Trend Analysis
There are many tools in technical analysis for identifying and analyzing trends. The choice of which to use will depend on many factors: your personality, your trading style, what kind of trend you want to identify, where (in terms of the age of the trend) you want
to identify it, and how you want to trade it. A trader looking for mature trends in markets that trend well might simply look for charts that “begin at one corner of the chart
and travel to the other.” This might seem to be an overly simplistic approach to finding
trending markets, but it works for certain kinds of traders. Other traders might look for
subtle patterns and momentum shifts that suggest a trend might be turning, with the idea
that they will aggressively pursue entries at those spots so that they have bought the low
or sold the high if a new trend develops. All of these approaches are valid, but let’s begin
with a broad, structural approach to trend identification. This is pure market structure
approach based largely on the work of the early authors who laid out the principles of
what became known as the Dow Theory.
Dow Theory Trend Patterns
An uptrend is a pattern of successively higher pivot highs (HHs) and higher pivot lows
(HLs) (see Figure 3.25). Both are important. Most people readily accept a definition of
an uptrend that requires higher highs; this is intuitive, but it is easy to overlook the importance of accompanying higher lows; if a market is only making higher highs, but is
not also clearly holding higher lows, the buyers are not solidly in control of that market.
Conversely, a downtrend is a series of both lower lows (LLs) and lower highs (LHs) (see
Figure 3.26). This is perhaps the most elementary definition of trend possible on any time
frame.
It is far better to have tools that
respect the realities of the market, and at times the market is simply uncertain. The best
trend identification tools will respect the potential for ambiguity.
One of the most important aspects of the study of trends is the study of how they end.
Under this idealized Dow Theory structure, there are two categories of trend changes. In
the first, the market fails to make a new extreme on a with-trend leg.
In an uptrend, if the
market falls short of the previous pivot high, the trend status becomes uncertain. Note
that it is not yet in a downtrend, because the downtrend requires both lower highs and
lower lows. Conceptually, buyers failed to push the market to new highs; this is a warning
shot across the bow, but not a confirmation of a trend change. It is not uncommon to
see a market fail to make a new high, consolidate a bit, and then continue the uptrend
unabated.
The trend change is actually confirmed only when price trades through the last
pivot low, marking a lower low (see Figure 3.27). Once that previous pivot low has been
violated, any upswing will now begin from a lower low. Since the market has put in both
a lower high and a lower low, the technical requirement for a trend change to downtrend
is satisfied.
The second trend change occurs when prices retreat so aggressively from the highs
that they take out the previous pivot low; at this point, the trend pattern is broken because the market shows a higher high and a lower low. (See point A in Figure 3.28.) This
pattern is less common, because it requires significant volatility off the high to take out
the pivot low in one swing. It is, however, an important pattern because it often suggests trapped trend traders and can set up very attractive countertrend trades, or a sharp
trend change with potential for continuation in the new trend.
The actual trend change
is more complicated in this case, requiring two more steps. The next rally must fall short
of the previous high (point B in Figure 3.28), but the trend change is not confirmed until
the market again takes out the previous low. Why? Because it would be possible for the
those areas for further attention. Also, in any trading tool there is always a trade-off
between being early with many false alerts and being late while waiting for confirmation.
Next, we examine a few other methods of identifying trends, all of which lag this swing
analysis and all of which also have their own false signals.
market to put in a lower high at B, hold a higher low than C, and then continue in an
uptrend by trading through B. The only way to be certain that the market will show the
lower high and lower low is for the previous low to fail to hold as support.
It goes without saying that these patterns are simply inverted for a downtrend changing to an uptrend.
In the first case, a downtrend fails to make a lower low, and then the
trend change is confirmed when the previous pivot high is violated. In the second case,
a sharp rally takes out the previous pivot high, the subsequent decline falls short of new
lows, and then the next rally makes a new high.
An Important Complication:
The Complex Consolidation Figure 3.29 shows
an uptrending market with a complex consolidation, which is a powerful continuation
pattern. Note that a naive application of the previous change-of-trend rules would have
flagged a downtrend at precisely the point you should have been buying this market.
This complex consolidation pattern is very common, and it often leads to exceptional
trade opportunities in the direction of the existing trend. If you were to use this structure
in a vacuum, you would frequently find yourself positioning short at precisely the point
you should be buying in these complex consolidations.
This does not compromise the validity of this simple labeling system, which does
what it is designed to do very well: it identifies breaks in the pattern of trends, and marks
Understanding
Trend Integrity
For most traders, the question of trend integrity is paramount. How strong is the trend?
Are there any warning signs that suggest it could turn? How far might it go? What should
our expectations be when it does turn? How can we monitor the strength of the trend as
it waxes and wanes, and gain some more insight into the relative buying and selling pressure behind the trend? These are all important questions, and they all can be addressed by
some very simple analyses. There are three primary points to consider: length of swings,
rate of trend, and the character of each trend leg.
Length of Swing Analysis
Simple math tells us that in an uptrend the upswings must be longer than the downswings, and the reverse is true in downtrends. If a market is gaining more on the upswings than it is losing on the pullbacks, the net effect will be to move to a higher price
level—this is a very elementary definition of a trend and is also consistent with the Dow
Theory trend construct.
One very simple way we can look at trends is to draw lines connecting the pivot lows to the pivot highs in each of the major swings, and then simply
compare the lengths of those lines to previous swings in terms of both vertical distance
(price) and horizontal distance (time). Some examples will help to clarify. In a strong
uptrend, the upswings are larger than the downswings, usually both in price and in time
(see Figure 3.31).
Any break or change in this pattern should be a warning that something is changing
and that the trend integrity could be weakening. For instance, a common pattern that
suggests the trend is running out of steam occurs when successive upswings are shorter
relative to previous upswings, as in Figure 3.32. It is also interesting to consider the
overlap between this length of swing analysis and traditional chart patterns. For instance,
Figure 3.32 might also be read as a “gently rounding top” by chart pattern–oriented
traders. With some slight adjustments, the same pattern of smaller upswings might
generate a double top, a triple top, or a head and shoulders pattern. This is a good
lesson—all of these patterns are essentially the same pattern.
A very important structural element in swing analysis is the first downswing in an
uptrend that is longer than the preceding upswing (see Figure 3.33). Vertically, this swing
will make a lower low, setting up a potential trend change condition, but it is even more
important to realize that this swing can indicate a distinct change of character in the
market. It usually shows a failure on the part of the buyers to support the market, and,
depending on the strength of the selling pressure in the swing (which must be judged
from price action or lower time frame market structure), it may even set up a potential
countertrend short on the next bounce. This is perhaps the single most important pattern
in length of swing analysis.
Of course, it is not always so simple. Though we might expect a shortable bounce
following the pattern in Figure 3.33, it is also possible that this type of downswing may
simply set up a complex consolidation. Furthermore, though a complex consolidation is
usually a trend continuation pattern, there are other possible resolutions that may follow
that pattern. Any of the possible pullback failure patterns apply equally well to complex
consolidations because they are simple pullbacks on the higher time frame.
These examples have dealt exclusively with uptrends, but they are simply reflected
and reversed for downtrends. These patterns can form a foundation for a robust understanding of trend analysis. Do not be put off by the simplicity of this analysis. In the right
context, simple tools work very well.
Character of Trend Legs
One important question for discretionary traders to consider is how to weigh objective
and subjective elements in technical analysis. Some things are simple and clear, which is
one reason that many traders focus on indicators: Price is above the moving average, or
it is not. The MACD histogram is higher than it was yesterday, or it is not. In each of these
cases, there could not be much room for debate. However, when we start talking about
things like character of moves or judging the conviction behind such moves, we are on
shakier ground.
Two analysts could look at the same chart and the same set of data,
and come to different conclusions, and the same analyst might even make a different call looking at the same data on a different day. To some critics, this invalidates the
discipline of technical analysis, or forces them to focus on only the objective elements.
This is a mistake, because some of the most powerful tools of technical analysis are at
least partially subjective. The question should be: How can we build, refine, and verify
the validity of our subjective analyses?
This is a good question. Part of the answer is to remember that the beginner has
not seen enough market data to start to develop this subjective sense. For this reason,
beginners are probably better advised to stick with more concrete elements, and to take
careful notes of their impressions and subjective judgments as intuition starts to develop.
Intuition, the classic “market feel,” is based on a combination of a number of elements,
most of which in themselves are fairly objective. Where the subjective element comes
into play is in the synthesis of many individual factors, and it can be difficult to articulate
precise rules for this part of the process. This is what good traders do: they are synthesizers, taking many disparate elements and combining them into a whole that is much
greater than the sum of the parts. As an example, in considering the character of trend
legs, the following elements might be important:
- Length of swing on the trading time frame. Longer swings usually mean more conviction, with the exception of potential exhaustion if a market is overextended. As a rule of thumb, if, after several swings in the same direction, a swing emerges that is two to three times the length of the average swing, this may indicate an overextended market and a possible climax.
- Number of bars in each leg. This is a measure of time, and is usually redundant because we can perceive the same information via the slope of the trend on the chart. There is almost never any need to count bars.
- Height of bars near the beginning and end of the legs. Larger bars (relative to the average bar size) usually indicate increased conviction, but very large bars near the end of a swing can indicate exhaustion or climax, which will usually be obvious on the lower time frame.
- The position of the closes in the trading time frame bars. In general, closes below the midpoint of the bar in an uptrend probably indicate some disagreement on a lower time frame. Conversely, closes right at the extreme high of the bar, especially for multiple bars in a row, can indicate exhaustion. This is counterintuitive, but it is a statistically verifiable principle of price behavior.
- Presence or lack of significant price action around previous resistance levels.
- Presence or absence of lower time frame pullbacks within each trend leg. Trend legs can be clean one-directional moves on the lower time frame, or they can hide ABC structures on the lower time frame. Complex consolidations can work off overextended conditions, setting the market up for another trend thrust.
- Higher time frame considerations. For instance, if a trend on the trading time frame is exhausting into a higher time frame resistance, this might be something to pay attention to. In contrast, if a strong uptrend develops on the trading time frame atthe same point where a higher time frame bull flag breaks out, this is a pattern that is likely to see some continuation.
- Volume and trading activity matter. How easily does the market go up? Are there gaps up that do not fill on a daily chart? Intraday, are price levels skipped because large orders clear many levels in the book?
Many traders focus their trading activity exclusively on trending environments; there is
certainly some justification for this because many outstanding trades come in trending
environments. Market structure in trends is often driven by a strong imbalance of buying
and selling pressure, it is relatively easy to define risk points for trades, and some of the
cleanest, easiest trades come from trends. However, markets do not always trend. We
do not always know when markets are trending, how long the trend will last, or what
potential our trend trades may have. A complete understanding of market structure also
includes a good grasp of the trading ranges, and the common patterns by which markets
transition between the two.