Of all the ideas and strategies that have evolved throughout the history of trading, the trend has been the one that has stood the test of time. It is unclear who first said it, but “The Trend is Your Friend” has become one of the most common sayings in trading today.
But what is the trend? How do we identify it? Most importantly, how do we use it to our advantage? First, we begin by looking at how we view trends and what they tell us about the markets.
Trends On a Price Chart
For most kinds of market analysis, we use a price chart to create a visual image of how the markets are behaving. At its simplest, a price chart plots the value of a given instrument or stock over time, this allows you to see market rises and falls as they occur.
By changing the timeframe, such as from plotting the price every 5 minutes to 1-hour, 1 day, 1 week, 1 month or more, the price chart can show us how the stock is performing at that moment or over a longer time period. For instance, on a 1-hour chart, the price may be shown to be going down, but by looking at a weekly chart, we can see that the price has been steadily rising for 6 months. That general direction is called the trend. It signifies what the price of that particular stock is doing over time. If the price is rising, it is an uptrend, if it is falling, that is a downtrend.
Figure 1: Uptrend vs. Downtrend.
In the stock market, understanding what direction the current trend is going has an obvious advantage. For investors looking for longer term positions, buying into an uptrend provides a great profit opportunity, likewise, short selling – trading on a price going down – can provide great profits when the trend is downwards.
It is important to make the distinction between a trend and current price movement. An uptrend does not mean that the price never goes down. In fact, apart from a few very specific situations that last for a relatively short time, markets never really travel solely in one direction. An uptrend means that on the price chart, we can see the price moving upwards steadily over time. It may have hours or days where the price falls again, but then continues back upwards.
Figure 2:This image shows an uptrend with periodic moves down with higher lows created each time, keeping the uptrend intact.
In terms of the chart, this will produce higher peaks, but also when the price does fall, those lower levels are also higher than the previous low point. This is often referred to as ‘higher highs and higher lows’, and depending on the type of price chart, are relatively easy to spot. The inverse of that for a downtrend would be lower highs and lower lows, as the market falls, retraces a little higher, then goes back down again. It is those constant higher or lower points that easily identify the trend on a chart.
Being able to spot trends on price charts is an essential skill that all traders and investors should master. To understand how to accomplish that, we need to recognize the kinds of charts we can use, and how to identify the trends within them. We begin by looking at the most popular chart options you will find, line charts and candlestick charts.
A line chart, as the name suggests, uses a line to connect the price point changes of a stock or other instrument over time. In general, the price depicted for each time period in the chart is the closing price, for instance if a chart is a one-day chart, the line connects the closing price of each day displayed on the chart.
Figure 3:This image shows a line chart which only plots the close of the day. However, the overall trend can still be seen in this type of chart.
While it is the most basic of chart types in common use, it has several advantages, as it is a very clear way to visualize the movement of a stock price. Unlike alternative kinds of chart, there is an immediate clarity with a line chart, and this can be very useful when analyzing markets. All that is shown on the chart is the time intervals and the closing price itself.
In addition to being perhaps the clearest way to display price movement, with no patterns or other detail to worry about, line charts are also easy to use too. Lines are a great place to start for those just beginning with trading or investing, as they distill everything down and present only the most crucial information you need.
However, that simplicity can become a liability in some situations, where charts that do more than tell you the closing price offer increased versatility. The candlestick chart is by far the most commonly used option for traders looking for more detail.
As with line charts, a candlestick chart displays price movement over time, however rather than a simple line that shows closing price, they use individual shapes, known as candlesticks, to display the various price movements for each individual time period. For instance, on a 5-minute chart, each candlestick will show the open and closing price for that 5 minute period, as well as the high and low. For a weekly chart, the same information about the week’s prices would be shown, and so on.
This ability to show much more information at a glance can be incredibly valuable, but there is a learning curve compared to a line chart. Understanding the makeup of a candle is not difficult though, and once you understand how they display data, it quickly becomes second nature.
If you look at a candlestick chart, you can see each candle has two distinct parts. There is a vertical line, that appears at the top, bottom or both, and a wider box shape. The wider area is known as the body, and that represents the open and closing price.
Figure 4: This image shows the different parts of a hollow candlestick formation.
If the body is colored red or black, then the candle closed lower than it opened, which means the upper point of that body will be the open, and the lower point the closing price. If the body is white or green, then the prices closed higher than it opened during that period, meaning the upper point of the body is the close, the lower point the open. This color scheme allows you to see at a glance what the market did in a very intuitive way.
The vertical line represents the price movement between the open and close, and it is known as a wick or shadow. A wick or shadow above the body is known as the upper shadow, and it represents the high reached during the trading period. A lower shadow appears below the body, showing the low reached.
Not every candle has a wick/shadow at both ends, or even at all. If a stock closes a time period at its high point, there will be no upper shadow for instance. The relationship between the body and shadows allow us to see at a glance what happened during that particular trading period, making the candlestick chart a much more comprehensive visual representation of chart movement than a line chart.
There are several ways in which all the extra information that a candlestick chart provides benefits traders looking for trend analysis. However, one of the key things to understand when looking at candlestick charts is how the timeframe of the chart changes what you see.
If you have a 1-hour chart, so each candle represents 1 hour of price movement, then you will see the price changes during the day, and a chart may show you that hourly movement over 2 or 3 days at most. This detailed look at the daily changes, also known as intra-day movement, can show seemingly drastic swings in price. However, ‘zoom out’ to a weekly chart, where each candle displays an entire week of trading data, and those smaller movements disappear. Instead, you may see a continuing upward move of price even if right at that moment, the price is actually going down.
For trend trading, a longer timeframe allows you to see the overall direction much clearer than the shorter timeframes. Day traders, those who specialize in trades that last less than a day and often just minutes, can make use of those smaller timeframes for short-term trends, but for most who use trends, the longer term offer a more definite signal for trading that smooth out the daily movement. This is important, as temporary effects such as a major news announcement can easily influence a short-term change in price, but that influence will disappear quickly. It is the longer-term trends that provide the stability that traders and investors are looking for.
Candlesticks are excellent for showing general trend direction as well as potential changes in that direction. One way that is done is through candlestick formations, that is patterns of candles that tend to appear as the market turns is specific directions.
Bull candle formations are patterns that suggest an upward move, and include:
- Bullish hammer – A powerful signal of a reversal in a downtrend. This candle has a long lower shadow, and a small bullish body with a close at the high of the time period.
- Bullish Engulfing Pattern – A large white or green body (higher close than open) that engulfs the previous candle body completely (that is, it has both a higher high and a lower low). The previous candle must be black or red, showing a lower close than open.
- Bullish Doji Star – On a downtrend, a black/red candle is followed by a candle that features significant upper and lower shadows, with the body being a line, signifying an open and close at or very close to the same level. This is a good indicator of a coming reversal of market direction.
Figure 5: Bullish Hammer, Bullish Engulfing, Bullish Doji Star
Bear candle formations, those showing a potential downward turn, are also important:
- Hanging Man – The opposite of the Hammer pattern, with a long lower shadow, and a black/red body with no upper shadow appearing after white/green candles in an uptrend.
- Bearish Engulfing Pattern – As with the bullish pattern, this can suggest a reversal, with a black or red body that completely engulfs the previous white or green candle body and appears during an uptrend.
- Bearish Doji Star – Again, appearing in an uptrend, following on from white/green candles, the Doji candle features long upper and lower shadows, and a narrow body that indicates open and close at or near to each other.
Figure 6: Examples of all three bearish candlestick formations mentioned above.
These signals are great for identifying potential changes in direction and the beginning of new trends.
Drawing a Trendline
Being able to draw trend lines accurately is a crucial skill to learn, as it can be the basis of so many trading strategies and help you make informed trading choices, perhaps more so than any other analysis methodology in use today.
Starting with our line chart, as the clearest, simplest way of showing price movement, it is also the easiest way to identify trends. On a line chart, you are looking for an uptrend showing a series of higher peaks, and higher lows as well, and for a downtrend, lower lows, but also lower highs. With a clear and simple line structure, this is the easiest way to identify trends.
Figure 7: This image shows an uptrend and downtrend on a line chart.
The same approach is true of candlesticks, however here the extra information included in the chart does mean that you need to pay attention. It is easy with a candlestick chart to focus on the colored bodies, and then forget about the upper and lower wicks/shadows. It is always about the highs and the lows, even on a candlestick chart, and if the high or low point is at the top or bottom of a shadow, that is the important point, not where the body starts or ends. This is especially important when drawing trend lines.
Figure 8: An example of changing your trendline drawing preferences on the TrendSpider platform.
An upward trendline is drawn by connecting the lows of a trend. So, as price moves upwards, we know it does not go in a straight line, the price will dip a little here and there, but in an upward trend, each dip will be higher than the last. To draw an upward trendline, you are looking to connect two or more of those higher lows. A downward trendline would connect two or more lower highs.
This may seem the wrong way around to begin with, but if you think about how the trendline is used, it all begins to make sense. When we draw an upward trend line by connecting the higher lows, we are marking the support level for that trend. Because we want to see when the trend begins to turn the other way in our trading, having that trend line below allows us to see when the price crosses it, and identify a potential failure of the trend. For a downward trend, we are looking for the move back upwards, and so a resistance line created on the lower highs does this in the same way.
When drawing the trend line, the more points you can connect the better, but you need at least two. In an uptrend it MUST be the lows, don’t use a close on a candlestick or other values, for an accurate trendline, only connect the low points themselves. Likewise, on a downtrend, it must be the highs that are connected.
Figure 9: Strong vs. Weak Trendlines.
Chart software, whether provided by your broker or a third party, or even online options, all have tools to draw trendlines, but in most cases, choosing the right points to use for plotting is still down to you. However, with TrendSpider, the process of drawing manual trendlines is made much easier through our trendline preferences feature.
With the trendline drawn, you now have your support or resistance levels, and as the market price begins to cross it, especially is it closes below support or above resistance, you can look for other signals to confirm a direction change. Candlestick charts are ideal for this because they often develop patterns to support that direction change, allowing you to see everything in one place.
Trends are one of the most powerful tools we have for making trading decisions. Understanding where the market direction is beginning to change and following trends over extended periods are proven methods of generating investing profits and have been used by traders at all levels since there have been markets to trade on. As technology continues to evolve with new charting platforms such as TrendSpider coming to market, there will always be a new, efficient way to make technical analysis and trend recognition easier than ever before.
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This post is not investment advice it is for informational purposes only.