The Basic Principle of Financial Technical Analysis – The Trend

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 assumption: Freely traded, market prices, in general, travel in trends.

Based on this assumption, traders and investors hope to buy a security at the beginning of an upward trend at a low price, ride the trend, and sell the security when the trend ends at a higher price. Although this strategy sounds 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? 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 from 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 might be more concerned about the business cycle trend that occurs over several years. Another investor might be more concerned about the trend over the next six months, and a third investor might 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, 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 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 prematurely, the analyst has then lost potential profits. The technical analyst thus 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. Academics have disputed that markets tend to trend because if it were true, it would spoil their theoretical models. However, 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; as it turns out, however, 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 sizable fortunes for those following it.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.