In the past year-and-half I’ve been writing a market outlook using a format that was probably another year-and-half in the making. There has been a minimum change to the tools used, but it’s not because I believe those are the only ones that are effective. This article and next week’s generalize the tools used in my outlook to provide a checklist to help you develop or further refine your outlook tools. The way I apply my tools is covered in the second part of January.
Trends
Clearly the current market trend is a critical piece of information for any trader or investor. In addition to subjective trend lines that can be drawn (two price touches establishes the line, a third confirms it), two primary objective tools used to identify trends include:
- Moving averages (MAs)
- Regression lines
As soon as you discuss trend, you also need to discuss time horizon. A market can simultaneously be trending upwards, downwards and sideways without a problem. The actual trend an individual may be referring to is dependent on a time horizon. While certainly straight forward, this is something you may have to remind yourself when you’re tempted to make short-term trading decisions with longer-term investments.
The following list identifies commonly used time frames with moving average speeds that objectively provide trend information:
- Short-term (days to a couple of months): 10-day, 20-day MA (same as 2-week, 4-week MA)
- Intermediate-term (2-3 months to 6-9 months): 50-day MA, 100-day MA (10-week, 20-week MA)
- Long-term (more than nine months): 200-day MA (40-week MA)
If you’re not very clear on the type of trader and investor you are in regards to time horizons, take some time at the start of this new year to identify those. While it’s beneficial to identify trends associated with all three timeframes starting with the longer-term, strongest trend; you want to be aware of the swings that will most significantly impact you and your positions.
Depending upon your charting software, regression lines can be drawn by specifying a start and end date or by specifying the number of past days to include in the line construction. In either case, the number of days used to construct the line corresponds to the type of trend being identified (short-term, intermediate-term or long-term).
The first type of regression line is commonly used to construct channels and is static—that is, the line remains in place unless changed by the user. It’s helpful to extend such lines forward (to the right) to monitor price behavior in relation to that line. If an uptrend is to continue, the trader expects future price action to move around that extended regression line. A regression channel quantifies the expected movement by adding an expected upper range and an expected lower range for price movement.
The second type of regression line may be dynamic, similar to a moving average. As new price data is added each period, the regression line adjusts by adding this new data value and dropping the oldest one. Since you may want to monitor more than one trend interval it’s reasonable to expect multiple MAs or regression lines on a single chart.
In each case the trader can readily identify a specific duration trend as upward, downward or sideways by assessing the direction of a corresponding MA or regression line. Other chart techniques that may help you identify trends more clearly include:
- Varying the chart type to a line chart or point-and-figure chart
- Varying the scale to logarithmic from arithmetic
Other trend tools include Welles Wilder’s Average Directional Movement Index [ADX], Bollinger Bands (to some extent) and different swing and proprietary tools available through different charting packages. When applying these tools, similar considerations apply: think about the type of trader/you are and how this relates to the chart interval monitored (daily, weekly, etc), as well as the setting or speed for the indicator. If you’re trying to decide which tool you prefer, you may want to have multiple trend tools on a single chart.
Support & Resistance
One advantage to MAs and regression lines & channels is that they also provide the trader with objective support/resistance areas that can be monitored. A tool similar to a regression channel is Andrews Pitchfork, which according to the ProfitSource contents manual, uses a median line rather than regression line which is then automatically extended forward as three parallel lines (when in doubt, check out the Help menu).
A second objective approach includes the use of retracement levels based on Fibonacci or Gann technique, among others. The point to keep in mind with any of these tools is that the base period used to construct the retracement levels provides the interval for the trend being monitored. Consider the importance of a price level that may coincide with multiple Fibonacci retracement lines from long-term, intermediate-term and short-term trends. Although I don’t generally use Fibonacci techniques in my trading, there are many traders who do and I would never discount them. Ditto Gann…
Your proficiency with the art side of technical analysis is definitely improved through experience monitoring price movement near support and resistance lines that are drawn using different techniques. Although that process may be slowed by changing markets, it is a process that technical analysts need to complete to understand the strengths and weaknesses in their tools, and possibly themselves.
Monitoring Price Action
I constantly talk about monitoring price action, but the goal is to establish trades that are consistent with, “the weight of the evidence” to quote Martin Pring. If you are convinced that no one really knows what will happen in the markets next week, tomorrow or in the next hour, then all you can do is try to identify conditions that support price movement in one direction and conditions that make such movement less likely. You take action on that ever-changing checklist. Entering and exiting a trade is the action taken as the pendulum swings between a likely move and one that seems less likely.
The challenge for you as a trader using technical analysis is learning enough about a broad group of tools so you can make informed decisions about the tools you ultimately use for trading, investing and to clarify your analysis when your standard tools don’t provide a good picture. It takes time to accomplish that and if you’re analytical in nature (good chance) you may have to pull in the reins on knowing everything about every indicator to find the tools that bit fit your style. Analysis is great, but for most people trading and/or investing is the bottom line.
In addition to where price is relative to a trend line, two other areas of technical analysis that can help you form a “weight of the evidence” checklist include volume and momentum. These are covered next week along with comments on how to put it all together.
To access other articles written by Clare White, please click here.
Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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