When a Trend is Trustworthy, and When It Isn’t

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When a Trend is Trustworthy, and When It Isn’t

One of the first lessons we often receive as traders is “trade with the trend.” This is good advice, which I recommend following. But how can you tell when a trend is trustworthy, or strong? While it is good to trade in the same direction as a strong trend, if the trend is weakening or potentially reversing then the probability of scoring a winning trade begins to drop, and you may wish to avoid that trade or seek a smaller profit target.

A Simple Technique For Determining Strength

When a trend is very strong, a pullback should be smaller than the trending wave that preceded it. For example, during an uptrend, you’ll see a strong wave higher, followed by a pullback lower which is smaller in length than the prior up wave. When this isn’t the case, it warns the trend may be reversing.

The chart below shows a strong trend. The pullbacks lower are smaller than the prior up waves, showing that momentum is still to the upside. As long as you see price action like this, keep trading the buy signals as the odds are still on your side.

Figure 1. Pullbacks Smaller than Trending Moves – Strong Trend

A pullback should respect the starting point of the prior trending price wave. If it doesn’t, the trend is weakening and you may need a more conservative profit target on your long positions, or you may opt to skip the long trades altogether when this occurs.

In figure 2 the starting points of each up wave have been circled. Notice how the next pullback (after we have drawn the circle) stops dropping before reaching the last circle (start of prior up wave) and then the price moves higher again.

Figure 2. Price Respects Start of Prior Move – Strong Trend

Figure2 shows a strong trend, and we want to be trading buy signals in such conditions.

Figure 3 shows more of this trend, and finally there is a price move which doesn’t respect the starting point of a prior wave higher. Marked “Doesn’t Respect,” the price continues to fall below the starting of the prior up wave, and indicates the uptrend is severely weakened or over altogether.

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Figure 3. No Respect – Up Trend Weakened or Finished

Once you see this sort of price action avoid taking buy signals, or at least be very cautious with taking longs. You may also begin to look for shorting/put opportunities. Once the downtrend begins, look for the same pattern to confirm a strong downtrend–pullbacks higher must respect the starting points of the trending waves lower.

By using the starting point of any wave during a trend, you can determine the strength of that trend. If the price doesn’t respect the start of the prior trending price wave, that means the pullback is as big or bigger than the trending wave, and that shouldn’t happen in a strong trend.

Under such conditions, “trade with the trend” is no longer sound advice, since the trend is likely about to change direction, or already has.

Most traders will want to focus on the major price waves and pullbacks, such as those highlighted on the charts. Whether you trade on a 1-minute chart or a daily chart, you can use this technique for determining market strength. This technique will provide you with a very early warning signal that the trend has weakened and may be changing direction.

This is not the only input you can use to determine trend strength, but is a good one. This information can be combined with the information found in Should I Hold Through a Pullback, or Get Out? Part 1 and Part 2 to develop a more comprehensive trend following trading strategy.

During a strong uptrend, a pullback should stop falling before the starting point of the prior wave higher. If it doesn’t stop, and falls through this starting point, it is an early warning sign that the uptrend is weakening or finished.

During a strong downtrend, a pullback should stop rising before the starting point of the prior wave lower. If it doesn’t stop, and rises through this starting point, it is an early warning sign that the downtrend is weakening or finished.

Use this technique, in combination with others, to trade with the trend, but also to realize when the trend is likely over.

Trend Trading: The 4 Most Common Indicators

Trend traders attempt to isolate and extract profit from trends. There are multiple ways to do this. Of course, no single indicator will punch your ticket to market riches, as trading involves factors such as risk management and trading psychology as well. But certain indicators have stood the test of time and remain popular among trend traders.

In this article, we provide general guidelines and prospective strategies for each of the four common indicators. Use these or tweak them to create your own personal strategy.

Moving Averages

Moving averages “smooth” price data by creating a single flowing line. The line represents the average price over a period of time. Which moving average the trader decides to use is determined by the time frame in which he or she trades. For investors and long-term trend followers, the 200-day, 100-day, and 50-day simple moving average are popular choices.

There are several ways to utilize the moving average. The first is to look at the angle of the moving average. If it is mostly moving horizontally for an extended amount of time, then the price isn’t trending, it is ranging. If the moving average line is angled up, an uptrend is underway. Moving averages don’t predict though; they simply show what the price is doing, on average, over a period of time.

Crossovers are another way to utilize moving averages. By plotting a 200-day and 50-day moving average on your chart, a buy signal occurs when the 50-day crosses above the 200-day. A sell signal occurs when the 50-day drops below the 200-day.   The time frames can be altered to suit your individual trading time frame.

When the price crosses above a moving average, it can also be used as a buy signal, and when the price crosses below a moving average, it can be used as a sell signal. Since the price is more volatile than the moving average, this method is prone to more false signals, as the chart above shows.

Moving averages can also provide support or resistance to the price.   The chart below shows a 100-day moving average acting as support (i.e., price bounces off of it).

MACD (Moving Average Convergence Divergence)

The MACD is an oscillating indicator, fluctuating above and below zero. It is both a trend-following and momentum indicator.

One basic MACD strategy is to look at which side of zero the MACD lines are on in the histogram below the chart. Above zero for a sustained period of time, and the trend is likely up; below zero for a sustained period of time, and the trend is likely down.   Potential buy signals occur when the MACD moves above zero, and potential sell signals when it crosses below zero.

Signal line crossovers provide additional buy and sell signals. A MACD has two lines—a fast line and a slow line. A buy signal occurs when the fast line crosses through and above the slow line. A sell signal occurs when the fast line crosses through and below the slow line.

RSI (Relative Strength Index)

The RSI is another oscillator, but because its movement is contained between zero and 100, it provides some different information than the MACD.

One way to interpret the RSI is by viewing the price as “overbought”—and due for a correction—when the indicator in the histogram is above 70, and viewing the price as oversold—and due for a bounce—when the indicator is below 30.   In a strong uptrend, the price will often reach 70 and beyond for sustained periods, and downtrends can stay at 30 or below for a long time. While general overbought and oversold levels can be accurate occasionally, they may not provide the most timely signals for trend traders.

An alternative is to buy near oversold conditions when the trend is up and place a short trade near an overbought condition in a downtrend.

Say the long-term trend of a stock is up. A buy signal occurs when the RSI moves below 50 and then back above it. Essentially, this means a pullback in price has occurred, and the trader is buying once the pullback appears to have ended (according to the RSI) and the trend is resuming. The 50 levels are used because the RSI doesn’t typically reach 30 in an uptrend unless a potential reversal is underway. A short-trade signal occurs when the trend is down and the RSI moves above 50 and then back below it.

Trendlines or a moving average can help establish the trend direction and in which direction to take trade signals.

On-Balance Volume (OBV)

Volume itself is a valuable indicator, and OBV takes a lot of volume information and compiles it into a single one-line indicator. The indicator measures cumulative buying/selling pressure by adding the volume on up days and subtracting volume on down days.

Ideally, the volume should confirm trends. A rising price should be accompanied by a rising OBV; a falling price should be accompanied by a falling OBV.

The figure below shows the shares of Netflix Inc. (NFLX) trending higher along with OBV. Since OBV didn’t drop below its trendline, it was a good indication that the price was likely to continue trending higher after the pullbacks.

If OBV is rising and the price isn’t, price is likely to follow the OBV and start rising. If the price is rising and OBV is flat-lining or falling, the price may be near a top. If the price is falling and OBV is flat-lining or rising, the price could be nearing a bottom.

The Bottom Line

Indicators can simplify price information, as well as provide trend trade signals or warn of reversals. Indicators can be used on all time frames, and have variables that can be adjusted to suit each trader’s specific preferences. Combine indicator strategies, or come up with your own guidelines, so entry and exit criteria are clearly established for trades. Each indicator can be used in more ways than outlined. If you like an indicator, research it further, and most importantly, test it out before using it to make live trades.

Learning to trade on indicators can be a tricky process. For those who have yet to enter the market or start trading, it’s important to know that a brokerage account is a necessary first step at getting access to the stock market.

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