Understanding what makes a trend is essential for gauging market direction effectively. All the tools used by a trader such as support and resistance, trend lines, exponential moving averages, etc., have the single purpose of measuring the trend in the market so as to be able to participate in that trend. We’ve all heard the phrases “always trade in the direction of the trend” and “the trend is your friend” and “ride the trend to the end”. Let’s take a look at how to define a trend in the market.
The trend is simply the direction of the market. But we need a better idea of what that actually means. Markets don’t usually move in a straight line in any direction. Typically, they move in what can be described as zigzag patterns. To be more precise, a series of zigzag patterns. The zigzags look a lot like waves with their peaks and valleys. It is these peaks and valleys that show the market trend. The trend is more clearly defined by whether this series of peaks and valleys is moving up, down or sideways. Trends have only three directions: up, down or sideways. It’s very important to be aware of this as most beginning traders think only in up or down.
A rising trend can be defined as a series of higher highs (peaks) and higher lows (valleys). Conversely, a descending trend can be described as a series of lower highs (peaks) and lower lows (valleys). When the peaks and valleys are roughly equal or have higher highs and lower lows, or lower highs and higher lows, the trend is described as being in consolidation or a ‘trading range’.
A trend also has three trends associated within it: the major, the minor or intermediate, and the near term. There is some ambiguity among traders as to how each trend is classified, but Dow Theory says the major trend is one lasting at least a year though I would say that for the currency markets something over six months would be long term. Dow defined the intermediate or minor trend to be three weeks to six months. The near term is two weeks and lower. The intermediate and near term trends become parts of the larger trend as seen below:
In general , most trend following approaches deal with the intermediate or minor trend.
Using Trend Lines
Trend lines are applied to charts by connecting swing lows (higher lows) on rising trends and swing highs (lower highs) on descending trends. When a trend is sideways (in consolidation) direction lines are marked on both the top and bottom.
Of course, trend lines can be marked on the top and bottom of rising or descending trends as well but they are defined with terms such as channel, wedge, triangle, pennant, etc.
Moving Averages for Defining Trends
Moving averages (MA) are another way of defining a trend. Though moving averages are a lagging indication of market direction, they are none the less useful in giving an idea of trend strength.
A minimum of two moving averages are needed to define a trend’s direction. When the two moving averages cross, the trend is considered to have changed direction. The issue with this definition is that the pair of moving averages can cross each other and then cross again very quickly in the opposite direction. It is for this reason I don’t recommend using moving averages to determine when the trend changes, but only to use them for trend strength. Trend strength is shown by how far apart the moving averages are from each other. The farther apart, the stronger the trend.
There are only two ways to define a trend. One is zooming out on the chart and using your eyes to determine which way price in moving. The second is to use trend lines connected to swing points with breaks and re-tests of those trend lines to confirm a change in trend.
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