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By: Chris Rowe — October 22, 2013

Technical Tuesday: Here's Your Technical Analysis Starting Point

For today's Tycoon Report article, I decided to literally take a page out of the book that comes with my technical-analysis home-study course, "Technical Analysis Millionaire", and share one of the most-basic, most-important and most-overlooked concepts of technical analysis: the trend line.

Sometimes we talk about complex investing in this space, and other times we get back to basics. 

Today is one of those back-to-basics days ...

The Trend is Your Friend

When charting stocks, Exchange-Traded Funds, futures, commodities, currencies or ANYTHING, identifying trend lines is where it all begins.

Simply stated, the trend is the direction in which the market is moving.  The market’s trends are characterized by a series of zigzags that resemble a series of waves with peaks and troughs.  The direction of those peaks and troughs is what signifies a trend.

There are three trends:

  • Uptrends
  • Downtrends
  • Horizontal trends

An uptrend shows a series of higher peaks (highs) and higher troughs (lows).  A downtrend shows a series of lower peaks, and lower troughs.

A horizontal trend (aka, a neutral trend) shows horizontal, or equal, peaks and troughs, and reflects a period of indecision.  This is also known as the consolidation phase.

Stocks or indices trade sideways as the bulls and bears slug it out, and eventually the previous uptrend or downtrend continues, or moves in the opposite direction.

Relationships Among Trends

When studying charts, you’ll find that there are many different trends all existing at the same time.  You’ll find that some trends tend to overlap each other.  And you’ll find trends within trends within trends.

For example, after identifying a long-term trend, you will find intermediate-term trends within it.  When you zoom in, you’ll find short-term trends within the intermediate trends, and so on.

Every trend is a small part of the next larger trend.

Where many people make a huge mistake is when they fail to realize the enormous importance of identifying the trend of the time period that they are trading in as well as the next larger trends. 

This gives you a much-clearer perspective.  It's like driving across the country and, not only looking at a map of the town you're in, but also looking at the map of the state, and then the country.

The larger trends have a major impact on the smaller trends within them.  Therefore, whatever trend you are using for timing purposes (intermediate, short-term, etc.), you must always determine and trade in the direction of the next longer trend.

Another analogy is having to guess what the weather will be like in three days from now (without any help from the media). 

Knowing what's happened in the last few days is a big help.  Knowing what season you're in is definitely going to help. 

(And knowing what part of the world you are in helps, too, but that is a good analogy for discussing the difference between different sectors.)

Back to Trend lines...

You can profit from a security's decline (with bearish positions like short-selling a stock or buying a put option), or from an advance (with bullish positions like buying a stock or a call option). 

You should buy a security (or, what I prefer to do is buy an in-the-money call option on the security) when the market is oversold in an uptrend, and sell short a security (or, what I definitely prefer is to buy an in-the-money put option on the security) when the market is overbought in a downtrend.

It’s just as easy to profit from stocks or indices that do nothing but trade flat, using very simple options strategies, as it is to profit from an increase or decrease in volatility.

Repeating myself is probably even more annoying for me than it is for you.  But I can’t stress to you enough how important this is, so I’ll repeat:

Whatever time frame you are looking at when viewing a chart, you must zoom in and zoom out:

  • Zoom out to identify the direction of the next larger trend, and the next one after that.
  • Zoom in to time the best execution on your trades.

I find that the best way to approach the trading process is to start with the long-range charts (with a time frame of several years) and then work your way toward the shorter-term charts (like one-year charts, and then move to six-month and three-month charts).

When You're Ready to Start Charting...

It's also helpful to start with monthly and weekly charts for the longer-term view.  Then check out the daily chart, which will be the chart that you base your trading decision on.

Then, for even-more-precise timing (i.e., finding the best time of the DAY to enter your trade), check out the intraday chart.  Checking the intraday chart is especially useful when trading options where a 2% movement in the stock could mean a 10% difference on the option.

So if you think you’ve found a good trade based on the chart, zoom in and out.

The definitions of the different trends’ time frames tend to be ambiguous.  Let’s start with the three basic trends that we’ll be focusing on.

  • Near-term trend (aka, short-term trend) = Days to Weeks
  • Intermediate trend = Weeks to Months
  • Long-term trend (aka, major trend) = Months to Years

Many will argue that “Dow Theory,” which is the cornerstone of the study of technical analysis, suggests that the "major trend" is defined as more than one year.

In the late 1800s, Charles Dow proposed a great deal of the theories of technical analysis that exist today.  (Respect to Chuck.)

But since people these days can’t seem to agree on the definition of each of the time frames, we’ll go with what the average technician will say, and we’ll keep in mind that they are ambiguous terms.

Profit From The Trend

Remember the law of physics: "A body in motion tends to stay in motion ... until a force or obstacle stops or changes that motion."

The reason for charting is to identify trends early and act on them by trading in the direction of that trend.  The idea is not to try to anticipate what the market will do next -- but, instead, to simply go with what the market is currently doing.

The focus should not be on why the market is doing what it’s doing, but on what is occurring.  It should be on where prices are in relation to the current trend.

The mistake that many traders make is that they anticipate or guess what the market’s next direction will be.  Charts show us the market’s current condition.  They reveal pictures of bullish or bearish psychology.

Charts show us a picture of human nature, which doesn’t change.

This is why, when it comes to charts, you’ll find that history repeats itself.  And that’s why the key to coming as close as we can to knowing the future is in understanding where we are in relation to the past.

If you can correctly interpret exactly what the market is telling you and act swiftly, you’ll only become more and more comfortable and confident with experience.

The first step in reading charts is in understanding where the key levels of support and resistance are found, and that's why trend lines are so important.  On Oct. 5, 2009 we were pretty certain the stock market would stop selling off (reversing lower) and would reverse back up and move higher. 

How did we know this?

Well, you can see the bear market bottomed out in March, 2009.  We simply extended the (green) line from that March low to the following low made in July (green arrow) and extended that uptrend line further. 

The low in July did NOT tell us we had a CONFIRMED uptrend line until the recent peak was penetrated (red arrow and red circles showing the high that needed to be broken before it's a confirmed trend line). 

Then came the recent sell-off.  People were nervous.  But on Oct. 5, 2009 the market told us it wasn't finished with the advance yet when it bounced off the trend line (blue arrow). 

Let's go over some examples:

Below is an old chart of Apple Inc. and I chose this example to show you how trend lines that had been acting as an upwards slanting support level become an upwards slanting resistance level once violated. 

I drew a very thin up trend line with a small black arrow pointing to original support in early 2009, and once that very thin up trend line was violated, it acted as resistance 5 or 6 times through the end of the year, as indicated by the small thin red arrows.

Another, more obvious, thing happened when the thin up trend line was violated; a new trend line was formed (the thicker more obvious one).  The thicker black arrows point to times when Apple found support, and if we extend that line up, even after the up trend line was violated, we realize it becomes a point of resistance.

If you look to the left, we see the same thing.  Old up trend line became a new support level about 9 or 10 months later!  It's truly amazing to me how trend lines can be so relevant so much later in the game -- sometimes over a decade!

Here's an old 5 year chart on Goldman Sachs.  You can see the up trend line, which was tested a couple of times early in 2009, turned out to be a support level in early 2010.  Once that trend line was violated at $160.00, the stock seemed to have the rug pulled out from under it as it slid right down to $130.00.

Here's a 5-year chart of Cisco Systems.  From 2006 - 2007 we had a tentative up trend line, and when it was violated (blue circle) the stock dropped like a rock from $34.00 - $22.00, almost without stopping for a rest.  From that point we draw a down trend line by connecting the 2007 high to the next 3 major highs made in 2008 until the exact opposite scenario of the prior scenario occurred: The down trend line was penetrated and that stock charged higher by 55%.

And of course you can see in early 2010 how the up trend line was violated, but there was so much momentum in the stock that it continued higher, realizing where its limits were (the old up trend line which then became a new resistance level).

Finally, I'll zoom into the same stock chart and look at some detail.  But instead of talking about it and pointing out all of the events, do an exercise by finding all of them on your own...

Okay, just one thing I'll mention:  I added an "S" at all support levels.

There is a lot more to learn in technical analysis.  It's important to use these indicators in conjunction with one another.  (That is, don't base trades solely off the trend lines.)

But this is your starting point.  Check out my Technical Analysis Millionaire course for more on how to analyze the market.  It's really not that difficult and, once you get the hang of it, you'll be banking profits like you never imagined possible.

This was a basic introduction to technical analysis.  Please leave a comment and tell me if this helps you at all.

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