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A Primer on
Technical Analysis
II. The Trend is your Friend
The concept of a trend is absolutely
essential to the technical approach to market analysis. All of the tools
used by the chartist - support and resistance levels, price patterns,
moving averages, trend lines, etc. - have the sole purpose of helping to
measure the trend of the market for the purpose of participating in that
trend. In a general sense, the trend is simply the direction of the
market, which way its moving. But we need a more precise definition with
which to work. First of all, markets don't generally move in a straight
line in any direction. Market moves are characterized by a series of
zigzags. These zigzags resemble a series of successive waves with fairly
obvious peaks and troughs. It is the direction of those peaks and troughs
that constitutes market trend. Whether those peaks and troughs are
moving up, down or sideways tells us the direction of the market. An
uptrend would be defined as a series of successively higher peaks and
troughs; a downtrend is just the opposite, a series of declining peaks
and troughs; horizontal peaks and troughs would identify a sideways
price trend.
The troughs are called support. It
indicates a level or area on the chart under the market where buying
interest is sufficiently strong to overcome selling pressure. As a
result, a decline is halted and prices turn back up again. Usually a
support is identified beforehand by a previous reaction low. Resistance
is the opposite of support and represents a price level or area over the
market where selling pressure overcomes buying pressure and a price
advance is turned back. Usually a resistance level is identified by a
previous peak. In an uptrend, the support and resistance levels show an
ascending pattern, while in a downtrend, the support and resistance
levels are descending. In an uptrend, the resistance levels represents
pauses in that uptrend and are usually exceeded at some point. In a
downtrend, support levels are not sufficient to stop the decline
permanently, but are able to check it at least temporarily. A solid
grasp of the concepts of support and resistance is necessary for a full
understanding of the concept of a trend. For an uptrend to continue,
each successive low must be higher than the one preceding it. Each rally
high must be higher than the one before it. If the corrective dip in an
uptrend comes all the way down to the previous low, it may be an early
warning that the uptrend is ending or at least moving from uptrend to a
sideways trend. If the support level is violated, then a trend reversal
from up to down is likely.
Most technical tools and systems are
trend-following in nature, which means that they are primarily designed
for markets that are moving up or down. They usually work very poorly,
or not at all, when markets enter these lateral or "trend less"
phases. It is during these of sideways market movement that technical
traders experience their greatest frustration, and systems traders their
greatest equity losses. A trend-following system, by its very
definition, needs a trend in order to do its stuff. The failure here
lies not with the system. Rather, the failure lies with the trader who
is attempting to apply a system designed for trending markets into a non trending
market environment.
There are three decisions confronting
the trader - whether to buy a market (go long), sell a market (go
short), or do nothing (stand aside). When a market is rising, the buying
strategy is preferable. When it is falling, the second approach would be
correct. However, when the market is moving sideways, the third choice -
to stay out of the market - is usually the wisest.
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