Technical analysis (TA) is the study of price action and volume. A core principle of TA is that that all relevant information is contained within price action itself. Therefor a technical analyst will study the historical price action of a chart as opposed to the fundamentals or news that drives the prices, in an attempt to predict the future performance of that security. In fact, a TA purist will go out of their way to ignore all external information other than the price chart itself.
An important observation of technical analysis is markets can trend directionally. We say ‘can’ trend as opposed to ‘do trend’ because markets are not constantly trending. But, if a trend can be identified, it can provide an opportunity to profit from that trend if the trader times their entry well and the trend continues in their favour. Trend analysis is therefore an important tool for chartists as it can help them select tradable securities to go long (buy) or go short (sell).
Trend analysis can help traders:
- Identify trends to select which securities to go long or short
- Monitor how strong (or weak) a trend is
- Be on guard for a potential trend reversal
Like most other forms of TA, trend analysis performs better in a highly liquid market (high trading volumes) and is applicable to all timeframes. This means trends appear on the one-minute chart all the way up to the weekly and monthly charts although, that is not to say they all point in the same direction (as they rarely do).
Above we have an example of an uptrend, which is also frequently referred to as a bullish trend or bull trend. No two trends are the same, but this is a fairly clean trend which rises evenly over time, even if the timing between peaks and troughs is quite varied.
And here is a good example of a downtrend, which can also be referred to as a bearish trend or bear trend. Notice how the speed of the decline accelerates as time passes. This can be a common feature of markets such as stock market indices or equities, although not always. Again, no two trends are identical but some markets can exhibit different or similar characteristics between them
Sideways / Ranging (Non-Trending):
If a market is not deemed to be trending, it can be referred to as a non-trending market, moving sideways, trading in a range or other words to that effect. In the example above the market is particularly ‘choppy’ and can easily fool one into thinking a trend is beginning, only to see prices reverse several times and effectively go nowhere whilst making a lot of noise. Such markets require a very different approach, but trend analysis aims to help minimise the odds of entering markets which are not trending.
Trends Can Be Identified with Peaks and Troughs
Whilst the concept of trends simple enough to understand, identifying them and profiting from them is not always that straight forward. So, we’ll break a trend down into its core components to help you better identify them for yourself.
As much as we’d like them to, sadly markets to dot move in straight lines and therefore neither do trends. Trends oscillate up and down, with bullish trends oscillating whilst they rise over time and bearish trends oscillating whilst they fall over time.
It is then important for the analyst to study peaks and trough and the relationships between them over time to help identify trend direction and strength.
If you’re familiar with sine waves then trends should become easier to break down. Each ‘cycle’ is comprised of a peak and a trough which can be measured by its amplitude (height). Like a price chart, time moves from left to right. Only with trend analysis we are looking for the cycles to move higher or lower each ‘cycle’.
A trend Can Be Identified with Higher Highs (HH) or Lower Lows (LL)
Using the same concept but changing the terminology, traders identify a series of higher highs and higher lows for an uptrend, or lower lows and lower highs for a downtrend.
During a single ‘cycle’ of a trend, we need to see one HH and a HL for an uptrend, or a LL and a LH for a downtrend. Whilst cycles of a sine wave can be measured from any part of the wave, it makes sense to measure the cycle from when prices break above or below the previous peak or trough as this is when, as a trader, we want to be alerted to the potential of a new trend.
UPTREND: Higher Highs (HH) and Higher Lows (HL)
Over time, each peak should rise above the previous peak to be called a higher high (HH). Once a HH is achieved, we then need to be able to identify a trough which trades above the prior trough to be called a higher low (HL).
A simple system to identify the beginning of a trend is to identify:
- A higher high
- A subsequent higher low
- Prices then break the original ‘higher high’ to confirm an uptrend
DOWNTREND: Lower Lows (LL) and Lower Highs (LH)
Over time, each trough should trade lower than the previous trough to be called a ‘lower low’ (LL). Once a LL has been achieved, we then need to identify a peak which trades lower than the previous peak to call it a ‘lower high’ (LH).
Conversely, we can flip that simple system around for downtrends by identifying:
- A lower low
- A subsequent lower low
- Prices then break the original ‘lower low’ to confirm a downtrend
Avoiding Choppy Ranges and Identifying Reversals
As a trend trader we hope to avoid non-trending / choppy/ sideways markets as much as possible. No system is perfect and there will be times where the trend morphs into a sideways range, correction, or reverse all together. But using the above approach can help a trader at least identify a potential trend early on. And the longer the series of HH or LL one sees, the more ‘established’ the trend is deemed to be.
In the above example the market is trending nicely lower until:
- A HH appears to warn of a change in trend.
- Despite this waring the market reverses lower to print a fresh LL. The trader would then be seeking another LH and break of the initial LL to confirm the bearish trend had resumed.
- Yet instead, the market reverses higher and creates a HH. The trader should then be seeking a new LH to form to warn of a new bullish trend, then use a break of HH to confirm the trend had bullish trend.
- Yet no confirmation arrives. Instead prices ricochet between key levels and do not confirm a new trend. A trend trader would then be sat on their hands and not participating on this timeframe.
- A bearish breakout occurred and a LL is formed to warn of a new bearish trend. The trader now needs to see a new LH and break of the LL to confirm the new trend. Yet prices reverse higher so the trend is not confirmed.
- A HH appears to warn of a bullish trend.
- A higher low occurs, and the trader now waits for a break of the HH to confirm the bullish trend.
- The new trend is confirmed with a break of the prior HH.
It is worth noting that once the trend had been confirmed at point 8, prices only made one more ‘cycle’ higher before reversing and invalidating the trend. This is a very frustrating scenario for a trader who wants to ride a long trend. But it can and does happen.
Visually Assessing Trend Strength
However, a trader can also monitor the strength and health of a trend by monitoring its ‘amplitude’. And the example above is not one of a strong trending market due to the amount of overlap of peaks and troughs.
For example, during a strong trend we would typically expect shallow pullbacks / retracements against dominant momentum. So for an uptrend, bearish corrections should not be deep and during downtrend, bullish corrections should also be shallow.
If the move is particularly strong, pullbacks hardly occur at all and we see small sideways ranges, pennants or triangles, before the dominant momentum returns.
In this example the down legs are fast and deep whilst the retracements are shallow. Yet as it nears the end of the trend, price action became choppier and there was a lot more overlap between swing points, before it eventually reversed. It does not always work out this way, but it is a good observation to make of price action to understand how strong (or weak) the trend is.
Here we can see that prices were accelerating lower initially, but then the pullbacks became much deeper and the general line of descent was significantly slower to show momentum was waning and we could be heading for a reversal.
So, pay close attention to the distance between subsequent peaks and troughs. Ideally, they should not overlap. And it can also be a tell-tale sign that the trend may be nearing an end if we see the distance between swings narrow significantly.