Spotting trends
An uptrend consists of higher highs and higher lows, a downtrend the opposite. The definition is simple; applying it in real time isn't.
Learning objective: After this lesson, you can identify an uptrend or downtrend from its highs and lows.
The common definition is mechanical. If every new high tops the last one and every new low sits above the last one, that's called an uptrend. The reverse defines a downtrend.
The upside of this definition is that it's unambiguous. You can count it out. That sets it apart from a lot of what else gets said about charts.
Its downside shows up in real time. You only know a high was a high once the price has fallen back. Every trend claim therefore lags the move, and how much depends on the time frame chosen.
The concept of a trend is mainly useful for one question: am I moving with the larger direction, or against it? Trading against a larger direction isn't impossible, but it's harder, and that's worth knowing.
Turn the observation of a trend into a systematic strategy, and you land on Momentum and Trend Following, one of the most extensively researched patterns in all of finance literature.
Formalization happens via extreme points, which only count once a minimum counter-move has occurred. This confirmation threshold is a free parameter, and its choice determines both how many trends get identified and how much the identification lags. Without stating this parameter, a trend claim isn't reproducible.
The empirically most robust manifestation is the momentum effect, meaning the observation that assets with relatively strong performance over medium time frames of several months tend to keep outperforming. The effect is documented across various markets and periods, but comes with pronounced drawdowns during trend reversals.
A distinction is needed between a trend and trend persistence. That a trend exists is a statement about the past and trivially verifiable. That it will continue is a statement about the future and needs statistical justification. Confusing the two is the most common mistake in practical application.
See for yourself: uptrend or not?
Six price series. Apply the definition from above before you click an answer.
Summary
- Higher highs and higher lows, that's the entire definition.
- A trend only becomes identifiable in hindsight.
- That a trend exists is history. That it continues is a claim.
Did you get it?
How is an uptrend defined?
Through consecutively higher highs and higher lows.
Why does every trend claim lag?
Because an extreme point only becomes recognizable as such after a counter-move.
Which trend effect is best empirically supported?
Momentum over medium time frames, though with sharp drawdowns at turning points.
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 3
- Moving averagesStage 3
- Chart patternsStage 3
- Matching questions for this stageQuestions