The trend is your friend is one of the oldest sayings when it comes to trading…whether it be stocks, bonds, commodities or any other trading vehicle. The trend is basically defined as the general direction of the market or price of a security. Technical traders use trends to identify patterns and determine which side of a stock they want to be trading. An uptrend would be identified by the price of a security making higher highs and higher lows, while a downtrend would consist of lower highs and lower lows within a given time frame. At times trends can be difficult to identify over a given period but see below for an example of what an uptrend chart may look like.
As you can see, each time the stock rallies, it pulls back but to a higher point than the previous low. Then each successive move higher is above the price point of the previous high. Each of the high points of the trend – 2, 4, and 6 – are higher than the previous high, while each of the low points of the trend – 3 and 5 – are higher than the previous low. For the uptrend to remain intact, the next move lower must stay above 5 and the move higher must go above 6. Once that pattern breaks, the trend may be changing, and further analysis and caution is suggested.
Below is a chart of SPY showing an uptrend over this time frame.
With a stock in an uptrend, traders are ideally looking to buy pullbacks that hold above the previous low. The opposite would be true for a downward trending stock. Traders would be looking to short rallies lower than the previous high move in the stock. Again, once the trend no longer remains intact, it is time to re-evaluate whether a position should be entered or it’s time to move on to another opportunity.
Many traders draw trendlines to try to identify areas of support and/or resistance to determine possible entry points for a stock. Trendlines are typically just straight lines drawn on a chart connecting lower lows or lower highs and are used to find where there may be potential support or resistance. When a stock in an uptrend pulls back and approaches the trendline, traders are often looking for an area to purchase stock. Conversely, with a stock in a downtrend, traders are looking to short the stock on rallies that approach the trendline. Trendlines can be used for any time frame from intraday to long term yearly charts but should be consistent with your trading time horizon. It’s entirely possible to have different trends and trend lines depending on the time frame chosen. Long-term trends are identified by daily or weekly charts, while minute or hourly charts are best for short-term trends. Also note that long-term trends are viewed as more significant than short-term trends.
Below is the same chart of SPY with two trendlines…the green is a longer term trendline while the blue is covering a smaller time frame.
Each of these trendlines shows SPY in an uptrend and can help a trader identify which side to trade and possible areas of entry. Each time SPY approached the green trendline, it rallied shortly thereafter. The same is true with the shorter term blue trendline until it was breached on the second to last bar on the chart. This breach would be a good signal for a trader to show some patience and possibly look for another entry near the longer term green trendline around the 282.50 area. Or even move on to another stock that is showing a better setup to trade.
Advanced traders use many different technical indicators to help them assess a potential trade. At times, it can be difficult to sort through all the data which makes it confusing for a novice trader. This is why trendlines can be a great place for traders to start. They are a relatively straightforward concept that are easy to understand and can help weed out potentially lower percentage trades.