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Part 5 - Demystifying Trends

Friday 17 August 2012

After having understood the basics of technical analysis and plotting of prices on a chart, it is time to learn about trends and trend analysis. The word 'trend' is often used for the purpose of analysis and forms the foundation for the interpretation of charts. A trend may be defined as a consistent direction in price movement.

The price of a scrip can logically move in three directions. Compared to its previously established prices it can progress up or move down or remain stable and not witness much of a rise or a fall. Thus, there can be three trends possible in the price of a scrip - if prices are going up, it is called a rising trend, if they are falling over a period of time, it is called a falling trend and if prices remain range bound, the phenomenon is called a flat trend. These three directions in trends are explained in much detail in subsequent paragraphs...


The price of a scrip very rarely moves in a single direction. It means that even if the scrip is witnessing a rising trend, there will be intermittent downward movements. Conversely, if the price is showing a downward trend, there will be counter moves that take the price to intermittent high levels. These counter moves are also known as reactions to trends. It is because of these reactions that price trend graphs are often zigzagged and not unidirectional. These zigzag movements in prices give rise to the phenomenon of new tops and bottoms. A top is a price level from where the scrip changes direction and sees a downward trend. A bottom is a price level from where the scrip breaks free and witnesses an upward movement. These new tops and new bottoms determine the trend direction in a scrip.

Rising trend
In a rising trend, the scrip price will witness an upward trend. The price movement graph will show higher tops and higher bottoms over a period. This can be explained by way of the following figure:


In case of a rising trend, the scrip witnesses an upward movement in its price, leading to higher tops and higher bottoms over a period. For example in the above figure, T2 is higher than T1 and B2 is higher than B1 too.

Falling trend

In case of a falling trend, the zigzag movement of the price curve shows a downward trend with intermittent upward counter moves. Here the scrip witnesses new bottoms and tops that are lower than the earlier bottoms and tops seen by the scrip. The figure above reveals this pattern. Price T2 is lower than price T1 and price B2 is below price B1.

Flat trend
In case of a flat trend, the scrip witnesses sideway movements and no clear new tops or bottoms are formed over time. The new tops and bottoms formed are almost similar to the previous levels.


Making use of trends
Trading strategies should invariably involve a consideration of the trend in the price of the scrip. Thus, if the trend is rising, it will pay if you are able to enter the market at an early stage of the trend. If the trend is falling, you will be rewarded if you exit the market at the peak or near the peak. In case of a flat trend, it is better to move away from the market, as the scrip is still searching for a direction and you may not reap much benefit trading in the scrip during a flat trend. Thus, it is better to study the trend seen by the scrip and act accordingly while making or exiting an investment.

Trend Reversal
As the saying goes "what goes up, must come down". So is the case of price levels of scrips - price movement in a scrip is never unidirectional. Thus, the price of a scrip may exhibit an upward trend but after a point, it may witness range-bound trading or even a fall in its price. So is the case with a scrip showing a falling trend. It may recover lost ground, make a smart recovery and handsome gains as time goes by. Thus, the trends in price movements of a scrip are susceptible to changes in direction. These changes in direction of movements of the prices of a scrip are termed as trend reversals.

The objective of understanding trend reversals is to anticipate these before the entire market is aware of a reversal in trend. This would enable you to move much ahead of the entire market. Hence, it pays very well if you are able to anticipate and act in time based on your analysis of trend reversals.

A trend reversal may be exhibited by the following example:


In the above example, after a formation of three new tops (T1, T2 and T3) and three higher bottoms (B1, B2 and B3), the scrip bucks the trend and witnesses a falling trend. This is also clear from the fact that the fourth top, i.e. T4, is lower than the previous top T3 and the scrip also falls below the previous bottom of B3 as is obvious from the areas exhibited by Y. Thus, the trend in the scrip is reversing from rising to falling and is prone to a fall in prices. Similarly, the trend may reverse from falling to rising and from flat to rising or falling.

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