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PART I
Foundational Principles
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CHAPTER 1
Supremacy of the Trend
Where do you start when you first look at a stock chart? Are your eyes drawn to the indicators first? Perhaps your chart has too many indicators and you don't know where to start. With so much information for the technical analyst to discover, new traders often do not know where to begin or what should guide them in structuring their price charts. Sometimes it can be helpful to remove the indicators and focus squarely on price itselfâafter all, you've certainly heard the axioms âPrice is Kingâ and âOnly price pays.â
This introductory chapter will examine why trend analysis is so important to formulating your trading plan. Using your assessment of the current trend structure as guidance for which indicators to use and which to ignore, you will then be able to envision a clearer pathway ahead for the next swing or directional move in price, and thus be better equipped to take advantage by trading the expected move.
After all, you must start your decision-making process somewhere and you must be as objective as possible, as opposed to subjective analysis which is prone to opinion, bias, and error. While technical analysis is more of an art than a scienceâwhich leaves the chart open to interpretationâyou build your foundation from time-tested principles that guide your analysis each time you review a chart and seek opportunities for profit. This chapter lays the foundation for successful analysis and trading, starting with the underlying principle of technical analysisâthe trend.
WHAT IS A TREND?
Before making any decisions about buying or selling a particular stock or market, you must first assess the current price trend as a backdrop to further analysis. Afterward, you will be better able to assess the longevity, magnitude, and probabilities of the current trend continuing. Before applying any intermediate or advanced analysis methods, you should always start with a firm understanding of the basic concepts of supply and demand, as revealed through the price charts. The best way to begin your analysis is by simply quantifying the current trend objectively, be it up, down, or sideways. While it seems so simple, many traders skip this step and jump right to the indicator signals, not understanding that some popular indicators work well when a trend is established but then fail when a sideways trend occurs. By objectively assessing the trend in place, you will then be prepared to take the next step in your analysis. Let's start with the basic question, âWhat is a trend?â
Breaking it down into simplest terms, a trend is a series of price swings traveling in the same direction over time. Most traders assess the strength of up-trends in order to find buying opportunities in a prevailing trend that has been confirmed. In the context of a prevailing up-trend, traders will be looking to put on new positions on pullbacks to expected support levels.
TREND
Trend is the prevailing tendency of the price of a security or market to move in the same direction over time. In the stock market, trends are often divided into long-term or secular trends, intermediate term trends, and short-term trends.
Up-trend: A series of higher price swing highs and higher price swing lows over a given period of time.
Down-trend: A series of lower price swing highs and lower price swing lows over a given period of time.
In his book Technical Analysis Explained, Martin Pring gave us the best definition of technical analysisâthe method of making decisions to the likely future price movement of a stock based on the past and current chartâwith the following definition, which underscores all of our efforts as traders:
The technical approach to investments is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors towards a variety of economic, monetary, political, and psychological forces.
The art of technical analysis is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed.
For traders, the most important parts of the definition are the âidentify trend changes at the earliest stageâ statement as well as the âweight of the evidenceâ portion. These two concepts underscore all of the decisions you make as a trader or an investor. Let's break them apart individually.
Identifying Trend Changes Early
One of the most commonly accepted principles of technical analysis states that the trend, once established, has greater odds of continuing than of reversing. If we accept this principle as true, then the most profitable, lowest risk opportunities will come by trading retracement-style set-ups in the direction of a confirmed, prevailing trend. Many new traders try to call tops and bottoms in a stock and thus fight established trends, which often results in monetary losses and psychological frustration. While all traders want to be the first to call reversals in markets, and indeed traders can make a public name for themselves by accurately calling major turns in a market, it is important to realize that for every correctly called market top or bottom, there are dozens if not hundreds of inaccurate calls of tops or bottoms that lie scattered in the graveyard of market analysis and in personal trading accounts. Some traders destroy their accounts by stubbornly fighting a trend, clinging to their opinions of what the market should be doing as opposed to what the market is actually doing. Traders lose money when they try to force their will on a market, and traders who fight prevailing trends can suffer major losses as they trade against the probabilities from the onset.
On the other hand, a trend cannot persist forever; as such, downtrends evolve over time into up-trends, and then mature up-trends must devolve again into down-trends as the market cycle continues throughout history. Chapter 7 describes the typical life-cycle of a price move from bottom, to top, to bottom again. Those who do well over their trading careers are the ones who understand this principle and act accordingly when the weight of the evidence has shifted, rather than remaining committed to a losing position. The majority of this book will be dedicated to identifying trend reversals as early as possible as you assess the weight of the chart evidence, which implies never looking at one indicator or variable in isolation, but as a composite whole to the best of your ability. While your goal should always be to determine trend structure, you must simultaneously be aware of potential signals that a trend in its mature stage might be reversing. No matter what your emotions or other anecdotal evidence suggest, you must be able to change your expectations once the price chart gives a trend reversal signal, and not stubbornly assume that the current trend will continue forever. Sometimes traders learn this lesson with one painful experience, as a child learns not to touch a hot stove, though other traders may need to be reminded throughout their career that the best trades often come in the direction of the prevailing trend, rather than against it.
You must be prepared to sell your position and take profits when the trend changes from up-trend to early down-trend, just as you must also be able to act on any positive reversal in a down-trend which is showing signs of reversing into an up-trend. It takes confidence to buy after a sustained down-trend, just as it takes a strong fortitude to sell a position with profit once a market signals odds favor a turn to the downside. Those who identify confirmed reversals at the earliest reasonable stage possible will outperform those who are not as systematic in determining the health of a trend in existence and the probabilities of continuation or reversal of the prevailing trend. We will be discussing this concept in great detail.
Waiting for the Weight of the Evidence
As mentioned earlier, you cannot wager consistently on a trend reversing. Doing so will often result in numerous losses and unnecessary frustration. Most of the easiest trades come from positioning yourself in the direction of a prevailing trend, usually during pullbacks or retracements to support or resistance levels, and assuming that the trend will continue rather than reverse. In those terms, you can think of almost all the trades you take as either betting on a prevailing trend continuing or of a mature, lengthy trend reversing. Do not make this decision lightly.
Many of the most successful traders have solid rules for assessing the markets or stocks they trade, and their methods can be summarized as assessing the evidenceâwhether from fundamental, technical, or quantitative methodsâand making a determination of the probabilities of a market continuing to rally or reversing into a down-mode. No single method is perfect, and no one method can ever call all tops and bottoms in a market.
Over the lifetime of your trading or investing career, you will do better to use noncorrelated methods to assess the probabilities from an unbiased approach to the best of your ability. In this book, I will be sharing how to combine leading methods into a unified approach for assessing the probability of the next likely swing or directional move in price. In so doing, you will be assessing the weight of the evidence using methods that you understand and that interest you. Do not feel as though you have to learn every single method of any trading system or strategy perfectly. By the same token, do not give any one method absolute dominance over others. When you observe noncorrelated methods and indicators such as moving averages, candles, divergences, and price patterns pointing in the same direction, you will increase your odds of a successful trade outcome more than if you used any one of these methods in isolation.
For example, if you see a reversal candle, it can be a bearish signal to exit a position. However, if you fail to assess the weight of the evidence, or the context in which the reversal candle occurs, you might be exiting a profitable position too early, or worse, if you chose to put on a short-sale position (attempting to profit from a market decline) based on a single candle, you might subject yourself to an unnecessary loss had you taken more time to assess the trend structure, volume signals, confirming indicators, or any number of analytical methods before making a final trading decision.
It can simplify your task immensely if you think of trading as a measurement of the probabilities of a trend continuing or of reversing, and taking specific entries and exits based on the developing structure that the price chart reveals to you. You will enter at more favorable levels, place stops at key points at the price where an idea will be proven incorrect, and play for realistic targets with exits that are generated by the weight of the evidence that solves the âexiting too early or too lateâ problem that most traders face.
METHODS FOR DEFINING TRENDS
âWhat is a trend?â seems like such an easy question to answer but, as you'll see, the answer can be as simple as âhigher highs and higher lowsâ or as complex as a linear regression analysis or other statistical calculations. Despite the complexity (not to mention usefulness) of some mathematical models, the best way to define a trend can still often be the simple principles defined by Charles Dow in the early 1900s.
Charles Dow was one of the earliest researchers of technical analysis, and modern traders study his principles of what developed later into the Dow Theory of technical analysis. Dow noted that an uptrend required a higher high and a higher low to be valid, just as a downtrend required a lower low and lower high to be valid. Dow noted that volume confirmed the trend, such that in the context of an uptrend, volume rose during the upward swings in price and declined during the downward corrections or retracements, just as volume rose during the downward swings in a downtrend and declined during the corrections or upward retracements in the context of a trend. Modern day traders have layered complex methods over these simple, basic principles.
Recall that early technical analysts did not have the benefit of computer charts as we have today. Instead, they calculated charts each day by hand and placed a high emphasis on trend structure as defined by price itself. This is called the Pure Price Method and it is still used today as one of the most accurate and objective methods of defining a trend. In addition to the Pure Price Method, contemporary traders use the Moving Average Method to assess the structure of a short-term, intermediate term, and long-term moving average, paying specific attention both to the orientation of the averages themselves, and the relation of price to these averages.
The preferred method combines both the Pure Price and Moving Average methods, as each give similar signals and exact prices where a trend officially reverses. It will be these official classifications that remove the subjectivity or confusion most traders experience when attempting to label trends on price charts.
The Pure Price Method
Let's start with the simplest concept and move to more detailed definitions. As its name implies, the Pure Price Method removes all indicators from the charts and builds the foundation for trend analysis on the price itself. The method is only concerned with locating swing highs and swing lows while comparing prior highs to recent highs and prior lows to recent lows. You can use a candle chart, standard bar chart, or even a line chart to define trends using this method; sometimes a line chart can be the best place to begin when objectively analyzing trend structure. The goal is to remove bias and get a clear picture of the steady rising or falling rhythm of the price of the stock or market you are analyzing and thinking of trading.
As most traders can recite without thinking, an uptrend is defined as a series of higher price highs and higher price lows while a downtrend is defined as a series of lower price highs and lower price lows. Using this phrasing as our departure point, let's see this definition in action.
Figure 1.1 shows a snapshot of the Dow Jones Industrial Average rising through 2006 to the October 2007 peak. According to the Pure Price method, we are only concerned with key swing highs and swing lows to develop our definition of the trend. Any change in the series of higher highs and higher lows will be a warning sign of a potential reversal ahead, but until we see price either form a lower swing low or a lower swing high, we must assume that the uptrend in place will continue and trade accordingly in the direction of the prevailing trend. We will learn trading tactics in later...
