learn. I was studying various charting-related topics—gaps, support-resistance, candlesticks, chart patterns, technical indicators, and so on—each in isolation. That is, I studied each area of charting as if it was a stand-alone topic. Hence, it is not surprising I felt overwhelmed. There are so many different topics to learn, or so I thought.

Then one day I had one of those crucial “aha moments.” I realized that all those topics I had been studying were actually directly related to the development of market trends. It was then that I recognized the study of trends is the primary role of technical analysis. It was so much easier to really understand and implement the various charting concepts when I put them in the context of how they contributed to the development of a trend. That realization simplified and streamlined my studies; and significantly impacted my trading activities and strategy development going forward.

Most everything in technical analysis relates to the concept of trends in some fashion; you'll see that clearly demonstrated throughout this book. Table 1.1 lists several charting concepts directly related to the start, advancement, or conclusion of a trend.

Table 1.1 Trend Development

Charting Topic Role in Trend Analysis Gaps Gaps often occur at the beginning (breakaway gap), middle (continuation gap), or end (exhaustion gap) of a trend. Those gaps reflect the start, acceleration, or end of a trend, respectively. Morning gaps play a significant role in short-term trends. Volume and Volatility Both volume and volatility often tend to increase during trending periods and decrease during periods of consolidation. Classic Reversal Patterns It is common to see a reversal pattern form at the end of a trend. For instance, a double top or head-and-shoulders top may form at the end of an uptrend. The inverse of those patterns may form at the end of a downtrend. Such patterns signal a potential trend reversal. Classic Continuation Patterns Continuation patterns may form within a trend stalling its movement for a short period of time (e.g., a flag or pennant) or for a longer duration (e.g., a triangle or trading range). Candlestick Lines and Patterns Candlestick lines reveal the sentiment of market participants as a trend develops. A bearish or bullish candlestick reversal pattern may form at the end of an up or down trend, respectively. Price Swings Minor, wavelike price movements create the peaks and bottoms that are the building blocks of intermediate-term trends. Those price swings may provide opportunities for short-term trades and profit-taking opportunities for long-term positions. Corrections Corrections are retracements of the prior trend. Trendlines Trendlines are used to determine the direction, slope, and duration of a trend (sloped lines), as well as to highlight support and resistance areas (horizontal lines). The break of a strong trendline can provide an important signal about the potential continuation or reversal of a trend. Technical Indicators There are many technical indicators designed for analyzing trends (e.g., to determine the direction and/or momentum of a trend). Some indicators can help identify when a trend may be weakening. For example, a divergence between price and a strong indicator may occur, warning of a potential trend reversal. Market Indicators Experienced traders may consult market breadth readings (market internals) to gauge the day-to-day strength of the market trend, as well as cumulative market indicators for monitoring longer trends. Trading Strategies Many trading strategies are developed around the fact that markets trend. Trend-following strategies take advantage of a trending market. The success of setups traded, and strategies employed, at any given time may depend greatly on the trend (or lack of) of the broad market.

■ Profiting from Market Trends

Because the phenomenon of trends is so pivotal, much of technical analysis is devoted to the identification of trends and gauging their strength, so chartists can implement appropriate trading strategies. A significant amount of the chart analysis I perform is dedicated to monitoring the trends of the stocks I trade, as well as the major market averages, sectors, and industry groups.

Clearly, it is essential to learn how to analyze trends effectively in order to become a proficient chartist, and for determining which trading methods to employ. Listed below are some of the key skills traders should learn in order to achieve those goals. Helping you develop those skills, and subsequently profiting from market trends, is the primary purpose of this book.

• Identify a trend as early as possible in its development in order to profit from as much of that trend's movement as possible.
• Determine a trend's strength and potential duration. Continually monitor the strength of the trend.
• Recognize technical events and price formations that occur within a trend that may offer trading opportunities.
• Understand the concept of support and resistance and its role in a trend's evolution.
• Identify signs that a trend may be weakening or reversing direction in order to protect profits and/or get aboard a new trend when a change in direction occurs.

■ Let's Build a Clock

I've been providing private tutoring for traders for almost 12 years. I've sat side-by-side with numerous traders of varying skill levels. I'm sure if you asked any of them, or the hundreds of individuals who have read my books, e-books, or attended my webinars, they'd tell you I'm ridiculously organized, very detail oriented, and probably too verbose. A client once said to me, “I asked you what time it is and you showed me how to build a clock!” I'd say he summed up my training style. I err on the side of providing tremendous detail rather than risk leaving questions unanswered.

As you...