What is Trend Analysis?
Trend analysis is part of technical analysis that tries to predict the future movement of a freely-tradeable asset upon incorporating the historical and the present price behaviour.
The rationale behind trend analysis is that what happened in the past is likely to be repeat in the future under the same circumstances.
Types of Trend
Trends could be broadly categorised into three, i.e., long-term, or primary, intermediate, and short-term. Many famous technicians such as, Charles Dow, Ralph Nelson Elliott have built the foundation stone of trend classification through prominent works like Dow Theory, Elliott Wave Theory, respectively, in the field of technical analysis.
Charles Dow – the father of technical analysis was one of the first of the modern technicians to identify and write about the fact that markets trade in trends. The work of Charles Dow which was never formulated until Robert Rhea succeeded William Peter Hamilton in 1932.
The non-formulated work of Charles Dow further marked his way to the modern and most popularised theory of technical analysis known as the Dow Theory.
Dow Theory is basically built on three principles, which are as below.
- The behaviour of the trend remains the same regardless of the time frame under consideration, i.e., trends are fractal in nature.
- The primary, the intermediate, and the minor are the only time horizons, which Charles Dow associated with tides, waves, and ripples, respectively.
- The trend tends to continue rather than reverse which is perhaps the most important observation as any particular trend is influenced by its preceding larger and next smaller trend.
Ideally, analysing a trend is rather simple and plain as compared to other advanced concepts such as Elliott Waves, Point & Figure analysis, of technical analysis.
However, it is considerably difficult in practice, and many mechanical trading systems which have remained profitable in the market, have been based on the rationale of jumping on a trend and riding it to its predictable or apparent end.
The Direction of the Trend
Defining the direction of a trend is one of the most import aspect of trend analysis and primarily, there are only three directional trends in the market, i.e., an upward, downtrend, and sideways (or consolidation).
Generally, when prices of a security under consideration show peak and through at higher price levels than the immediate previous peak and trough, the trend is said to be an uptrend. The exact opposite of such a price behaviour is what is considered as a downtrend.
However, sideways or consolidation differs in that prices of the security under consideration neither show consistent higher peak and trough nor do they show consistent lower peak and trough. In consolidation, prices tend to oscillate between a price range.
How to Identify the Direction of a Trend?
The direction of the trend is one of the major building blocks of trend analysis and several methods could be used to determine the ultimate direction of a trend and signs of a directional change in a trend. Some of the most prominent and widely used methods and tools to spot the direction of a trend are as below.
By far, the oldest and the simplest method for determining a trend is manually drawing a trendline on a price chart. The method primarily suggests connecting the price action over a time horizon under consideration to form a line on a chart by connecting either the highs of the price range or the lows.
Therefore, an upward sloping trendline represents an uptrend and a downward sloping line trendline represents a downtrend.
Drawing a trendline on a price chart is a method which is often at the discretion of the individual analysing the chart.
Some technicians prefer to connect the extremes of trading days, i.e., the high and the low to draw an uptrend line; however, some technicians prefer to connect the closing price of trading days to draw a trendline on a chart.
The ideology behind connecting the closing price of trading days rather than the highs or low is that some technicians believe that the closing price is the most important price of the day. And, when a technical analyst uses the closing price to draw a trendline, it is often referred as internal lines.
Certain standard rules have been developed concerning trendlines for trend analysis, and some of the most widely known and used rules are as below.
- The longer the trendline, the more significant the price break above and below it would be.
- The greater number of times a trendline has been tested, the more significant the price break above and below it would be.
- The steeper the trendline, the sooner it would be broken.
- Intraday trendlines penetration should be confirmed before interpreting any directional change.
Moving averages are one of the most successful methods next to trendlines used for identifying a trend. A moving average could be defined as a constant period average of prices calculated for successive periods.
Ideally a series of market events tend to hamper the price of security whilst increasing its volatility. Moving averages could be a very great tool in such matters as it tend to smooth the price fluctuations over a specified period.
Regression is ideally defined as a mathematical formula that can fit two dependent variables in a straight line, which is known as the regression line.
- A regression line has mainly two determiners, i.e., the beginning point and the slope.
- Generally, technicians remain interested in the location of the regression line on the chart and to some extent, its slope.
- The emergence of computational power has made the task comparatively very easy & more effective, and many statistical tools such as Microsoft Excel, various programming languages such as R and Python, and several TA software, have made it very simple to draw a regression line and check for its direction.
- Ideally, the interpretation of the regression line is that, if it is sloping upwards with fewer outliers, the trend is an uptrend. Likewise, if the regression line is sloping downwards with fewer outliers, the trend is a downtrend.