Spotting trends
An uptrend consists of ever higher highs and ever higher lows, a downtrend of the opposite. The rule is simple. Applying it in a live market isn't.
Learning objective: After this lesson you can recognize an uptrend or downtrend by its highs and lows.
The usual rule is purely mechanical. If every new high is above the previous one and every new low is also above the previous one, people speak of an uptrend. In the opposite case, of a downtrend.
The strength of the rule
The good thing about this rule: it's unambiguous. You can count it. That sets it apart from much of what's said about charts.
The drawback in a live market
Its drawback shows in a live market. You only know a high was a high once the price has fallen again afterwards. So every statement about a trend comes too late, and how late depends on the time frame you're looking at.
What a trend is good for
A trend is mainly useful for one question: am I trading with the big direction or against it? Trading against the big direction isn't impossible, but it's harder, and you should know that.
If you turn the observation of trends into a fixed strategy, you end up with momentum and trend following. That's one of the best researched patterns in financial markets.
To pin down trends precisely, you need a rule for when a high or low counts as one. Usually the price must then have moved a minimum amount in the opposite direction, say 5 percent. You can choose this threshold freely, and it decides how many trends you find and how late you spot them. Without it, nobody can check a statement about a trend.
The momentum effect
The best supported is the momentum effect. Stocks that have done better than others over the past months tend to keep doing a little better over the next months on average. That shows up in many markets and over many decades. However, there are violent setbacks when the market suddenly turns, as in spring 2009, when the weakest stocks suddenly rose the most.
Past versus future
Distinguish two statements. That a trend exists is a statement about the past, and you can check it easily. That it will continue is a statement about the future, and that needs good reasons. Confusing these two is the most common mistake when people work with trends.
Is this an uptrend?
Six price series. Apply the definition from above before you click an answer.
Summary
- Higher highs and higher lows, that's the whole rule.
- You usually only recognize a trend afterwards.
- That a trend exists is the past. That it continues is a claim.
Did you get it?
How do you recognize an uptrend?
By successive higher highs and higher lows.
Why does every statement about a trend come too late?
Because a high or low can only be recognized once the price has moved the other way afterwards.
Which trend effect is best supported?
Momentum over a few months, though with violent setbacks when the market turns.
Check your understanding
Your task
A price forms these turning points in order: high 40, low 36, high 43, low 39, high 47, low 42, high 51, low 41. Check point by point against the rule from the lesson where the uptrend first stops being clean. Write down why you only know this in hindsight.
Sources and further reading
- Jegadeesh and Titman's original 1993 study on the returns to buying past winners and selling past losers over medium-term holding periods. View source ↗
Related
- Fundamental vs. technical analysisStage 4
- Moving averagesStage 4
- Chart patternsStage 4
- Matching questions for this stageQuestions