As in all markets, whether used cars, grapefruit, real estate, or industrial products, the economic principle of interaction between supply and demand determines prices in trading markets. Each buyer (demand) b ids for a certain quantity at a certain price, and each seller (supply) offers or asks for a certain quantity at a certain price. When the buyer and seller agree and transact, they establish a price for that instant in time. The reasons for buying and selling can be complex—perhaps the seller needs the money, perhaps the seller has learned of unfavorable information, perhaps the buyer heard a rumor in the golf club locker room—whatever the reason, the price is established when all this information is collected, digested, and acted upon through the bid and offer.
Price, therefore, is the end result of all those inexact factors, and it is the result of the supply and demand at that instant in time. When prices change, the change is due to a change in demand or supply or both. The seller might be more anxious; the buyer might have more money to invest—whatever the reason, the price will change and reflect this change in supply or demand. The technical analyst, therefore, watches price and price change and does not particularly worry about the reasons, largely because they are indeterminable.
Remember that many players for many reasons determine supply and demand. In the trading markets, supply and demand may come from long-term investors accumulating or distributing a large position or from a small, short-term trader trying to scalp a few points. The number of players and the number of different reasons for their participation in supply and demand is close to infinite. Thus, the technical analyst believes it is futile to analyze the components of supply and demand except through the prices it creates. Where economic information, company information, and other information affecting prices is often vague, late, or misplaced, prices are readily available, are extremely accurate, have historic records, and are specific. What better basis is there for study than this important variable? Furthermore, when one invests or trades, the price is what determines profit or loss, not corporate earnings or Federal Reserve policy. The bottom line, to the technical analyst, is that price is what determines success and, fortunately, for whatever reasons, prices tend to trend.
1. What Trends Are There?
The number of trend lengths is unlimited. Investors and traders need to determine which length they are most interested in, but the methods of determining when a trend begins and ends are the same regardless of length. This ability for trends to act similarly over different periods is called their fractal nature. Fractal patterns or trends exist in nature along shorelines, in snowflakes, and elsewhere. For example, a snowflake is always six-sided—having six branches, if you will. Each branch has a particular, unique pattern made of smaller branches. Using a microscope to look closely at the snowflake, we see that the smaller branches off each larger branch have the same form as the larger branch. This same shape carries to even smaller and smaller branches, each of which has the same pattern as the next larger. This is the fractal nature of snowflakes. The branches, regardless of size, maintain the same pattern. Figure 2.3 shows a computer-generated fractal with each subangle an exact replica of the next larger angle.
The trading markets are similar in that any period we look at—long, medium, or very short—produces trends with the same characteristics and patterns as each other. Thus, for analysis purposes, the length of the trend is irrelevant because the technical principles are applicable to all of them. The trend length of interest is determined solely by the investor’s or trader’s period of interest.
This is not to say that different trend lengths should be ignored. Because shorter trends make up longer trends, any analysis of a period of interest must include analysis of the longer and shorter trends around it. For example, the trader interested in ten-week trends should also analyze trends longer than ten weeks because a longer trend will affect the shorter trend. Likewise, a trend shorter than ten weeks should be analyzed because it will often give early signals of a change in direction in the larger, ten-week trend. Thus, whatever trend the trader or investor selects as the trend of interest, the trends of the next longer and next shorter periods should also be analyzed.
For identification purposes, technical analysts have divided trends into several broad, arbitrary categories. These are the primary trend (measured in months or years), the secondary or intermediate trend (measured in weeks or months), the short-term trend (measured in days), and the intraday trend (measured in minutes or hours). Except for the intraday trend, Charles H. Dow, founder of the Dow Jones Company and the Wall Street Journal, first advanced this division in the nineteenth century. Charles Dow also was one of the first to identify technical means of determining when the primary trend had reversed direction. Because of his major contributions to the field, Dow is known as the “father” of technical analysis. We will look more closely at Dow’s contributions in Chapter 3, “History of Technical Analysis,” as we study the history of technical analysis, and in Chapter 6, “Dow Theory.”
Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.