Trend is the easiest and the most difficult thing to understand. The difficulty arises because of the time factor. Whenever we talk of trend it has to be related to the context of time.
An intraday (relates to action on that particular day only) price chart may show a significant trend, which is contrary to a trend recognizable on a daily price chart, which may be contrary to a trend on a weekly chart.
Success depends on recognizing and trading the appropriate trend. Successful investing depends on recognizing the short, medium or long-term trend and their correction (Rallies and Dips) inside the larger trend.
We will usually be trading when at least the short term and intermediate term trends are in the same direction. The ideal will be when all three trends are in unison, but this is not a prerequisite, as intermediate trends can be substantial in both time and price.
It would be too exclusive a trading strategy to ignore these opportunities and only trade when all three trends are in harmony.
A simple definition of trend is basically the general direction of price movements. An up trend is present when prices make a series of higher highs and higher lows.
A downtrend is present when prices make a series of lower highs and lower lows. When prices move without such a discernible series, prices are said to be trading side ways in a range or trendless.
Once a trend is discernible then trend lines can be drawn to define the lower limits of an up trend or the upper limits of a downtrend. It is essential that trend lines be drawn correctly. It is the recognition of the trend line and the violation of this trend line that is your key to successful trading and fortune building.
As you can see from the diagram below, the trend is moving up. To draw a trend line, draw a straight line from the lowest low of the period to the next lowest low. Make sure the line does not pass through any bars.
To draw a trend line, draw a straight line from the highest high of the period to the next highest high. Make sure the line does not pass through any bars
During development of a trend the growth of the trend proceeds at different rates at different times.
A frequent sequence is the following – a short initial explosive breakout and advance from a previous prolonged period of range trading, a much longer period of steady progression at a lower rate of change and, finally, a shorter period of noticeably slower rate of progression.
Each phase of trend advancement is followed by a period of retracement and consolidation. The initial growth phase is too rapid to be sustained and the ensuing correction is often quite deep.
The second phase of advancement is one of steady sustainable growth and often persists for some time. Inevitably this too ends and a period of retracement follows but usually not as deep as the initial correction.
This second correction often takes more time than the first to complete the corrective process. When the correction is complete the final phase of trend advancement occurs usually at the slowest rate of change for the whole progression of the trend and then this too corrects.
The three trend lines that can be drawn from the initial point of the trend through each of the retracement extremes are known as Fan Lines.
They illustrate the decaying rate of progress of the trend. When finally prices violate the third fan line it invariably means the trend so monitored has finished and a reversal of the trend is underway.
Channels are a good visual representation of the struggle between buyers and sellers. It is important to realize that you must know the time frame you intend to trade.
The channel on a 4-hour chart may be different from that on another time period. Once you are committed to a particular time frame we can then define trend and emphasize the importance of drawing correct trend lines within the context of the time frame. Now we will combine these insights to maximize the efficiency of trading. This we will do by establishing channels in the particular trend we are working with.
We learned that the trend line acts as underlying support to up trend lines and overhead resistance to down trends. We also can observe that prices once finding support or resistance will move ahead and away from the trend line then return to the trend line. Over time we can recognize that this movement of price to and from the trend line forms a channel, which once identified can be traded.
In an up trend, as prices come back to the trend line, new increased buying comes into the market and overwhelms the sellers. These buyers are made up of previous buyers in the market adding to their positions, intending buyers who missed earlier opportunities and are now buying the dip.
The buying that stops the selling at the trend line impresses some of the previously uncommitted. Now convinced that the buyers have the upper hand, buy. This new buying takes prices up and away from the trend line and the further it moves up the more impressed the uncommitted become and more buyers come into the market.
The previous short sellers become frustrated and buy to cover their short positions and prices move up further. After a while, buying becomes exhausted and is overwhelmed by selling and profit taking.
As buying is overwhelmed more profit taking occurs and nervous recent buyers will have their close trailing stops (To be discussed later) triggered as market orders and so price retreats to the trend line again.
This starts the whole cycle off again if the up trend is to continue. This to and fro, buying and selling in the direction of the trend plots out a recognizable channel of dynamic flux of the trend.
Recognizing the trend line and the opposing parallel channel line – channel return line – and understanding the human dynamics that account for its structure, increase the efficiency of profit making by initiating or adding to one’s position at trend lines and profit taking at the channel return line.
One can, but I do not usually, trade the retracement. For those who do not wish to trade the trend so aggressively one can use the trend line for placing and moving stops and to initiate new trades. Also when a channel is in force we can respond to trend violation by having a recognizable entry level to trade the new trend.
Also, as the trend progresses one can recognize support and resistance levels, which can also be used for further trading on the placement of stops.
As you can clearly see from the diagram, the trend line can change slope as the trend may move at different rates and it is mandatory to adjust the trend as necessary.
So it is with channels, as these too must be adjusted as the trend accelerates or decelerates.
Also it can often be recognized that channels can exist within channels. These channels within channels are plotting the short, medium and long-term trend.