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CHAPTER OBJECTIVES
After reading this chapter, you should be able to
• Define the term "trend"
• Explain why determining the trend is important to the technical analyst
• Distinguish between primary, secondary, short-term, and intraday trends
• Discuss some of the basic beliefs upon which technical analysis is built
"The art of technical analysis—for it is an art—is to identify trend changes at an early stage and to maintain an investment position until the weight of the evidence indicates that the trend has reversed." (Pring, 2002)
Technical analysis is based on one major principle—trend. Markets trend. Traders and investors hope to buy a security at the beginning of an uptrend at a low price, ride the trend, and sell the security when the trend ends at a high price. Although this strategy sounds very simple, implementing it is exceedingly complex.
For example, what length trend are we discussing? The trend in stock prices since the Great Depression? The trend in gold prices since 1980? The trend in the Dow Jones Industrial Average (DJIA) in the past year? Or, the trend in Merck stock during the past week? Trends exist in all lengths, from long-term trends that occur over decades to short-term trends that occur minute-to-minute.
Trends of different lengths tend to have the same characteristics. In other words, a trend in annual data will behave the same as a trend in five-minute data. Investors must choose which trend is most important for them based on their investment objectives, their personal preferences, and the amount of time they can devote to watching market prices. One investor may be more concerned about the business cycle trend that occurs over several years. Another investor may be more concerned about the trend over the next six months, while a third investor may be most concerned about the intraday trend. Although individual investors and traders have investment time horizons that vary greatly, they can use the same basic methods of analyzing trends because of the commonalities that exist among trends of different lengths.
Trends are obvious in hindsight, but ideally, we would like to spot a new trend right at its beginning, buy and then spot its end, and sell. However, this ideal never happens, except by luck. The technical analyst always runs the risk of spotting the beginning of a trend too late and missing potential profit. The analyst who does not spot the ending of the trend holds the security past the price peak and fails to capture all of the profits that were possible. On the other hand, if the analyst thinks the trend has ended before it really has and sells the security, the analyst has then lost potential profits. Therefore, the technical analyst spends a lot of time and brainpower attempting to spot as early as possible when a trend is beginning and ending. This is the reason for studying charts, moving averages, oscillators, support and resistance, and all the other techniques we explore in this book.
The fact that market prices trend has been known for thousands of years. Specific records are available from the eighteenth century in Japan. Academics have disputed that markets tend to trend because if it were true, it would spoil their theoretical models. Recent academic work has shown that the old financial models have many problems when applied to the behavior of real markets. In Chapter 4, "The Technical Analysis Controversy," we discuss some of the new academic findings about how market prices behave and some of the evidence against the old finance theories. Academics and others traditionally have scorned technical analysis as if it were a cult, but as it turns out, the almost religious belief in the Efficient Markets Hypothesis has become a cult itself, with adherents unwilling to accept the enormous amount of evidence against it. In fact, technical analysis is very old, developed through practical experience with the trading markets, and has resulted in some sizeable fortunes for those following it.
How DOES THE TECHNICAL ANALYST MAKE MONEY?
There are several requirements needed to convert pure technical analysis into money. The first and most important, of course, is to determine when a trend is beginning or ending. The money is made by "jumping" on the trend as early as possible. Theoretically, this sounds simple, but profiting consistently is not so easy.
The indicators and measurements that technical analysts use to determine the trend are not crystal balls that perfectly predict the future. Under certain market conditions, these tools may not work. Also, a trend may suddenly change direction without warning. Thus, it is imperative that the technical investor be aware of risks and protect against such occurrences causing losses.
From a strategic standpoint, then, the technical investor must decide two things: First, the investor or trader must choose when to enter a position, and second, he or she must choose when to exit a position. Choosing when to exit a position is composed of two decisions. The investor must choose when to exit the position to capture a profit when price moves in the expected direction. The investor must also choose when to exit the position at a loss when price moves opposite from what was expected. The wise investor is aware of the risk that the trend may differ from what he or she expected. Making the decision of what price level to sell and cut losses before even entering into a position is a way in which the investor protects against large losses.
One of the great advantages in technical analysis, because it studies prices, is that a price point can be established at which the investor knows that something is wrong either with the analysis or the financial asset's price behavior. Risk of loss can therefore be determined and quantified right at the beginning of the investment. This ability is not available to other methods of investment. Finally, because actual risk can be determined, money management principles can be applied that will lessen the chance of loss and the risk of what is called "ruin." In sum, the basic ways to make money using technical methods are
• "The trend is your friend"—play the trend.
• Don't lose—control risk.
• Manage your money—avoid ruin.
Technical analysis is used to determine the trend, when it is changing, when it has changed, when to enter a position, when to exit a position, and when the analysis is wrong and the position must be closed. It's as simple as that.
WHAT IS A TREND?
What exactly is this "trend" that the investor wants to ride to make money? A rising trend, or "uptrend," occurs when prices reach higher peaks and higher troughs. An uptrend looks some- thing like Chart A in Figure 2.1. A declining trend, or "downtrend," is the opposite—when prices reach lower troughs and lower peaks. Chart B in Figure 2.1 shows this downward trend in price. A sideways or flat trend occurs when prices trade in a range without significant underlying upward or downward movement. Chart C in Figure 2.1 is an example of a sideways trend; prices move up and down but on average remain at the same level.
Figure 2.1 shows a theoretical example of an uptrend, downtrend, and sideways trend. But, defining a trend in the price of real-world securities is not quite that simple. Price movement does not follow a continuous, uninterrupted line. Small counter-trend movements within a trend can make the true trend difficult to identify at times. Also, remember that there are trends of differing lengths. Shorter-term trends are parts of longer-term trends.
From a technical analyst's perspective, a trend is a directional movement of prices that remains in effect long enough to be identified and still be playable. Anything less makes technical analysis useless. If a trend is not identified until it is over, we cannot make money from it. If it is unrecognizable until too late, we cannot make money from it. In retrospect, looking at a graph of prices, for example, many trends can be identified of varying length and magnitude, but such observations are observations of history only. A trend must be recognized early and be long enough for the technician to profit from it.
How ARE TRENDS IDENTIFIED?
There are a number of ways to identify trends. One way to determine a trend in a data set is to run a linear least-squares regression. This statistical process will provide information about the trend in security prices. Unfortunately, this particular statistical technique is not of much use to the technical analyst for trend analysis. The regression method is dependent on a sizeable amount of past price data for accurate results. By the time enough historical price data is accumulated, the trend is likely beginning to change direction. Despite the tendency for trends to be persistent enough to profit from, they never last forever.
BOX 2.1 Linear Least Squares Regression
Most spreadsheet software includes a formula for calculating a linear regression line. It uses two sets of related variables and calculates the "best fit" between the data and an imaginary straight (linear) line drawn through the data. In standard price analysis, the two variable data sets are time and price—day dl and price XI, day d2 and price X2, and so forth. By fitting a line that best describes the data series, we can deter- mine a number of things. First, we can measure the amount by which the actual data varies from the line and thus the reliability of the line. Second, we can measure the slope of the line to determine the rate of change in prices over time, and third, we can ' determine when the line began. The line represents the trend in prices over the period of the line. It has many useful properties that we will look at later, but for now, all we need to know is that the line defines the trend over the period studied.
Many analysts use moving averages to smooth out the shorter and smaller trends within the trend of interest and id
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