Trend Trading Report Part III - Identifying Trends

Just because a stock price is increasing doesn't mean it is trending. It's important to understand the characteristics of a trend. I'll explain that here.

In review, a trend is a term that refers to the general direction of the market as seen in the price of a stock market index such as the S&P500. More often it is applied to the general direction of the price action for a specific stock.

Trends may be referred to as:

1. An upward trend (aka ascending trend)
2. A downward trend (aka descending trend)
3. A sideways trend (aka trading range or consolidation)

When not moving up or down, the price of the market, or the price of any equity, may be moving sideways. Some traders might refer to this as a sideways trend. Others will argue the semantics and say it isn't a trend. For the purpose of this report, I'll discuss the market characteristics of sideways movements. You can decide for yourself whether you want to call it a trend.

There are two ways to easily identify an upward trend or a downward trend. They are based on:

1. The highs and lows in the price action.
2. The moving averages in the price action.

Using Highs and Lows To Identify A Trend

Upward Trend

An upward trend is characterized by higher highs and higher lows. This is more evident when looking at the following chart.

Notice the dark horizontal lines marking low prices in the chart above. Notice that the lows keep moving higher than the previous low. Also notice the light blue horizontal lines marking high prices in the chart above. Notice that the highs keep moving higher than the previous high. This series of higher highs and higher lows confirms the presence of an upward trend. As soon as the series of higher highs, or higher lows, is broken with a lower high or lower low, the trend has been broken.

Downward Trend

A downward trend is characterized by lower highs and lower lows. This is also more evident when looking at the following chart.

Notice the dark horizontal lines marking low prices in the chart above. Notice that the lows keep moving lower than the previous low. Also notice the light blue horizontal lines marking high prices in the chart above. Notice that the highs keep moving lower than the previous high. This series of lower highs and lower lows confirms the presence of a downward trend. As soon as the series of higher highs, or higher lows, is broken with a higher high or higher low, the trend has been broken.

Sideways Action

Sideways trading action can take on a number of different forms. One example is evident when looking at the following chart.

Sideways trading action (as seen in the chart above) is characterized by a series of highs that are relatively (not necessarily precisely) at the same level. Also notice the series of lows that are relatively (not necessarily precisely) at the same level. This is also referred to a range-limited movement or consolidation. Other examples are:

• The price range may be very small.
• The price action may be very choppy.
• The price action may drift higher.
• The price action may drift lower.

However, in all cases sideways trading action does not include a series of higher highs and higher lows, or lower highs and lower lows.

For more information on determining trends, the duration of the trend, the strength of the trend, and the role of volume in characterizing a trend, click on stock market trends.

Using Moving Averages To Identify A Trend

The following discussion involves moving averages. If you're not familiar with moving averages, click on Moving Averages.

When the moving averages for an equity are aligned, it can certainly be said that a trend is present. For example:

1. If on a chart, the 5 period moving average, is above the 10 period moving average, which is also above the 20 period moving average, which in turn is also above the 50 period moving average, which in turn is above the 200 period moving average. then we can say absolutely that an upward trend exists.
2. If on a chart, the 5 period moving average, is below the 10 period moving average, which is also below the 20 period moving average, which in turn is also below the 50 period moving average, which in turn is below the 200 period moving average. then we can say absolutely that a downward trend exists.

The moving average alignment, as described above, does reinforce the fact that a trend exists. However, failure to demonstrate the moving average alignment does not mean that an upward trend or a downward trend has ended. The end of a trend should be confirmed with the characterization of a trend being a series of higher highs and higher lows, or a series of lower highs and lower lows.

End of a Trend

A trend is no longer a trend when:

• The series of higher highs and higher lows is broken with a lower high or lower low.
• The series of lower highs and lower lows is broken with a higher high or higher low.

End of Part III

Part IV of this report will be released in about one week. The topic is "Simple Candlestick Patterns And How They Impact The Trend Trader".

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