What are trends and how to define them
(This is the 4th lesson on a series of preview chapters for a course that is due to be released soon. Please read the disclaimer before proceeding. If you found this lesson useful, don’t hesitate to share it and please follow us on all our social media for more updates!)
Outline of today’s lesson, we will be covering:
- Uptrends and downtrends in stocks
- The market can move sideways
- Why are trends important
- Drawing trendlines
- False breakouts
- To sum up this lesson
Uptrends and downtrends in stocks
As you look at the charts, you will realize that stocks will form trend at times. Stocks can be on uptrends or downtrends and when a trend has been formed, it is best to follow the trend. Always remember “the trend is your friend!”
An uptrend is defined by a series of higher highs and higher lows. A higher high is when the current high is higher than the previous high.
A higher low is when the current low is higher than the previous low.
A downtrend is defined by a series of lower highs and lower lows. A lower high is when the current high is lower than the previous high.
A lower low is when the current low is lower than the previous low.
Examples of trends
You can see that in real markets, the uptrend is not as ideal as what you learn. It moves up and down, a stock never goes all the way or all the way down. This is due to the ebb and flow of the market. For every sharp rise in prices, there is almost certain to be a short pullback, where prices will retrace a bit before rising again.
Yum brands downtrend
For downtrend, the drop is also accompanied by a throwback, where the stock price rises for a bit before falling again.
The market can move sideways
When you look at charts, you might realize that some charts are not in a clear uptrend or downtrend. They seem to be in a channel, or moving within a range. We call this a sideways market, as the stock is still undecided on where it is going.
Why are trends important
In technical analysis there is a saying, “it is best to trade with the trend and not against it.”
Imagine you are swimming in the ocean. In this scenario, the currents in the ocean refer to the trend. When you swim in the same direction as the current, it is easy. You face very little resistance and the current will help push you to your destination.
But when you swim against the current, you will face a lot of resistance. Even after exerting a lot of effort might not get you to your destination and in most cases the current will just push you away.
We always ask you trade with the trend because it is easy to follow the trend. However when you try to trade against the trend, it is much more difficult and most of the time you will lose money unless you have a very sound strategy.
One way to help you identify trends clearer and to gauge how strong a trend is, is to draw a trendline on the chart.
Trendlines are drawn by using the highest high or lowest low. By connecting the highs together or by connecting the lows together, you can draw trendlines for uptrends or downtrends. A trendline is able to help to show you the current trend and how the stock might possibly continue in the future.
- Use lowest low in the stock as the starting point for the trendline.
- Connect to the nearest ideal low (The next closest low that gives an meaningful trendline)
- Trendline provides support to the stock.
- Use the highest high in the stock as the starting point for the trendline.
- Connect to the nearest ideal high (The next closest high that gives an meaningful trendline)
- Trendline provides resistance to the stock.
*Support and Resistance will be covered in the next topic.
A meaningful trendline is a trendline that is not too steep and will give the trend space to continue in the future.
Things to note
An ideal trendline is between 30° to 45°.
- A trendline with an angle that is too steep will not last. If the angle is too shallow, it is not much of a trend.
- A strong trendline will have many touches
- When a trendline is repeatedly tested, it becomes more significant.
- When a trendline is broken, it is a sign that the trend might be ending and the investor should pay close attention and use other signals to help confirm this.
Drawing a trendline is an art. There is no fixed or correct method to follow. Just try to draw a line that touches the most points, occasionally there might be points that cut the trendlines briefly but it looks fine in the bigger picture.
Sometimes you will not be able to draw a trendline, just let it go if you can’t draw it. Remember, let the market show you if there is a trendline. Never try to force and draw a trendline out.
This refers to when the stock breaks the trend line shortly but closes back below the trend line shortly afterwards. A good way to make sure a breakout is valid is to observe for high volume and large price movement. You can also wait for a few days after the breakout to observe and see if the stock closes below the trend line.
*Price movement refers to how large a move the stock made in a day. A long candlestick represents a large price movement.
Some examples of trends
To sum up this lesson
- Stocks tend to trend from time to time
- An uptrend is formed by a series of higher highs and higher lows.
- A downtrend is formed by a series of lower highs and lower lows.
- Trendlines makes it easier to identify trends
- Draw trendlines by connecting the highs or lows, use the ideal highs and lows to get meaningful trendlines
- Use the highest high for a downwards trendline and the lowest low for an upwards trendline.
- A strong trendline is one that has numerous touches
- When a trendline breaks, it is a sign that the trend could be changing. Always use other signs to confirm.
More info who those who are interested
Most website don’t allow you to draw trendlines on them, you need to use a charting software or some brokerages also provide it on their platforms.
It is also possible to make money during a downtrend, as there is a method known as shorting a stock. This means you make money when the stock price falls. However, we will not be covering it in this course. Here is a link of a simple explanation of shorting or short selling.