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.

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