Trend trading is all about the data. This unique investment strategy is highly effective due to its dependence solely on hard data, rather than the opinion of a market guru or on the investor’s intuition. The key to developing the best trend trading technique that suits your needs and interests is accurate technical analysis. Here are a few tips on how to approach technical analysis to get precise statistical information on which to base your buying and selling decisions.
A Brief Overview of Trends and Trend Trading
Before you get too deep into the technical aspects of the practice, you should first establish a greater understanding of what trends you’ll see on the stock charts and how they influence your trend trading strategies.
A trend represents the general trajectory of an asset on the market and can progress in only three directions: up, down, or sideways.
- Uptrend: This, of course, is when a stock is moving upward. These are distinguished by higher highs and higher lows in the stock price, meaning the price is rising and the stock is gaining value.
- Downtrend: This occurs when the trendline is moving downward. These represent the decline of a stock’s price and are indicated by lower highs and lower lows.
- Consolidation or trading trend: This is when a stock is moving sideways – fluctuating between similar highs and lows, but generally stable.
As a trend trader, you may generally wish to enter long positions when a stock is in an uptrend and a short position when a stock is in a downtrend. This is because the direction of the trend you’re observing is a primary indicator that informs you of your potential success in trading that stock.
How to Perform a Technical Analysis of a Stock
Analysis of trendlines requires the use of support and resistance lines that can be visualized on a stock chart in one way or another. Depending on your trading style, you may expect to use a support level – which functions as the “floor” of a share’s market value – as a potential entry point, particularly for placing stop losses. On the other hand, you can also use resistance areas – a stock price which the share value has been unable to exceed, but has repeatedly approached – as an entry point instead. (The most successful traders, however, use a combination of these strategies, along with technical indicators, monitoring of market patterns, and other statistics-based methods.)
Technical analysis is defined as the forecasting of future price movements based on historical data. This technique does not result in absolute results, just reliable predictions on which you can confidently base your decision-making process.
The most common approach to technical analysis of stocks is the top-down method. With this practice, you would begin your analysis on a macro scale, then gradually working toward a micro-level evaluation. There are three general guidelines for performing such an analysis:
- For the best results (that apply to virtually any stock), base your macro analysis on data sourced from major indices like the S&P 500 or the New York Stock Exchange (NYSE) Composite.
- Once you have collected the desired data, break this down further into sectors to identify groups within the market that display either the strongest or weakest performance.
- Now, you can progress toward the micro-scale. Within each sector of your choosing, isolate the stocks within them to determine the strongest and weakest stocks. From this data, you can confidently select your points of entry.
Although this may sound surprisingly easy, this type of analysis takes a great deal of practice for consistently positive results. Still, you don’t need an advanced degree to analyze trends – whether you are studying a stock in the scope of several years or just a few months, anyone can recognize uptrends or downtrends. It’s knowing what to do with this information that sets you apart. To make informed decisions on your buying and selling points, you’ll need to keep the following factors in mind:
- Support Level: A low price point from which the stock has repeatedly risen from, but not fallen below. (Breaks below the support level are considered to be bearish and negatively impact the overall trend.)
- Resistance Level: A high price point that the stock has never exceeded, but has gotten close to. (Breaks above the resistance are considered bullish, and they positively impact the overall trend.)
- Momentum: The rate at which a stock’s volume changes.
- Buying/Selling Pressure:
- Buying Pressure: When the number of buy orders exceeds that of sell orders. This causes the stock price to rise.
- Selling Pressure: When there are more sell orders than buy orders. This results in a falling stock price.
- Relative Strength: The comparison of a stock price trend to another stock or asset of the same or a different industry, calculated by dividing the price of the focal asset by another. This demonstrates whether the stock is out- or underperforming the major index.
After you’ve performed your top-down analysis, you must consider these factors based on the data you’ve gathered. These elements combined will provide you a solid foundation on which to base your decision to enter or exit the market.
Further Details to Consider in a Technical Analysis
There are a few key assumptions you must adhere to as you perform your technical analysis:
- Cyclicality of the Market: Experts believe that traders are inclined to repeat behaviors, even in the stock market. If a behavior is deemed “repeatable,” so to say, there is an implication that one can use past data to predict price patterns. This knowledge allows traders to identify points at which trends are in their favor.
- Predictability of the Market: The predictability of the market is in the same vein as the first assumption, technicians assert that trends are not only predictable but explainable. There are no random elements in market patterns.
- Inability to Predict Extreme Events: With the above assumption in mind, it is still important to recognize that technical analysis cannot predict extreme events. Instead, technicians just have to wait until the charts settle and re-establish a “new normal.” Of course, stock prices can be predicted following an event as the result of impacts on the market, but the event itself cannot be foreseen.
An effective technical analysis strategy will improve your stock market performance and help you to invest only in the stocks that will benefit you for both the long- and short-term positions. Keeping these guidelines (and assumptions) in mind as you develop your trend trading strategy will help you achieve success, no matter what industry you choose.
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