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«Diversification is protection against ignorance.
It makes little sense if you know what you are doing.»

(Warren Buffett)

According to the Dow Theory’s fundamental principle we know that “prices move in a trend”, so the main chartist’s task is to identify these trends and follow them.

That’s it. As a matter of fact, price trends is nothing but the market’s direction: being able to identify that direction allows the trader to enter profitable positions which can be kept until a trend reversal occurs. However, either because of a limited financial availability or because of a sort of “gambling mania” deriving from on-line trading, many investors progressively moved the importance of trend analysis to the background.

Actually, beginning traders will hardly get interested in trend analysis and in constructing a balanced portfolio as a natural consequence of it: a novice would-be trader instead usually prefers to put his efforts in intraday analysis or, in the worst case, in a scalping activity, thus dedicating very little time to technical analysis of price charts . What a big mistake!

The newbie, even if he starts to study the trading basic principles, he quickly puts them aside, convinced that it is much important to learn some kinds of sophisticated techniques but being unable to simply identify a mere market’s direction. Before even thinking to a scalping activity or a quick intraday analysis, it is necessary and essential to perfectly know market’s dynamics in order to technically understand the quality behind a price rally or a price drop.

Uptrends and Downtrends

We have an uptrend (bull market) when every relative low is higher than the previous one: during this market phase, both prices and volumes grow enticing more investors as the trend keeps unfolding.

Trend 1 sample.jpg
Price unfolds from the bottom-left corner to the top-right corner. That’s a classical uptrend.

Conversely, a downtrend (bear market) is characterized by falling prices and growing volumes and by the fact that each relative high is lower than the previous one. Dow used to explain this phenomenon with a suggestive metaphor involving seas high and low tides: a growing market is compared to the growing phase of a high tide, during which the water flow even if it retreats between each wave, constantly gains territory. For a bear market, the opposite is true. The first signal of a possible trend reversal will lie in the market’s failure to create a new higher high (lower low).

Trend 2 sample.jpg
Price unfolds from the top-left corner to the bottom-right corner. That’s a classical downtrend.

Neutral trend

Last but not least in this classification of trend directions, we have the neutral trend or sideways trend in which prices move in a range without giving any relevant trading opportunities. Short-term upward phases are immediately followed by downward phases and prices tend to remain essentially on the same level.

Trend 3 sample.jpg
Price without a defined tendency, ending to the middle right side of the screen. That’s a classical sideways trend.

According to some prudent statements, markets move in a sideways trend almost 1/3 of the time, in a substantial balance between buyers and sellers. Identifying these trends is very important since traders very often attempts to catch extreme price levels, remaining sometimes trapped and paralyzed in a stagnating market which has no definite tendencies. Of course, it is possible to see the just mentioned types of trend in an intraday chart as well, where we can find the same trends of a weekly, daily or yearly chart.

Time in a trend

Besides the direction of the trend, if we also take into account the time when analyzing a tendency, we would be able to recognize different kinds of trend. The major trend, which is the main tendency acting in the market and which involves multiyear price cycles providing us indications on the long term direction (from 2 to 4 years or more), the intermediate trend which is a correction in the major trend (from some months to a couple of years) and finally the minor trend, represented by the short term fluctuations inside an intermediate trend lasting not more than two months.

Obviously, a daytrader focuses mainly on intraday levels, often using a 5 minutes chart or even smaller timeframes. Sometimes anyway he uses a 15 minutes chart paying attention to the previous days in order to find key support and resistance levels, thus mixing the intraday analysis with a multiday approach.

The probability for a major trend reversal is greater if the market has already had a phase of accumulation or distribution, characterized by noticeably rising volumes. Knowing how to discern between a valid intermediate movement and the early stages of a new major trend appears to be very important so prices cycle is the ideal theoretical model to this issue. This is maybe the most difficult part of the theory to interpret but it is without any doubt the most decisive as well.

If we want to technically manage a position, we necessarily need to take into due account the ongoing trend both for setting a stop and evaluating the risk of our investment; when we do focus our attention on the very short term trend we risk to incur in the stress of a frenetic activity, missing the chance to catch the truly profitable movements in a stock’s chart.

Trend’s strength

There are neither too high prices for a bull’s horns or too low prices for a bear’s claws. The way in which prices reach some levels is measured thanks to the trend’s strength defined as follows:

1) linear strength when prices show a grow rate which is constant in time.;

2) exponential strength when the grow in prices is broad and violent with frenetic exchanges, gaps and price bursts . This is typical for the latest stages of a trend.

We can generally say that the stronger is the increase of a trendline, the greater is the probability of a correction. In other words, there’s a proportional correlation between time and price.

Price movements are not all equal though: downtrends are much faster than uptrends. This is due to the fact that during an uptrend many investors who bears different expectations intervene gradually building their positions in different moments, thus conferring the trend a fluid conformation. Besides that, when we find ourselves in front of an uptrend we can find many great points where to buy, but usually there is only one technical point where to bail out.

Furthermore in a downward trend, the main investors need is to preserve their realized profits and to protect themselves against price drops, so because of this reason every kind of trader come into the market at once giving the trend a much greater speed.

A consideration...

Descartes, French philosopher, wrote:

" it is more likely that the truth would have been discovered by few than by many" ...

for the traders, it means:

"once the trend direction is clear to all of us, it is likely to change "...

A nice thought, too bad that it's in the DNA of aspiring traders to fail to follow the trend and think that, when one thing is clear, it will probably change direction. The strongest trends have produced cobbled streets of tombstones, the epitaph is always the same:

Here lies a trading account which financial death came before the price reversal happened.
But don’t be sad, ideas never die and, sooner or later, the movement will end.
In that moment, the evidence will coincide with the general change of opinion.

A wannabe trader, always contrarian, will always have an apparently valid reason not to follow the trend. At least until they run out of money, then he can spend his time saying that technical analysis doesn’t work ...

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