What are Trend Analysis Methods?

Definition of Trend

Trend Analysis Methods or Trend trading has transfixed traders for decades with the promise of rapid profits. Countless books have been written expounding the virtues and advantages of such an approach. In this chapter, we shall attempt to unveil the underlying characteristics of trend action and how to decipher pure price action to better understand the behaviour of the market. We will also discuss price filtering and the effective application of trade sizing and stop sizing for technical trade setups.

A trend, as defined by John Murphy (1999), is the direction of the market or the way it moves. Martin Pring (2014) defines it as a straight line connecting either a series of ascending bottoms and or descending peaks. Since markets do not move in a straight line but are characterized by a series of Zig Zag movement., trends are represented by the general direction of the peaks and troughs. Horizontally moving peaks and troughs identify the sideways movement. Trend analysis keeps you tune in the direction of a market or the stock. And thus trend analysis increases your success ratio of trade result.


Drawing Trend Lines & Channels

Provisionary (Tentative) and Confirmed (Valid) Trendlines

A trendline is created by projecting a line forward into the future drawn from two significant inflection points. For uptrends, a line is drawn between two significant troughs and projected into the future, whereas for downtrends a line is drawn between two significant peaks and projected into the future. When drawing trendlines, lines must not cut through any price action at any point along the line. A trendline is said to be only provisionary or tentative until it is tested for the first time, that is, at the third point of price contact on the trendline. Once tested, it is then regarded as a confirmed or valid trendline. See Figure 1.1.

Valid Trend line Example
Figure 1.1 - Valid Trendline Example

Short, Medium & Long Term Trendlines

A trendline may be defined as short, medium or longer‐term depending on the amount of price activity it contains above or below it. Longer‐term uptrend lines
contain more price activity above them than shorter‐term uptrend lines. The converse is true for downtrend lines. See example 1.2.

Example of Long Term, Medium Term & Short Term Trendline
Figure 1.2 - Example of Long Term, Medium Term & Short Term Trendline

Valid Trend Line & Invalid Trend Line

The first rule to note in the case of drawing a trend-line is there must be at least two points giving evidence of the trend, as seen in Figure 1.1 (above). See Figure 1.3 for an example of valid vs in valid trend-line.

How to draw valid trend line.
Figure 1.3 - Valid Trend Line Vs Invalid Trend Line

Including All Prices

An important factor to consider when drawing a trend line is which prices to consider. In bar chart and candlestick patterns, where both open and close prices, as well as high and low prices, are given, it is to be decided which of these prices should be taken while drawing the trend line. Some technical analysts prefer taking close prices since close is considered more important than the intra-day highs and lows. However, experts like John Murphy suggest that the trend line should include all price actions.


Violation of the trend line

Traders often have their own view points on what is a valid violation of the trend line and therefore reversal. During any period, the original trend line may be violated, but the price will close within the trend by the end of the period. In such case, the trend line can be treated to be valid. It may be useful to remember here that the trend violation may be followed by either a reversal or a consolidation.


Support and Resistance Role Reversals

In technical analysis, price barriers change roles once breached, that is:
– Support turns into future resistance.
– Resistance turns into future support.
This applies to all overlay barriers, which include channels, trend lines, pivot points, price envelopes, and so on. See Figure 1.4 & Figure 1.5.

Example of Resistance Become Support
Figure 1.4 - Resistance Become Support
Example of Support Becomes Resistance
Figure 1.5 - Support Becomes Resistance

Trend Channel

Channels may also be created by projecting a trendline from a significant peak or trough that is parallel to the uptrend or downtrend line. Channels are useful in that they indicate potential:
– Entry levels
– Profit‐taking levels
– Future price targets
– Stoploss levels
Figure 1.6 illustrates the construction of a rising channel. First, draw an uptrend line based on two significant peaks, indicated at Points 1 and 2. Then locate a significant trough below the trendline, which in this case would be the trough at Point 3. Draw a line parallel to the resistance line between Points 1 and 2 & place it parallel at trough i.e. point 3. Extend the line at point 3 to project the probable trough in near future.

Example of the upward channel.
Figure 1.6 - Trend Channel

References

Covel, Michael W. 2009. Trend Following.
DeMark, Thomas. 1994. The New Science of Technical Analysis. New York: John Wiley and Sons.
Hill, John, George Pruitt, and Lundy Hill. 2000. The Ultimate Trading Guide. New York: John Wiley and Sons.

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