Market Trend Analysis
Trends are easy to spot in hind site, but how do we get in on them early and ride them to the end? Market trend analysis should be a core component to your trading system. As traders, we never know for sure when the trend will begin or when it will end. We can only look for probabilities. Once the trend has been confirmed, there is no guarantee that it will continue. All we can ever do it to take small, calculated risks, when the odds seem to be stacked in our favor. Here are some ways to improve the odds.
Trend Line Breaks
When a trend line is violated, it is a warning that the trend is going to go sideways or even change direction. If a trend line is broken, but previous lows remain inviolate, there is a high probability that a trading range has begun. If a trend line is broken and a previous low is violated, there is a higher probability that the trend is reversing. Combining trend line breaks with other technical events can increase the odds of being on the right side of a trade. Let’s look at a couple of examples below.
QQQQ shows trend line break followed by a lower low and high. Trend quality is good until the flash crash in May
Trend Quality
Let’s categorize trend quality into two camps: tight and predictable, and whippy and uncertain. A tight but predictable trend can be characterized by opens and closes that are close together, gaps are small or nonexistent. The average range is predictable and relatively small, with no wide range bars or long tails against the trend. Retracements typically reverse near previous areas of supply or demand, where the trend continues. Areas of congestion are tight and breakouts follow through.
Low quality trends are full of gaps and overlapping price bars in both directions. The average price range per period can fluctuate wildly and is marked with engulfing and piercing bars. Retracements are steep, swift and violent. Breakouts typically fail as prices whip in the opposite direction.
Notice the change in the trend quality in the QQQQ weekly chart above. The range of the bar at the beginning of May is several times wider than any of the previous bars shown. It is followed by a gap up inside bar. The up trend is in question.
Fibonacci Retracement Levels
Retracements within a trend provide traders opportunities for low risk entries into the market. A 30% retracement within an uptrend that reverses at a previous high is more bullish than a 100% retracement that retests a previous low. Fibonacci/retracement analysis is based upon key ratios found in nature. The primary fib ratios are .382, .50, and .618. It is believed by many traders that the combined activity of mankind follows the same patterns and ratios found in nature.
To simplify your trading, visually estimate retracements as 1/3, 1/2, and 2/3. Retracement analysis should be used in conjunction with other elements such as support/resistance, reversal patterns, trend quality, and moving average relationships. In addition to the depth of the retracements, a good trader also observes the angle of retracement. In an uptrend, pull backs with an angle less than 45 degrees are more bullish than those that are steeper.
Trend Analysis Elements
Support and Resistance Analysis
Major support (demand) in an uptrend can be found near the area of the previous low. Minor support in an uptrend can be found near the area of a previous high. Strong up trends typically find support near the previous high. Trends that retrace to areas of major support may indicate the beginning of a trading range or even a trend reversal.
Major resistance (supply) in a downtrend can be found near the area of a previous high. Minor resistance in a downtrend can be found near the area of a previous low. Strong downtrends typically find resistance near the previous high. Trends that retrace to areas of major resistance may indicate the beginning of a trading range or an eventual topping pattern.
Support and resistance areas are based on price alone. Retracement/Fibonacci analysis, moving averages, and trend lines, do NOT form support or resistance. These elements are to be used as confluent events that help to increase our odds.
Continuation and Reversal Patterns
Although these patterns by themselves do not make a trend, they do give clues as to whether the trend will continue or soon come to an end. A good trader must observe WHERE these patterns occur. Continuation patterns such as retracements and breakouts that occur near support have a higher probability than those that occur far away from support. Volume that increases in the direction of the trend also increases the odds.
Objective Analysis of Highs and Lows
This is one of the simplest, most objective elements of trend analysis. Higher highs and higher lows together form an uptrend, while lower highs and lower lows defines a downtrend. An objective definition of an uptrend is a combination of two higher highs and two higher lows. Two lower highs combined with two lower lows confirms a down trend. There is no guesswork involved.
Following these strict but simple rules may sometimes cause a trader to miss a good part of the initial move. When combined with other elements of trend analysis, it is possible to find an earlier, low risk entry, before the new trend has been confirmed. It is up to each individual trader to define specifically the when, where, and why, to enter the market. These details should be written down in a trading plan and then tracked for results within a trading journal.
Moving Average Relationships
There is no single, magical, moving average. I have used simple, exponential, and displaced moving averages and have settled on these simple moving averages: 20SMA, 50SMA, and the 200SMA. Each market (stock, futures, or forex) has a unique flavor or relationship to its moving averages. Each phase of a market cycle also demonstrates ever changing and evolving behavior in relationship to the moving averages. The secret to using moving averages to find low risk entries is to combine them with other elements, especially areas of prior support and resistance.
In the down trend below, the 20SMA is below the 50SMA. As the trend matures, the 50SMA crosses below the 200SMA. Look for retracements and areas of congestion at or near the 20-50-200SMA’s that also line up with areas of major or minor resistance. Avoid entries that are far away from the 20SMA AND areas of resistance above. Use the 20SMA to develop patience by waiting for lower risk setups at or near resistance. NEVER use a moving average AS support or resistance.
Moving Average Relationships
