The meaning in finance isn't all that different from the
general definition of the term - a trend is really nothing more than the
general direction in which a security or market is headed. Take a look at the
chart below:
Figure 1
It isn't hard to see that the trend in Figure 1 is up.
However, it's not always this easy to see a trend:
Figure 2
There are lots of ups and downs in this chart, but there
isn't a clear indication of which direction this security is headed.
A More Formal Definition
Unfortunately, trends are not always easy to see. In other
words, defining a trend goes well beyond the obvious. In any given chart, you
will probably notice that prices do not tend to move in a straight line in any
direction, but rather in a series of highs and lows. In technical analysis, it
is the movement of the highs and lows that constitutes a trend. For example, an
uptrend is classified as a series of higher highs and higher lows, while a
downtrend is one of lower lows and lower highs.
Figure 3
Figure 3 is an example of an uptrend. Point 2 in the chart
is the first high, which is determined after the price falls from this point.
Point 3 is the low that is established as the price falls from the high. For
this to remain an uptrend, each successive low must not fall below the previous
lowest point or the trend is deemed a reversal.
Types of Trend
There are three types of trend:
Uptrends
Downtrends
Sideways/Horizontal Trends As the names imply, when each
successive peak and trough is higher, it's referred to as an upward trend. If
the peaks and troughs are getting lower, it's a downtrend. When there is little
movement up or down in the peaks and troughs, it's a sideways or horizontal
trend. If you want to get really technical, you might even say that a sideways
trend is actually not a trend on its own, but a lack of a well-defined trend in
either direction. In any case, the market can really only trend in these three
ways: up, down or nowhere. (For more insight, see Peak-And-Trough Analysis.)
Trend Lengths
Along with these three trend directions, there are three
trend classifications. A trend of any direction can be classified as a
long-term trend, intermediate trend or a short-term trend. In terms of the
stock market, a major trend is generally categorized as one lasting longer than
a year. An intermediate trend is considered to last between one and three
months and a near-term trend is anything less than a month. A long-term trend
is composed of several intermediate trends, which often move against the
direction of the major trend. If the major trend is upward and there is a
downward correction in price movement followed by a continuation of the uptrend,
the correction is considered to be an intermediate trend. The short-term trends
are components of both major and intermediate trends. Take a look a Figure 4 to
get a sense of how these three trend lengths might look.
Figure 4
When analyzing trends, it is important that the chart is
constructed to best reflect the type of trend being analyzed. To help identify
long-term trends, weekly charts or daily charts spanning a five-year period are
used by chartists to get a better idea of the long-term trend. Daily data
charts are best used when analyzing both intermediate and short-term trends. It
is also important to remember that the longer the trend, the more important it
is; for example, a one-month trend is not as significant as a five-year trend. (To
read more, see Short-, Intermediate- And Long-Term Trends.)
Trendlines
A trendline is a simple charting technique that adds a line
to a chart to represent the trend in the market or a stock. Drawing a trendline
is as simple as drawing a straight line that follows a general trend. These
lines are used to clearly show the trend and are also used in the
identification of trend reversals.
As you can see in Figure 5, an upward trendline is drawn at
the lows of an upward trend. This line represents the support the stock has
every time it moves from a high to a low. Notice how the price is propped up by
this support. This type of trendline helps traders to anticipate the point at
which a stock's price will begin moving upwards again. Similarly, a downward trendline
is drawn at the highs of the downward trend. This line represents the
resistance level that a stock faces every time the price moves from a low to a
high. (To read more, see Support & Resistance Basics and Support And
Resistance Zones - Part 1 and Part 2.)
Figure 5
Channels
A channel, or channel lines, is the addition of two parallel
trendlines that act as strong areas of support and resistance. The upper
trendline connects a series of highs, while the lower trendline connects a
series of lows. A channel can slope upward, downward or sideways but,
regardless of the direction, the interpretation remains the same. Traders will
expect a given security to trade between the two levels of support and
resistance until it breaks beyond one of the levels, in which case traders can
expect a sharp move in the direction of the break. Along with clearly
displaying the trend, channels are mainly used to illustrate important areas of
support and resistance.
Figure 6
Figure 6 illustrates a descending channel on a stock chart;
the upper trendline has been placed on the highs and the lower trendline is on
the lows. The price has bounced off of these lines several times, and has
remained range-bound for several months. As long as the price does not fall
below the lower line or move beyond the upper resistance, the range-bound
downtrend is expected to continue.
The Importance of Trend
It is important to be able to understand and identify trends
so that you can trade with rather than against them.
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