Recognising a Trend
Probably you’ve heard the following phrases “Follow the trend”, or “The trend is your friend.” It may sound trivial, but the question is What is the trend? How do we spot it? This concept is essential to a market analyst.
In simple words, a trend is the market direction, the bias of the price action. But this definition is incomplete. We must consider that the market moves in zigzags which makes a succession of highs and lows. Therefore, the shape of the sequence of high and lows is what defines the trend of the market.
Higher/Lower Highs and Lows
When the market is running in a sequence of higher highs (HH) and higher lows (HL) we are facing a bullish trend. And when the market develops a succession of lower lows (LL) and lower highs (LH), we are watching a bearish trend. When the market does not create new higher highs or lower lows, the market is in a sideways or consolidation phase. It means that the market does not have a defined trend.
On the first example, the Adobe (ADBE) daily chart, we identify how the market movements, developing new HH and HL drives the price in an uptrend. After the upward sequence, the price creates a bear market retracement, in which we are able to identify fresh LH and LL.
The second example corresponds to Automatic Data Processing Inc. (ADP) daily chart. In ADP we see the case we highlighted the areas where the price has no defined direction. In other words, in these segments, the market is sideways.
After the support and resistance concept, the trendline is the other essential tool for technical analysis. Before start tracing a trendline, it is necessary to have evidence about the trend existence. Now, the question is How can we be sure that the price is moving in a new trend?
In bull markets, we draw a trend line linking the lows of the price action. The ascending trendline should have at least one higher low, and a new higher high is in progress. On the following chart, the Dollar Index (DXY) 4-hour chart shows the start of a movement labelled 1-2-3-4. The breakout above 2 (90.57 level), provide us with evidence that a new bullish trend is in development. When the uptrend is detected, we trace the first trendline connecting lows 1 and 3 as shows the next example.
Analogous to the upward trend, in a bear market, the trend line is drawn linking the minor market tops. Here, it is drawn when the price breaks and close under 2. On this case, the trendline is traced connecting the lower highs 1 and 3 as shown the EURUSD 4-hours chart.
Summarising, we need two points to trace a trendline, but we need three points to confirm as valid a trendline.
How to Use a Trendline
Once validated a trendline with the market confirming its direction, we can use the trendline in different ways:
– To determine the change of the trend.
– If the price respects the trendline, we can define entry zones to follow the main trend.
The Ibex 35 1-hour chart shows a trendline application. On this case, the fourth time the price touches the downward trendline is an opportunity to enter with a short position. But when the fifth retracement happens, we see that the trendline fails, and the Spanish Index starts a bullish cycle.
When we analyze any market, we must follow the trend from the upper to lower timeframe. The reason is to have a global perspective of the main trend. In the following example, we examine the ETF S&P Biotech (XBI) daily chart.
In the big picture, XBI shows a bullish sequence. Brown lines are the trendlines of the main market direction. Dotted lines represent trendlines which were supporting the trend but then failed in a corrective move.
As commented in the first part of this article, the price moves in zigzags, which in successive movements creates a trend. Due to the market fractality, we have that in each zigzag exist a trend. Then, in each part of this zigzag exist a micro-zigzag which have its micro-trendline. In our example, the XBI 4-hours chart we observe micro-trendlines marked in blue, red and green lines.
As we can observe, when the price corrected the micro-trend, it tested the main trend moving with the main market direction.
A channel is a trendline variation. Sometimes the price moves between two parallel lines. The construction is simple. In a bull market, the first step is to draw the upward trendline connecting the lows. The second step is to draw a parallel line in the two lows high.
As seen in the GBPNZD daily chart, the price tested the bottom line of the bullish channel on diverse opportunities. Once the price drops below the dynamic support, it is acting as a dynamic resistance. Probably, the succession of increasing highs and lows will confirm a new bullish trend to the GBPNZD cross.
For trade channels, an approach is:
- On bull markets, we buy when the price is near the lower trendline.
- On bear markets, we sell when the price is near the upper trendline.
- If the price breaks above/below the trendline, we wait for the close to open a position.
Trendlines are a useful tool to identify and follow the main trend. Also, we can use trendlines to detect a market reversal move. Due to the market’s fractal nature, the sum of micro-trends creates a trend in an upper degree. Another application of trendlines is the creation of trend channels, which allow to enclose the price action and be positioned with the trend.
An excellent method to execute market entries or exits in combination with trendlines and channels is a breakout (or breakdown).