Trend is one of the most important concepts to understand in Technical Analysis and this post explains why. Trend is defined in Technical Analysis as the direction of the market and can be of three types: uptrend, downtrend and sideways trend. If the direction of the market is upward, the market is said to be in an uptrend; if it is downward, it is in a downtrend and if you can classify it neither upward nor downward or rather fluctuating between two levels, then the market is said to be in a sideways trend.
Trend is so important to a Technical Analyst because a majority of stocks tend to follow the overall market trend. Hence, knowing the trend and trading in the direction of the trend helps to maximize the chance of success.
Identifying the direction of the trend is not sufficient though. Whenever you talk about the duration of the trend you also need to classify the duration of the trend as one of the following:
- Short-term – usually from a few days to 3 weeks
- Intermediate-term – between 3 weeks to 6 months
- Long-term – greater than 6 months
The reason we do this is because if you are a short-term trader, then you usually only care about the short-term trend. Another way to say this is that if the market is going down in the long-term, you can still make money by going bullish short-term as long as the short-term trend is uptrend!
Trend is also important to know because of another important reason. Whether you use indicators or candlesticks in your analysis, if you do not know the trend, you will not be able to make the final buy/sell decision. Why is that? Because the interpretation of most Buy/Sell signals based on candlesticks or technical indicators can change once you know the trend. Are you seeing a 5/20 EMA Crossover buy signal? If it is in a sideways trend, you most probably need to ignore it as it might be a false signal. Are you seeing a Hammer candlestick pattern formation? Again if it is in an uptrend you have to ignore it as a Hammer pattern is a reversal pattern and is valid only as a reversal signal at the end of a downtrend.
So what are the different ways that Technical Analysts use to identify trends? One way is by drawing trendlines in a chart with a trendline tool. Another is by use of certain other technical indicators like ADX (along with DI+ and DI-). By far the most accurate and popular way is by means of drawing trendlines on the chart itself. This is because indicators like ADX itself (although being a good indicator to use to confirm the trend) do give false signals and hence the final trend needs to be confirmed with a trendline itself. In fact no indicator can capture the trend perfectly in all possible scenarios as hand-drawing a trendline by a Technical Analyst can (It’s not to say that a trendline break cannot be a false signal but the chances are less compared to say what you can get with an indicator like ADX). This is also one of the reasons why one cannot rely on some automatic signal perfectly to detect a trend.
In fact, trend is so important that we spend almost the first half of the session of our “Basics of Technical Analysis” training on Trend and Support/Resistance Analysis explaining how to identify the trend, how to differentiate between strong/weak trends etc. Trend classification is also explained with a current example of Nifty so that at any point of the time, if you want to do a current market analysis, you can do it yourself. This is because Trend/Support/Resistance Analysis of the market (i.e., Nifty for NSE traders and Sensex for BSE traders, for example) is the first thing that a trader should do before jumping into the market because your entire trading strategy depends on it! Smart traders adjust their trading strategy based on the market conditions and you should too! If the long-term market is in a downtrend, there is absolutely no point in holding stocks through the downtrend and seeing your portfolio erode down rapidly (like a lot of novice investors learnt the hard way during the long-term downtrend of 2008!)