Investment: Technical Analysis basics 5

Introduction to Trends

Technical analysis is based on the assumption that prices follow a trend. Trend lines are hereby important for trend identification and confirmation. A trend line is a straight line that connects two or more price points and extends into the future to act as a line of support or resistance.

An uptrend line has a positive gradient and is formed by connecting two or more low points. Uptrend lines act as support and indicate that net demand is increasing even as the price rises. A rising price combined with increasing demand is very bullish, and shows strong determination on the part of buyers. As long as prices remain above the trend line, the uptrend is considered intact. A break below the uptrend line indicates that net demand has weakened and a change in trend could be imminent.

A downtrend line has a negative gradient and is formed by connecting two or more high price points. Downtrend lines act as resistance, and indicate that net supply is increasing even as the price declines. A declining price combined with increasing supply is very bearish, and shows strong resolve of sellers. As long as prices remain below the downtrend line, the downtrend is intact. A break above the downtrend line indicates that net supply is decreasing and that a change of trend could be imminent.

Again, it takes two or more points to draw a trend line. The more points used to draw the trend line, the more validity attached to the support or resistance level represented by the trend line. Even though trend lines are important to technical analysis, occasionally it is not always possible to draw trend lines on a given price chart. Sometimes the lows or highs do not match up. The general rule in technical analysis is: it takes two points to draw a trend line and a third to confirm its validity.

As the steepness of a trend line increases, the validity of the support or resistance level decreases. A steep trend line comes from either a sharp advance or decline of price over a short period of time. The angle of a trend line created from such a sharp move is unlikely to offer any meaningful interpretations. Even if the trend line is formed with three seemingly valid points, attempting to play a trend line break or to use the support and resistance level established will often prove difficult.

Sometimes there appears to be the possibility for drawing a trend line, but the exact points do not match up cleanly. The price highs or lows might be “off”, the angle might be too steep, or the points too close. If one or two points could be ignored, then a fitted trend line could be formed. With volatility present in the market, prices can over-react and produce spikes that distort highs and lows. One method for dealing with over-reactions is to draw internal trend lines, as an internal trend line ignores price spikes.

Trend lines can offer insight, but if used improperly may also produce false signals. Then again, other analyses can be employed to validate trend line breaks. While trend lines have become very popular again, they are merely one tool for establishing and confirming a trend. Trend lines should not be final, but should serve merely as a warning for changes in price trends. By using trend line breaks as warnings, investors can pay closer attention to other confirming signals.