Last week we learned what a trend is in relation to the ebb and flow of stock prices. To review: The trend is the prevailing direction of price movements within a given time period, regardless of the day-to-day up-and-down fluctuations in price.
In an upward trend prices make a series of successfully higher peaks and troughs; a downward trend is the same series of peaks and troughs in the opposite direction; a horizontal or sideways trend would be a trend in which prices more or less stay the same over time.
When the direction of a trend shifts, it is analyzed to determine why and to predict the continuation of the trend’s direction.
Analyzing the trend of a stock price by charts requires drawing the trend line, one of the most valuable technical tools employed to stock analyzes.
Drawing a correct trend line is very important, and to do so the following steps are taken:
1) Select the period of time under study. This means using a chart covering a short-term trend (minutes to days to weeks) or intermediate term trend (weeks to months) or long-term trend (months to years).
2) For an upward trend draw a line from the lowest trough to the highest trough preceding the highest peak. The line must not pass through prices in between. Extend the line upward. Here it may go through prices past the highest point, this may be an indication of a change in trend.
3) For a downward trend draw a line from the highest peak to the lowest peak preceding the lowest trough so that the line does not pass through prices in between the two peak points. Extend the line past the lowest peak downward.
If you are familiar with linear regression, you will notice that the slope of the trend line is approximately close to the slope you would get by doing linear-regression analyses on the same price data over the same period under study.
Step one above implies that a person has already chosen the trend classification that he/she wishes to participate in. Within each trend three classifications exist; major, secondary or intermediate and short term.
Within each classification three market participants exist: The traders, the speculators and the investors.
The traders usually focus their activities on the short-term trend; the speculators center their activities on the intermediate or secondary trend; and finally investors focus on the major long-term trend.
The competences and skills required by each market participant can be compared to the analogy of the floater, the swimmer and the diver.
The floater would be the investor, a person mainly dealing with the long-term major trend, lasting for more than a year; the investor follows a buy-and-hold strategy not bothering with daily market fluctuations; and the swimmer would be the speculator, focusing on the intermediate trend and holding positions for more than three weeks to months. Finally there’s the diver, the most competent of the three market participants who places his trading activities on the short-term trend lasting from minutes to weeks.
Divers can easily swim and float. Likewise, market participants that have trading skills can easily shift their activities to either investing or speculating.
Finally, after the correct trend line is drawn, it is very important to be able to identify a change of trend, three basic changes in price movements usually define a change:
1) A trend line is broken, prices cross the trend line.
2) The trend stops making higher peaks in an up trend or lower troughs in a down trend.
3) Prices go below a previous short- term minor sell off in an upward trend, or above a short-term minor rally high in a downward trend.
If all of the above three points have occurred, the equivalent of the Dow theory confirmation of a change in trend has appeared.
Understanding the concept of the trend and drawing the correct trend line, and being able to identify when a trend reversal occurs are critical tool to profiting in today’s volatile markets.
Always ride the trend and close your positions before or shortly after a trend reverses again.
