Understanding Trends and Trends Lines

Trend is the main tendency to change: for example, in mathematics - a time series. Trends can be described by various equations - linear, logarithmic, power, and so on. The actual type of trend is established based on the selection of its functional model by statistical methods or by smoothing the initial time series.

In economics and trading, a trend is a direction of the predominant movement of indicators. Trend is used by traders and investors to predict the further direction of the price of an asset. In technical analysis, identification of a trend is the first step in learning Technical Analysis (TA) and being able to speculate on asset’s price, long on a bullish trend (uptrend) or short on a bearish trend (downtrend)

How to identify a trend?

Charles Dow in his publications defined three types of trends: primary (long-term), secondary (mid-term) and minor (short-term). Primary trend of a market lasts for a year or more, secondary - three weeks to three months, and minor which lasts not longer than three weeks. One should note that all trends have a tendency to correct, a correction in the direction of a primary uptrend, will most likely symbolize the beginning of a secondary downtrend. Let’s see examples on a chart.

Bitcoin was in primary uptrend from early March 2020 up to April 2021, which is more than a year, so this trend is long-term. But in its way to reach new highs in it’s bull market trend, Bitcoin experienced corrections, which are in fact downtrends of each lower trend types, secondary and minor.

The three phases of the Primary trends

According to the Dow Theory, each primary trend has three phases (based on the trend direction).

For a bull market - the accumulation phase, the participatory phase, and the excess phase.

For a bear market - the distribution phase, the public participation phase, and the panic (or despair) phase.

During the first phase, the most discerning investors start buying (selling off) assets contrary to the general sentiment of the market. This phase is not accompanied by strong price changes, since the number of such investors is quite small. At some point, a part of the market catches a new trend and active traders who use technical analysis begin to follow these discerning investors, and the trend enters the participation phase. This phase is accompanied by a strong price change. During the third phase, the new trend recognizes the entire market and the buzz begins. At this point, astute investors begin to take profits and close positions.

Three other postulates of Dow’s Theory regarding a trend

Stock indices must be consistent

This statement applies to the Dow Jones Industrial Average and the Dow Jones Transportation Index. According to Dow Theory, the current trend and trend reversal signals should be confirmed by both indices. In this case, some discrepancy in the time of the signals is allowed, that is, one of the indices can give a signal about a trend change earlier than the other.

Trends are confirmed by trading volumes

Dow believed that trading volumes must be taken into account in order to recognize a trend. The change in stock prices with a small trading volume can be explained by many different reasons and does not characterize the current trend. If the price change occurred against the background of large trading volumes, then this reflects the “real opinion” of the market and characterizes the development of the current trend or the formation of a new one.

Trends are active until a clear signal of termination appears

This statement should be understood as follows: the market tends to continue price changes that do not correspond to the trend, which, in case of uncertainty, should be interpreted as a temporary correction, and not as a trend change.

Based on the aforesaid, traders identify trends and look for signals such as trend continuation and trend correction or reversal juxtapositioning all of these postulates and rules of the co-founder “Dow Jones Co.” and the first editor of the “Wall Street Journal”, brilliant journalist and researcher, founder of the Dow Jones Industrial Average - Charles Dow. Traders draw trendlines on the chart to identify the next price action of asset’s price.

How to draw a trend line?

First postulate of the Dow Theory is that the preceding close (low) price should be higher than the previous for a bull market, and lower for the bear market. By connecting two or more lows, the trader sees a trendline and can continue following the price action within this identified trend. See the importance of the trendline in the image below.

What is the importance of having this trendline some might think, but in general this line doesn’t only identify the tendency of the price action but also acts as a dynamic resistance to show traders areas where the price is expected to retrace.

Let’s see steps to how to draw a trendline.

Find a Drawing tools toolbars on your platform and find a “Line” or “Trend Line” tool to start drawing, those who use TradingView charts can easily navigate and find the Trend Line. Overbit has TradingView charts integrated, so follow this image to find the Trend Line drawing tool.

Now that you have your Trend Line tool ready, let’s validate our trend with drawing a trendline. To draw a trendline we should connect lows for a bull market and highs for a bear market, as a general rule, however you can connect both highs and lows, thus having a trend channel of the price.

Arrows on this BTCUSD chart identify points which should be connected to draw a trendline on the chart. As you probably noticed, both trendlines are used as dynamic resistance (red) and support (green). Hence, by having the trendline drawn on the chart a trader already has a signal line and can use it to execute trades. Signals can be displayed as points on the trendline as support or resistance, breakout from the trendline which signals the short, mid-term trend reversal.

Summary

Trend is your friend, whether you are a day trader or a mid-term trader, or an opportunist who is looking for rebounds and trades the reverses. Identifying the trend is not as hard as it might look like. Use the info about phases wisely, apply volume and RSI indicators to track the trend. Train your knowledge on Overbit’s demo account to firm your trading skills.

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