Trend Analysis Basics
Introduction :
Like it is easier to swim along the stream, the odds of winning a trade increase when one is trading in the direction of the trend. Not only the odds, but trading along with the trend also allows one to capture larger moves. Trend analysis is used to identify the prevailing direction of the stock based on its historical movement.
Traders use many different techniques for trend analysis. Trendlines and Moving averages are some of the most commonly used techniques. Going forward, we shall discuss some simple techniques to analyze and confirm trends.
What is a trend ? :
A unidirectional general move in a stock price establishes a trend. If supply and demand is biased a lot on one side, it gives rise to trends. Economic, Geopolitical and other fundamental reasons are responsible for their formation.
Quoting Newton’s 1st law of motion :
Every body continues to be in its state of rest or uniform motion unless acted upon by an imbalanced force to make a change.
This law can be used as an analogy to understand trends. The forces acting are comparable supply and demand. The state of rest is a consolidation phase where there is no directional movement. When the forces i.e supply and demand are balanced, the price stays in a state of rest otherwise, we witness the development of trends.
Trend analysis is carried out to project the present trend into the future to gauge the future direction of the prices or to find levels from where the price might reverse.
Uptrend V/s Downtrend :
The below image shows a bullish and bearish trend. A downtrend is characterized by the formation of lower highs and uptrend is characterized by higher lows formation.
Trend identification using Trendlines :
A trendline is a straight line connecting two or more points and projected in the future to find future support and resistance levels. The points that are connected are pivots. Pivots are basically points of reversal.
Uptrend Line :
An Uptrend line has a positive slope i.e it is rising in nature. Connecting two or more higher lows forms an uptrend line. An uptrend line acts as a support level. An uptrend line signifies a bullish trend as far as the price remains above the trendline. If the trendline is breached by the price, it suggests that a reversal may happen or at least the current trend might discontinue.
Downtrend Line :
A downtrend line has a negative slope i.e it is falling in nature. Connecting two or more lower highs. This trendline acts as a resistance level. A bearish trend is said to be intact as far as the price remains below the downtrend line. If the line is breached by the price, it suggests that a reversal may happen or at least the current trend might discontinue.
Important points to note :
- The trendline must touch three points to be considered as a valid trendline.
- The uptrend line is always drawn by connecting higher lows. Must not be drawn by connecting higher highs.
- The downtrend line is always drawn by connecting lower highs. Must be connected by drawing lower lows.
- The steeper the trendline, the difficult it gets to sustain it. A very strong and steep trend needs a very strong supply or demand which is not sustainable for very long.
Trend identification using Moving Averages :
Moving Averages smoothen the price data and make it easier to identify trends. There are various different types of moving averages. Simple Moving Average and Exponential Moving Averages are the most popular ones.
The simplest method to identify a trend is comparing the price relative to the moving average. Either a single or two different moving averages can be used to identify trends. Moving averages also act as support and resistance levels.
Identifying Uptrends :
- Using 1 moving average: If the price is trading above the moving average, the trend is said to be upwards. Larger period moving average e.g 200 days moving average is generally used to identify long term trends as 200 days is approximately 1 trading year. 50 days moving average is generally used to identify the intermediate-term trend. 50 days approximately represents 2 months.
- Using 2 moving averages: If the smaller period moving average is above the larger period moving average, the trend is said to be upwards.
- Using the slope of moving average: If the slope of the moving average is positive i.e it is pointing upwards, the trend is said to be upwards.
Identifying Downtrends :
- Using 1 moving average: If the price is trading below the moving average, the trend is said to be upwards.
- Using 2 moving averages: If the smaller period moving average is below the larger period moving average, the trend is said to be upwards.
- Using the slope of moving average: If the slope of the moving average is positive i.e it is pointing upwards, the trend is said to be upwards.
Above is Apple 15 min chart. The red line is SMA 50 and the blue line is SMA 200. We can see that when the stock is in an uptrend, SMA 50 is higher than SMA 200 and during a downtrend, SMA 50 is below SMA 200. The slope of the moving averages can also be analyzed. We can see that the slope of the changes of the moving average at the points from where the price reverses.
Using Volume for Trend confirmation :
Volume is used to confirm if a trend is weak or strong. A trend that is accompanied by high volumes is considered as a strong trend. The rules for trend confirmation using volumes is shown in the table below :
Conclusion :
Trendlines and moving averages are the simplest techniques for analyzing trends. Volume is the most popular indicator of the strength of the trend. Since volumes can sometimes be faked, it is necessary to confirm that the volume data is accurate.
Traders can gain insight into the future movement of the stock using trend analysis. It is fruitful to trade in the direction of the trend as it increases the chances of success. Bullish strategies can be traded when the trend is up and vice versa. Trend analysis can also be used to find future support and resistance levels.
