CHAPTER 5

How to Identify Trends

The greatest wealth is a poverty of desires.

—Seneca (4 BCE–65 AD)
Roman philosopher and statesman

Strategy to Professional Status: Part IV: Phase 1

This section is split into two chapters, as follows:

Phase 1: Identifying trends.

Phase 2: Identifying patterns.

This section is the first part of a two-fold phase to Part IV. The first is to identify which of your selected shares have trends that comply with your strategy, and secondly, to identify trading patterns.

Identifying Trading Trends

Aim: To determine whether the share is liquid.

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Candles

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As a precursor to this lesson on technical triggers, I would like to introduce the concept of candlesticks to you. These are similar to bar charts, but candlesticks are more graphic, in that they display a range of information that is often critical for traders to see at a glance. In addition to opening and closing prices, candlesticks display high- and low-price statistics.

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In the preceding chart, the filled black bar indicates that the share closed weaker than its opening price. However, if the closing price is higher than the opening price, then the block in the middle will be white or hollow. Note that the top of the block is the opening price and the bottom of the block is the closing price.

If you are to use candlesticks as your preferred trigger to display shares and other securities, then it is important to understand the following:

Type

Explanation

Hollow candlestick

Occurs when the closing price is above the opening price.

Black-filled candlestick

Occurs when the closing price is below the opening price.

Real body

Displayed by the hollow or filled section of the candlestick.

High/low range

•  Displayed by the thin lines above and below the body.

•  These lines are also called shadows.

•  Top of the upper shadow is the high.

•  Bottom of the lower shadow is the low.

Upper shadows

Signifies a high-trading session.

lower shadows

Signifies a low-trading session.

Long bodies

Indicates a strong buying or selling activity.

Selling or buying pressure

Signified by a longer body.

Poor buying or selling activity

Signified by a short body.

The purpose of using candlestick charts is to effectively see the basic price statistics in graphic form. I recommend that traders get used to using these charts, instead of the normal line charts as:

Candlesticks are easily displayed, and thus, analysis is instant. They are perfect starting charts for novice traders to start chart analysis.

Candlesticks can be used to identify reversals from an uptrend to a downtrend or the opposite.

Professional traders usually combine single, dual, and triple candlestick formations with support and resistance levels to obtain more accurate trading signals or triggers. Now that we have covered the preferred diagram method, let us move to the business of technical analysis.

Phase 2 looks at how we determine a trend.

Does a Trend Exist?

Trend lines are essentially a line drawn on a graph that touches three points. If drawn correctly, trend lines can be as accurate as any other method, but many traders make the mistake of trying to make the line fit their strategy.

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Therefore, an uptrend or downtrend line is drawn along the bottom of easily identifiable support areas, called valleys.

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In an uptrend or downtrend, the trend line is drawn along the top of easily identifiable resistance areas, called peaks.

How Do You Draw Trend Lines?

To draw trend lines properly, all you have to do is locate three major tops or bottoms and connect them. The following figure highlights up, down, and sideways (also ranging trends) trends.

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Note the following:

Two points touching a line at the top and at the bottom define a valid trend line.

However, if three or more points touch the line, the trend is confirmed.

Trend lines are strong indicators when many points touch the line, but these become less reliable if the line is very steep.

What are the Support and Resistance Levels?

Also extremely easy to draw, support and resistance lines have become widely and popular used signals in trading. Let us take a look at the basics first.

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In the preceding chart, the share price is moving strongly upward, bouncing off the support and resistance levels. It can be said that the share is in a bull run, as each support level is getting progressively higher. This is also called higher lows, as each day’s lowest price is actually higher than the previous day’s lowest price.

In addition, the resistance level is also getting progressively higher. This is also called higher highs, as each day’s highest price achieved by the company is actually higher than the previous day’s highest price.

There are a number of exceptions that tend to be better viewed when using candlesticks. There will be times when a share seems to break through its support or resistance level, only to resume its previous trend. Experts suggest that this is a possible change in investor sentiment, and the share is now testing support or resistance levels.

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How do novice traders know whether support and resistance have really been broken?

Unfortunately, there is no definite technical answer, other than to use the break as a warning that a support or resistance level may be broken. One possible way is to have multiple support and resistance lines, which some experts call zones.

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The preceding graph highlights some interesting aspects:

When the stock price breaks through the first support level, the share can move higher to form a new support/resistance level. When this occurs, the support level effectively becomes its new resistance level.

When a support or resistance level is broken through, the ability of the share price to form new levels depends on the strength of the new momentum.

Now that the basics of trend lines and support/resistance levels have been set out, let us look at how to apply these in trading. There are two simple trading techniques, namely, the bounce and the break.

The Bounce

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A basic method of using support and resistance levels to trade is to buy equities after a share bounces off the support. Too many novice traders tell me that they want to buy shares before the share hits the support. After all, they say, you cannot get the share once it hits the support level. There is some truth to that statement, as many institutional buyers often mop up shares if they fall below value.

However, the problem of buying before the share hits the support level is that it may not stop at the level. Many traders make the error of setting their buy or sell orders directly on support and resistance levels. What actually happens in the market is that everyone else has the same strategy—so, your position gets sold just before the share bounces.

After all your trading strategies, you get sold out of your position because your stop loss was not just below the support level.

If you intend to buy a stock, first wait for the share to bounce off the support level. If you already have the share in your portfolio, have a stop loss just below the support level. That way, if the share falls to the support and major selling occurs—and the share bounces—you will have kept your position.

If you are a student of human behavior, you will identify that many people repeat the same thing over and over again. So, if a share falls or climbs to a zero or a five position, many times the share will be sold or bought. For instance, if a share fall from 115 cents, it is likely to be bought at 100 cents or 95 cents. The trick is, thus, to have your stop loss at the seven or three, that is 97 cents or 93 cents.

The Breakthrough

As a trader, it is important to have a strategy when you have identified that the support or resistance levels are no longer adequate. Here are a few basic strategies to follow:

You can be aggressive and dump your stock when it gets to your stop loss or move the support line to the resistance level if the share comprehensively breaks through the resistance level.

You can sit back and see the share fall through your stop loss in the hope that prices will return to original trends.

Sell at your stop loss, wait for the pull back and buy the stock. In this case, the buy signal is your original stop loss.

Draw the Channels

Channels are no different to support and resistance lines, except that channels are parallel lines following the same angle of the uptrend or downtrend. A channel’s top and bottom lines represent potential areas of support or resistance.

In fact, the bottom of a channel is usually a buy trigger, while the top of channel is a sell trigger.

There are essentially only three types of channels:

Rising channels (higher highs and higher lows).

Falling channels (lower highs and lower lows).

Sideways channels (ranging).

Moving Averages

A moving average is calculated by taking the average closing price of a security for a defined period of time. On the following chart, two moving averages have been used, a 21-day MA and a nine-day MA.

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There are two basic types of moving averages, as follows:

Simple

Exponential

Simple Moving Averages (SMA)

A simple moving average (SMA) is calculated as follows:

A nine-day MA: You would add up nine days of closing prices and then divide that number by nine. Each day, the last number is dropped and the new closing price is added and then the total is divided by nine.

Charting systems do the calculations instantly.

The aim of moving averages is to compare the current price to its average, as determined by the last defined period. The moving average provides the trader with an ability to gauge the general direction of its future price. Using SMAs, traders can assess whether a pair of averages (like the nine- and 21-day MA) is moving up, down, or sideways.

The interesting aspect of moving averages is that, they forewarn of a possible changing trend.

Exponential Moving Average (EMA)

Exponential moving averages (EMAs) give more weight to the most current price movements. In the preceding example of a nine-day MA, the EMA would put more weight on the prices of the most recent days, which would be Days 7, 8, and 9, and thus less relevance on the earlier days.

SMA versus EMA

Traders combine SMA and EMA to identify short- and long-term trends. These are discussed in greater depth in later chapters. Suffice to say that these averages can be used by traders as early warning signals.

The rule is that, the shorter period the MA is, the quicker the signal will respond to a price action. The downside to using the moving averages is that technical triggers can incorrectly indicate a sell signal. This occurs during share price consolidation or a slowing down of trading activity prior to an expected cautionary announcement.

For instance, if a trader wants to assess a general trend, he or she would use a longer-term SMA and a shorter-period EMA to create a buy trigger.

Let us reiterate: An SMA helps traders to determine a trend. However, using two averages simultaneously can forewarn of a potentially changing trend. The simplest way is to just plot an SMA on a chart. When a share price is above the moving average, it signals that price is in a general uptrend. If price is below the moving average, then it indicates that it is in a downtrend.

The following chart highlights these trends:

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The following use of two averages on charts gives traders a clearer signal of whether the pair of averages is trending up or down.

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In an uptrend, the faster moving average (nine-day MA) should be above the slower (21-day MA) moving average.

In a downtrend, the slower moving average should be above the faster moving average.

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Moving Average Crossover Trading

Traders will notice that, by using two averages, there will be times when these cross over each other. If the nine-day MA crosses over the 21-day MA upward, it is a buy signal. Conversely, if the nine-DMA crosses the 21-DMA downward, it is a sell signal.

Volume

We have set out trends, channels, resistance and support levels, and outlined moving averages. The next logical step is to understand what the market sentiment is toward a proposed stock selection.

I always recommend a top-down approach. First, look at the overall market sentiment (exchange volume), follow that with an assessment of the sector sentiment (index volume), and finally, sentiment in the actual stocks (share volume).

The Importance of Volume

Many technical traders state that they will not even assess a share unless there is enough volume of buyers and sellers, which enables them to have entry and exit levels. The following are some reasons provided as to the importance of assessing volumes.

General market strength. A significant share price movement is always linked to increased trading volume, so volume analysis must always form part of your technical analysis.

Existing trend strength. Price movement can either be up or down. So, if volume is high, you need to assess whether there are more buyers than sellers or the opposite.

Sector shifts. The volume of trades in an industry is crucial in predicting buyer sentiment within all the sectors and also whether one sector’s strength will mean a trend reversal in another sector.

Supply and demand. If the calculation of volume is simply the number of shares traded during a specified time frame, then the greater the demand for the share over supply, the stronger the upward pressures on price.

Reversal points. This means that volume can be used to determine entry and exit levels as the trading volume is one of a few leading technical triggers that shows traders when and where a change in market sentiment could occur.

Institutional trading. After a protracted rally, institutional traders often sell stocks because the uptrend is close to the end. Additionally, unlike many indicators, volume is applicable to every timeframe and must form part of a serious trader’s strategy.

Volume and Sentiment

Exchange Volume

Exchange volume represents the sum total volume of all stocks in a particular exchange or stock market, and thus, is a predictor of general market mood or sentiment.

For me, analysis of such technical indicators helps reveal bullish and bearish markets, define bottoms of the stock market crashes and tops of the market madness.

Index Volume

Index volume represents the total volume of all stocks included in a particular index.

What many novice traders do not understand is that an index is made up of some, and not all, stocks in a sector. Therefore, the volume of an exchange’s property index would be sum of all companies indicated as blue chip for that sector.

Thus, index volume represents the trading activity in a particular market sector or particular group of stocks that are covered by this index. Index volume also helps to define the money flow and sentiment in specific market sectors.

Stock Volume

Stock volume is the number of shares of a security that are traded (bought and sold) during a specified period of time.

It tells you how many shares changed hands between buyers and sellers. In essence, stock volume represents the volume of a specific stock and defines the liquidity of that stock.

Chapter 6 is a more comprehensive study of technical triggers.

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