Thursday, February 09, 2017

Swing trading with candlestick charts

This article was written in 2009. 

The Japanese Candlestick chart is currently the most popular price chart. It is interesting to know that the Japanese Candlestick chart had been used in Japan since the 18th century. It was developed by a Japanese rice trader named Munehisa Homma. Munehisa Homma, considered one of the most successful traders in history, claimed that the psychological aspect of the market was extremely critical to trading success. The emotions of traders were reflected in the prices and showed in the candles.
A candlestick consists of the candle body and the shadow; the body denotes the opening and closing price whereas the shadow denotes the intra-period high and intra-period low. The period can range from one hour, one day, one week to even one month depending on the time period. The color of the body depends if the bulls or bears have won the period. If the bull has won and the closing price is higher than the opening price, then the body is white in color. If the bear has won, which means that the closing price is lower than the opening price, then the body is black in color. Therefore, with just a glance, a person can easily see if the bull or bear has won within a period.

A candle pattern can be a single candlestick or multiple candlestick lines. Most candle patterns are inversely related. For each bullish pattern, there is a similar bearish pattern. The primary difference is their position relative to the prior trend of the market.

In this article, we will study two single candlestick reversal patterns: The Hammer and the Hangman.

The Hammer


Hammers are found at the bottom of a downtrend. For the past few days, the bear was very strong and was victorious in the battle, thus, a number of black candles appeared and the price trended down. One fine day, when the bear was expected to win the day again, the bull appeared out of nowhere and ambushed the bear! This shows that the market has a very bullish feel about it, hence chances of stock price changing to a short term uptrend is higher.






 









Figure 1: Hammer candle

There are several criteria that must be met:

       -          Hammers are usually seen at the bottom of the trend
       -          The shadow must be at least twice the size of the body
       -          Can exist in both white or black
       -          Very little or no upper shadow

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Figure 2: Hammer with white candle confirmation

As seen in Figure 2, there was a preceding downtrend before we observed that a Hammer had formed, which was then followed by a white confirmation candle.





Figure 3: Double Hammer with white candle confirmation


Figure 3 is another example of a Hammer. Instead of having a single Hammer, another Hammer appeared the next day, which signaled that the bull was fighting very hard to win the battle, thus signifying a bullish trend.

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The Hanging man


As the name implies, the Hanging man has a bearish connotation. The story is very similar to the hammer but with opposite roles. This time, the bear ambushed the bull and the market has a bearish feel to it.




Figure 4:  Hanging man candles

There are several criteria that must be met:
-          Hanging men are usually seen at the top of the trend
-          The shadow must be at least twice the size of the body
-          Can exist in both white or black candle
-          Very little or no upper shadow



 Figure 5: Hanging man candles foretell a bearish feeling



Figure 6: The Hanging man foretells a major retracement



Both Hammer and Hanging man candles look the same but appear in different trends. Look for the Hammer when stocks have been coming down and look for the Hanging man when the stock has been continuously going up. When the Hammer or Hanging man appears, it signifies a possible strong trend reversal.

The examples above are screened using ChartNexus software with XPertTrader (www.chartnexus.com). The Hammer and Hangman are two of the patterns that are taught in the ChartNexus Candlesticks Analysis (CCA) course. Apart from learning about various types of candlesticks patterns, ChartNexus trainers also educate participants on how to combine candlesticks analysis with various indicators to achieve the all-important upper hand in trading.

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This article first appeared in Smart Investor in 2009. 
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.

Thursday, February 02, 2017

Bollinger Band - Trading on Volatility

This article was written in 2007.

With emerging markets like the Chinese and Indian economies growing at a fast pace and recording high percentage growth year over year, the bullishness has spilled over to the global stock markets with all major indices hitting new highs at the end of 2006. However, it is unlikely that the world indices will continue to scale up without any corrections. A classic example of a worldwide market correction occurred when the Chinese stock market recorded a near 9% drop in a single-day in Feb 2007. This together with the Yen Carry Trade triggered a chain reaction of global stock markets melt-down.  Since then, global markets had a fast recovery with the likes of the STI index touching the 3500 points and the Dow Jones breaking the 13000 points barrier in April 2007. The example of global markets melt-down and fast recovery demonstrate how volatile the stock market can be. The willingness to take a higher risk is heavily linked to the fact that people are better educated and information is easily available with the help of the internet.  Moreover, the one factor in the stock market that has not changed since its establishment is market psychology. The human psychologies of fear, greed and hope remain the main culprits of the high volatility in the stock market. 

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The Bollinger Band, developed by John Bollinger, is widely used by traders to trade the market effectively. The Bollinger Band is constructed using 3 lines; the upper Bollinger band, the Simple Moving Average line (SMA) and the lower Bollinger band. The upper and lower Bollinger bands are usually placed at a distance of 2 standard deviations above and below the SMA respectively. Standard deviation is a mathematical term in which the value is proportional to the volatility of the price movement. SMA line is the averaging of the close price over a certain number of days.  Hence, when the stock is trading sideway or the price volatility is low, the upper and lower bands will converge toward the SMA line. On the other hand, the upper and lower bands will begin to widen and move away from the SMA line when there is substantial fluctuation in the stock price. This article will look in the different ways that Bollinger Bands are used. 

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The first application of Bollinger Band is its use in providing an indication of support and resistance level. As we expect prices to move in between the upper and lower bands, the upper band acts as a resistance level to more upsides while the lower band acts as a support level to more downsides.  The following shows how the upper and lower bands provide support and resistance to the price movement.


Figure 1: Use of Bollinger Band as Support and Resistance

During the month of January 2007 to April 2007, FerroChina’s stock price was well-resisted by the upper band, refusing to break new grounds. On the other hand, during the price retracements in early March 2007 and late April 2007, FerroChina was able to find good support level at the lower band that prevented the price from diving further.  


The second application of Bollinger Band is in the powerful Bollinger Squeeze which trigger high probability buy and sell signals. The Bollinger Squeeze occurs when a stock protracted to a period of low volatility has the upper and lower bands appearing to be squeezed together. A buy or sell signal is generated when there is a Bollinger breakout from this squeeze of the lower and upper bands. Figure 2 shows the occurrence of the Bollinger Squeeze and the subsequent Bollinger breakout when the upper and lower bands begin to expand suddenly.


Figure 2: Bollinger Squeeze and Subsequent Bullish Breakout

During the period of January 2007 to March 2007, the big gap between the upper and lower bands shows that Hyflux was trading with high volatility. However in Apr 2007, Hyflux started trading sideways and as a result, the upper and lower bands contracted and squeezed together, indicating the occurrence of the Bollinger Squeeze. A Bollinger breakout then happened when both bands suddenly diverged with the price hugging the upper band thereby triggering a bullish signal. The reverse is true for a breakout to the downside. This is illustrated in Figure 3 where a Bollinger Squeeze was formed in April 2007 with the subsequent bearish breakout happening on 23rd of April 2007.


Figure 3: Bollinger Squeeze and Subsequent Bearish Breakout

We can further enhance the Bollinger breakout after the Bollinger Squeeze with another indicator thus increasing the probability of making a trade in the right direction of breakout. One popular indicator that can be used together with the Bollinger Squeeze is the Relative Strength Index (RSI) which was developed by J. Welles Wilder. The RSI is a powerful indicator used to measure the velocity of the price movements and the values are calculated based on the number of days that the price closes up and the number of days that the price closes down over a certain period of time. In this article, the period of time used is 14 days which is originally proposed by Wilder. Let us re-visit the earlier chart (Figure 2) which featured Hyflux where a buy signal was generated by Bollinger Squeeze on the 25th Apr 2007. An analysis of the RSI indicator shows that the RSI was well supported during the Bollinger Squeeze and was trending upwards as the price approaches Bollinger breakout. This signifies that the price action remain firm throughout the Bollinger Squeeze and it grew in strength as breakout came beckoning. Figure 4 shows the chart of Hyflux using RSI indicator in conjunction with Bollinger Band.


Figure 4: Usage of Bollinger Squeeze with the RSI indicator

The above scenario of combining RSI and Bollinger Band in our analysis can be easily captured by using an automated software program which could save a significant amount of time from looking for these opportunities. One such software is ChartNexus XPertTrader (www.chartnexus.com) that can be used to automatically screen the whole market for stocks that have Bollinger Squeeze together with the RSI trending higher. 


This article has highlighted the importance of understanding the volatility of the stock market in order to make profitable trades. A powerful indicator such as Bollinger Band is widely used to identify buy and sell signals based on two applications. The first involves using the bands as support and resistance with the second involving looking for a Bollinger Squeeze followed by a Bollinger breakout.. Combining Bollinger band with the RSI indicator also increases significantly the probability of the signal being valid.

This article first appeared in Smart Investor in 2007. 
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.

Wednesday, January 18, 2017

Continuation Patterns

This article was written in 2007. 


In the last issue we shared how to trade short term price patterns. In this article we will share another form of price patterns known as the triangles or continuation patterns where price is expected to breakout after consolidations. They are also well known as intermediate or near term patterns.  Although they are essentially continuation patterns, but sometimes they act as reversal pattern as well. Let's begin our discussion with a introduction to ascending triangle.

The ascending triangle will have a flat resistance and a series of higher lows.  While the price met with resistance at one particular price, it must be observed that buyers are very keen and that the dips from the resistance is higher one after another.  Breakout happens when the resistance finally gives way.  Ascending triangle breakout is biased to the upside and one should note where the breakout occurs.  The best breakout of triangles happens away from the apex of the triangle.

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Figure 1: ascending triangle example


As shown in Figure 1, the price chart of Boustead shows a resistance at $2.03 thereabouts.  For 3 months from Apr'07 to Jun'07, it is unable to breakout from this resistance.  However, it must be noted that the price retracement from the resistance achieved the higher low characteristic.  This is a very bullish sign as it meant that investors are very keen to buy and the buying pressure is strong as the price is unable to trade lower. On late June'07, the price broke out of the resistance and went on to new high.  Do note that it is away from the apex of the triangle.

Second in line is descending triangle. As the name suggest this price pattern is biased to the downside. Instead of a flat resistance as in the case of an ascending triangle, for a descending triangle we will be looking out for a flat support. The price will have seem to have found support at a particular price and that gives investors an impression that the price seems to be holding at this level very well. Not obvious to the untrained eyes, every price rally is actually getting lower. Then a breakout to the downside will catch investors unaware.  

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Figure 2: descending triangle example



As shown in figure 2, the price chart of Unionmet shows a flat support at $0.51  thereabouts.  For nearly 3 months, the support gave a false sense of security to investors because while the support is holding well, every price rally is getting lower and lower.  It is suggesting strong overhead selling at every rebound.  Investors should be cautious of such characteristic.  This is a very bearish sign as it meant that investors are very keen to sell and the selling pressure is strong as the price is unable to trade higher.  In middle of Jul'07, the price broke out of the support and went on to new low.  Do note that it is away from the apex of the triangle.

Last but not least, symmetrical triangle.  This price pattern can breakout either to the upside or downside.  Price will trade lower high as well as higher low, converging towards the apex of the triangle.  It's like the buyers and sellers are very balanced in power and the price was traded in a converging manner until a breakout to either side happens.

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Figure 3: symmetrical triangle example


As shown in figure 3, the price chart of HiapHoe shows converging lower highs and higher lows.  While the ascending and descending triangle pattern dictate the market tone, where it is bullish and bearish respectively, symmetrical triangle dictates a balance between buyers and sellers.  Hence it is only after a break to either side then only can we conclude whether it is trending higher or lower.  From early Nov'07 to late Dec'07, we can see that every price rally is lower than the previous attempt and every price retracement ends up higher than the previous.  A breakout to the upside then occurs in late Dec'07. 

There are other essential factors to consider when we are trading triangle patterns. The best triangle is formed between one month to not more than three months. The volume should be drying up as the price trades towards the apex of the triangle.  Upon breakout of the triangle pattern, volume should be significantly higher. It will be even more bullish if the price gaps up in the breakout.

In this article we have discussed the 3 types of price patterns known as the triangles.  Breakout of triangles should not be too close to the apex and that it should be accompanied with heavy volume.  The time taken for the triangle pattern to form should be between one month to 3 months typically.




This article first appeared in Smart Investor in 2007. 
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.

Tuesday, January 10, 2017

Understanding Price Gaps

This article was written in 2007. 

Overnight closing on Wall Street, ground breaking news and surprising positive or negative announcements never fails to excite investors.  Stock prices responded by bursting into the perceived direction in an explosive manner as investors poured into the market.  This exuberant mood resulted in a vacuum between the last traded price and the previous.  In technical analysis, this vacuum in price is known as a price gap.  There are 3 types of price gaps worthy to look into and we shall study their characteristics and discuss how to trade them.
     
A gap occurs when the lowest price of a specific period is above than the highest level of the previous trading period.  The specific period can be that of a daily chart,  weekly chart or any other time frame.  The gap is represented by an empty vertical space between one trading period and another.  It can be formed by overnight good or bad news disseminated by the market.  A gap is considered “closed” when the price retraces the whole range of the gap.  By definition, all gaps will be closed.  However it is noted that while many gaps are closed within days or weeks, there are some which took months or years to close.  You can only imagine how much the price has to retrace to close a gap many months later.  Price gap is a result of irrational decision to buy or sell at any price  the equity is trading at and hence when rational thinking returns to the investors, they will start to unwind positions and thus lead to the closing of price gaps. Trading strategies can then be deployed in anticipation that the price will close the gap either partially or completely.
A breakaway gap is created when the price breakout from a chart pattern.  Generally, price gap symbolized the bullishness or bearishness of the breakout as per the direction.  It will be useful if we combine this analysis of breakout with volume confirmation.  Typically we would like to see breakout to the upside with heavy volume.  However, breakout to the downside does not require heavy volume.  


Figure 1: Breakaway Gap


In Figure 1, Aztech formed an ascending triangle price pattern which is bullish in nature.  It broke out of the price pattern accompanied by a price gap up.  As an ascending triangle is biased to the upside, the breakaway gap added more bullishness in the direction.  It must be noted that the volume accompanying the breakout is high as well.
     
A Continuation gap occurs during a sharp price movement in advance or decline.  This type of gap often occurs halfway between a previous breakout and the ultimate duration of the move.  It is normally accompanied with positive news and investors reacted to it in an exuberant manner. 


When a price contains more than one runaway gap, it indicates that the trend is very powerful.  However, market participants should be wary if there is a presence of a second or third gap as this is a sign that the move is likely to be out of steam soon.  There is a possibility that a second or third runaway gap may be the last one.  Hence an exhaustion gap is associated with the termination of a preceding move and is the last in a series of runaway gaps.  One good clue would be to look at the volume.  Exhaustion gap is normally accompanied with unusually high level of volume.  It is important to note that, exhaustion gap signals a likely price consolidation after the termination of a move and may not regarded as a major reversal.

Figure 2: Continuation Gap & Exhaustion Gap

As shown in Figure 2, after Genting International had been awarded the Sentosa IR project, investors reacted positively and price gaps up on 11th Dec 2006.  In the same month, stock price continues to gap up as investors continues to savor the happy occasion and great expectations from the news.  At the third gap up (exhaustion gap), it was observed that the volume was much higher.  Investors should be cautious by now as this is a warning of a potential exhaustion gap and price consolidation is a possibility.

 Figure 3: Continuation Gap with high volume

Osim as shown in figure 3 had a first gap down in late Oct 2006.  3 month later it had another gap down accompanied with unusually high volume.  It qualifies as an exhaustion gap as this is a second gap and since it comes with high volume.  Price then went into consolidation as what is expected from an exhaustion gap.  This consolidation lasted 3 months to late April before the price gaps down again.  

This article has discussed 3 types of price gaps and how we can use them to aid in our analysis.  Breakaway gap is most useful if there is a preceding price pattern.  Continuation gap which extends the preceding movement may lead to exhaustion gap which in turn may hint of price consolidation ahead.  Lastly, volume is a big clue in identifying an exhaustion gap.  

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This article first appeared in Smart Investor in 2007. 

DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.

Friday, January 06, 2017

Fibonacci Retracement – Waiting for the Right Moment

This article was written in 2007. 

IT has been 3 years since the Singapore stock market begun its amazing bull run, scaling to new highs and reaching the all time high of more than 3600 points in June 2007. The exponential increase in trading volume in the stock market shows that more and more beginners may be getting involved in stocks. Most are looking for big rewards and are determined to make a killing to profit from this bullish market. However largely unknown to beginners, the lack of a comprehensive trading strategy or technical knowledge in analyzing the behavior of the stock market is leaving them exposed to high risk. On the other hand, most experienced traders understand the behavior of the stock market well and would know how to anticipate price movements in any given time frame.  For example, some stocks would form a chart bottom formation before resuming the uptrend while some stocks with stronger bullish sentiment would resume its uptrend ferociously. Either way, the experienced traders would know how to identify when is the best time to take up positions where there is lesser risk. Therefore, it is crucial for beginners to learn some form of technical analysis so as to time their trades better. No one likes to buy high and sell low, but not many know how to buy low and sell high.  This article will introduce an effective tool that will help identify the chart bottoms and the best time to enter the stock market. This tool is well known as the Fibonacci Retracement levels. Last but not least, we will also discuss how Fibonacci Retracement can be used to manage and minimize risk in the stock market.



The Fibonacci sequence is a series of numbers that were first derived by Leonardo of Pisa in the 15th century after observing the population expansion of a pair of rabbit. Recognising the importance of Fibonacci numbers to real-life application, mathematicians derived the Fibonacci Retracement levels for trading in the stock market; the latter levels being made up of 6 percentage numbers or lines. Depending on the preferred trading period of the trader, the Fibonacci Retracement lines are drawn for an uptrending stock by first identifying the bottom and then the top. After the identification of the bottom and then the top, we start to calculate the retracement levels between the highest price and the lowest price. Nowadays, this can be done by a simple click of the mouse.  Most charting software in the market allow you to draw the Fibonacci Retracement levels effortlessly.  ChartNexus is one such tool which also comes with free end of day data for download.  The fibonacci retracement levels commonly used are 23.6%, 38.2%, 50% and 61.8% with the most significant levels being 38.2%, 50% and 61.8%. As the saying goes, what goes up must come down.  In an uptrend, a stock will make higher high and higher low.  Fibonacci Retracement is used to identify the price level as it retraces to a higher low before testing the higher high. The first possible level of support for a retracement is usually the 38.2% line. The following figure below illustrates how the 38.2% line is effectively tested as support in the chart of China Energy.




Figure 1 China Energy rebounded off 38.2% level

In the figure above, China Energy began to pullback after forming a top from May 2007 to early June 2007.  On 12th June 2007, the stock tested the 38.2% level and subsequently rebounded off the level. Again, from 24th to 25th June 2007, the stock tested the 38.2% level a second time and rebounded off it. 38.2% in this case served as a very strong support for China Energy.


The following figure shows Tech Oil & Gas rebounding after hitting the 61.8% line. 


Figure 2 Tech Oil & Gas rebounded off 61.8% level

However, the 61.8% line is also known as the last line of defense for the stock price. A break below the 61.8% line usually means that the uptrend of the stock is negated.  In Figure 3, Luzhou broke the 61.8% line on 1st March 2007 (in red) and the stock price went down further thereafter.





Figure 3: Using Fibonacci Retracement lines as support and resistance level

As observed from Figures 1 & 2, Fibonacci Retracement Levels offer very strong support or resistance to the price movement.  In Figure 3, we can see that Luzhou’s stock prices were able to find good support at the 50.0% line from Oct 2006 to Jan 2007. However, in the month of March the 50.0% line turned from support to resistance, resisting Luzhou’s price from heading higher. Similarly in the month of April, Luzhou’s price found resistance at the 61.8% line and went into a downtrend shortly thereafter.
The Fibonacci Retracement levels can also used in conjunction with other indicators to help in analyzing the stock chart. This is known as confluence of signals. The combination of other indicators further enhances and compliments the usage of Fibonacci Retracement levels thus resulting in higher probability of a successful trade. In this article, one of the popular indicators used by many traders, the 100-day moving average is used to analyze the stock chart of Tech Oil & Gas which is shown in Figure 4 below. 

Figure 4: Using Moving Average with Fibonacci Retracement level 

Figure 4 clearly shows that the prevailing trend of Tech Oil & Gas is an uptrend and that the price found support on the 100-day moving average from May 2007 to July 2007 . The next observation is that the price was trading near the 61.8% Fibonacci Retracement level.  While the 100-day moving average is supporting the price movement, Fibonacci Retracement is also providing support at the 61.8% level which is about the same price level as the moving average line.  Hence the price is said to be very well supported because we have the confluence of two types of analysis, namely moving average and Fibonacci levels. 

This article has highlighted the importance of understanding the stock market behavior in order to enhance one's timing of the stock market. A powerful tool such as Fibonacci Retracement is widely used to identify possible support and resistance to the price movement.  This helps experienced traders to buy low and sell high.  In addition, the usage of the Fibonacci Retracement line together with the concept of support and resistance level and the confluence with the 100-day moving average helps to forecast the possible price movement and increases one’s confidence to take the trade.
This article first appeared in Smart Investor in 2007.

DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.



Thursday, January 05, 2017

Determining the direction and strength of trend

This article was written in 2007.

One general rule of thumb in trading is to identify the trend of the stock market. There are 3 types of trend namely uptrend, downtrend and sideway, representing the overall mood of the stock market. In any trend condition, an uptrend, downtrend or sideway represents the mood of the stock market is bullish, bearish or trendless (sideways) respectively. Hence, the trend is commonly determined to help establish a basic analysis for traders to take up long or short position in any stocks. Normally, in a bullish mood or an uptrend, buyers are more likely to take up a long position and buy stocks at higher prices thus pushing the stocks prices to go up. In addition, when the trend is determined, trader can identify the tops and bottoms of the stocks for buying or shorting opportunities. Most traders prefer to trade along the trend as the rise or fall of the stock prices can be anticipated easily and hence reducing risk exposed in the stock market. In the situation of an uptrend market, there are more days the prices of stocks are going up compared to down. Whilst in a downtrend situation, it is the direct opposite. Therefore by following the trend, the probabilities of positive returns could be increased. Moreover, by first determining the trend, traders can plan out effective trading strategies before putting up a position in the stock market. However by determining the trend alone usually may sometime deemed as inadequate to help traders to enter a position in any stocks. Most traders would also like to confirm the strength of the trend to further increase their probabilities of positive returns. The stronger the trend, the higher the probability of riding the trend successfully. Moreover, confirming the strength of trend could help traders to identify any sign of trend reversal. A weaken trend strength would probably indicate the end of the current trend and start of a new trend, which means the beginning of either downtrend or sideways. Thus, this article will look into how trends can be identified and the major technical aspects of the indicator in determining the strength of the trend.

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Trend analysis used to determine the trend can be quite complex. Factors like defining the appropriate time frame and the ability of drawing useful trendlines contributes to the complexity. Nevertheless, there are a few trend analysis popularly used by many traders to determine the current trend. Methods like drawing trendlines and using technical indicators can be utilized to ascertain the trend. Basically trendlines are drawn by connecting 2 points together in a chart - an uptrend line is drawn by connecting 2 points of higher lows and extends to the desirable time frame while a downtrend line is drawn by connecting 2 points of lower highs and extends to the desirable time frame. There are 3 common types of trendlines and they are classified into short-, intermediate- and long-term trendlines as shown in the chart below.

 Chart 1: The drawing of Short-term, Intermediate-term and Long-term trendlines

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A few technical indicators commonly used by technical analysis (TA) practitioners are the Moving Averages (MA) lines (normally 50 Days / 100 Days MA) and Guppy Multiple Moving Averages (GMMAs) lines. The MA lines make use of the simple moving average to indicate the direction of the trend. The MA lines sloping up with prices of the stock above is seen as an uptrend while a downtrend is the opposite. In a trendless market, the 50 days and 100 days lines are seen together as a horizontal line. Meanwhile, the GMMAs make use of 3 sets of the exponential moving averages (EMA) lines to indicate the trend. The 3 sets of GMMA lines consist of short-term, mid-term and long-term EMA lines. In an uptrend, all 3 sets of EMA lines would normally slope upwards with the short-term EMA lines above the mid-term EMA lines while the mid-term EMA lines are above the long-term EMA lines. On the other side of uptrend, the downtrend will have all 3 sets of EMA lines sloping downwards with the short-term EMA lines being the lowest followed by the mid-term EMA lines. On a trendless period, the 3 sets of EMA lines will often be noticed as a single horizontal line. The following chart shows the indication of trend by MA lines and GMMAs.

Chart 2: The identification of trend using MA lines and GMMAs

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After exploring the methods in identifying the trend, this article will next discuss the most popular indicator used by most TA practitioners; the Average Directional Index (ADX) which measures the strength of the trend effectively. The ADX indicator was developed by J.Welles had been the favorite indicator used by among most traders to assist them in measuring the strength of the trend. The ADX indicator is an oscillator that usually consist of 3 lines; the +DI line, the -DI line and the ADX line. The ADX line is a derivative of +DI and -DI which provides the reading that fluctuates between 0 and 100, indicating the strength of the trend. A reading of below 20 indicates a weak trend whilst a reading above 40 indicates a strong trend. In addition, an ADX reading strengthen from below 20 and moves above 20 may signify the end of a trading range and a trend could be developing. On the other hand, an ADX reading falls from above 40 and moves below 40 could signify the current trend is losing strength and a trading range may develop. Some TA practitioners use the reading from the ADX to identify the potential changes in the stock market from trending to non-trending. The following chart shows how the ADX indicator measures the strength of current trend corresponding to a particular stock.

Chart 3: The direction of the trend versus the strength of the trend

In the above chart, it is coincidental that the ADX reading for the featured stock corresponded to a strong uptrend and the development of uptrend. However, it is important to note that the ADX reading does not point to the direction of the trend but merely the strength of a trend. For example, an ADX reading of above 40 could also mean that the strength of a downtrend is strong. The most basic form of using the ADX indicators can be generated when +DI line and -DI line crosses. A buy signal is generated when +DI line crosses over the -DI line whereas a sell signal is generated when -DI line crosses over the +DI. Nevertheless, many experienced TA practitioners found that buying or selling based on the crossover rule is insufficient as there are whipsaws and hence the accuracy of getting into the right trade based on crossover rule is low. Consequently, the experienced TA practitioners refine the crossover rule by considering the ADX reading as well. A cross up of +DI line over the -DI line with ADX reading between the +DI line and -DI line is often considered as a more accurate buy signal as shown in Chart 3 (orange highlighted). The other way around, a more accurate sell signal is considered when the +DI line cross down the -DI line with ADX reading between both the +/- DI lines. 

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Finally, the identifying the direction of the trend and determining the strength of the trend played an important role when the traders want to take up a position in the market. The trend analysis and indicators make the traders' job in determining both the direction and strength of the trend easier and thus increasing probabilities and accuracy in entering into a good trade. Therefore, traders are exposed to minimum risk in the stock market while profits are maximized. 

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This article first appeared in Smart Investor in 2007.

DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.