In my past posts I have talked a lot about trends and that you should always buy or sell short in the direction of trend. What I have not talked about is how to actually identify an existing trend. In this post I will try to give you some idea how a trend existance can be confirmed.
Firstly, what is a trend?
A trend simply indicates that there’s more willing buyers than sellers or vice versa. There’s three main trends – upwards, downwards and sideways movement. Upwards and downward trends can then also be classified by duration – minor trends (couple of days to couple of weeks), intermediate trends (couple of weeks to couple of months) and major trends (couple of months to couple of years).
There’s different ways to confirm a trend. Firstly there are simple trendlines. It is difficult to notice the beginning of the trend. But you can just start drawing trendlines on the charts – lines which connect different tops or bottoms. A good trendline consists of at least 3 tops of which each is moving in the same direction as the previous or 3 bottoms of which each is moving in the same direction as the previous. Usually 4th top or bottom should be seen in order to actually confirm the trend. While a straight line through the tops or bottoms would be an ideal version this doesn’t happen that often. Because of that – very often after you have drawn your first trend line through eg 2 tops or bottoms you would have to draw another trendline once the third top or bottom appears. The second trendline is then drawn through the first and third top or bottom.
Note that the trendlines in a rising market are drawn through the low’s and in the falling market through the tops. See an example here –
Now see the second chart here where you can see that the trendline #2 has got a 3rd low thus making it more trustworthy than the trendline 1.
If, however, the new bottom is not in the line with either of the previous two trendlines then we have to draw a new trendline, third trendline from the first bottom. If the third trendline now exists like you can see on the following chart, then it is more likely that this so-said trend is going to reverse. These 3 trendlines are called fanlines.
How can trendlines help you set your entry and exit points? For example, if you see a there’s a trendline with 4 increasing bottoms but then you notice that the price goes below the trendline (this is called penetration), this is often a good indication to sell or sell short. You should also see if it was a minor or major penetration and if the volume was big on the penetration day compared to the previous day. Note though that this is just one indicator and additionally you should use more indicators to base your trading decisions on.
When you draw both – the bottom and top trendlines then the area in between it is called trend channel. See the green line between the two trend lines – if the price goes above it it’s could be good idea to go long or if the price goes below it it’s a good idea to go short.
I already mentioned that volume must confirm the trend. Here we could also bring in another indicator – VOI (Volume Open Interest). VOI is a measurement of the number of contracts traded in a day and it's is a sign of market activity. And here are some more good thoughts to consider –
- If prices are going up plus volume and VOI are rising, the market is considered strong (bullish). Alternatively, if the prices are going up but volume and VOI are declining, the market is weak (rather bearish).
- If prices are going down and volume and VOIare rising, the market is considered weak (bearish). Alternatively, if prices are going down and volume and VOI are declining, the market is strong (rather bullish).
- Volume often increases dramatically at tops and bottoms.
In addition to simple trendlines, moving averages can be used to work with trends. There’s 3 ways to identify direction of a trend with MA – they are direction, location and crossover.
Direction – we can identify a trend by taking a look at the direction of a moving average. If MA is rising, the trend is upwards, if falling, the trend is downwards. We should always look at the general look of the MA not act on small changes in it. One of the best moving average to use could be (exactly as said - *could be*) EMA (Exponential Moving Average). How long MA should you use? Well, it depends on how many signals you’d like to see and how timely you’d like them to be. You could use something like 50-day EMA.
Price location – here we compare the current price compared to moving average. If the price is above the moving average, the trend is considered bullish, if the price is below the moving average, the trend is considered bearish. The Buy and Sell signals are then generated when price crosses above and below the moving average.
Crossovers – here we would use multiple moving averages with different length. If the shorter moving average crosses the longer moving average, a signal is generated. Eg. If short moving average goes above long moving average, it would be a Buy signal.
There will be more on this topic in the future, but for now I hope I managed to give you some useful information or at least remind you what you already had forgotten.