Trend Indicators

Trend indicators are probably the second most common way of organizing price data. The most popular trend indicator is the moving average. It is easy to construct and can be used alone or in conjunction with other technical methods, such as bar charting. Moving averages also can be smoothed or optimized to fit different markets and market conditions.

Trends

Since it appears that markets at times are not efficient in discounting the  fundamentals, particularly over a short time horizon, it helps to have other methods of forecasting price movement, and that is where technical analysis comes in.
Although there are many ways to trade the markets, the most popular is trend  following. Immortalized in the adage "the trend is your friend," trend following has great intuitive appeal. Virtually anyone can look at big price moves on a chart and see the potential for profit (Example 2.1). Trends occur quite often and the technical methods designed to capture them are easy to understand and put into use. Not coincidentally, one of the keys to profitable trading, "Let your profits run and cut your losses short," is trend following in a nutshell. Under favorable trading conditions, the result can be a few sizeable profits but smaller losses.

Following Trends

What causes trends? Consistent bullish or bearish market changes in the fundamentals over a period of time. For example, a strong economy in Japan is likely to push Japanese yen futures higher. Because it’s not always readily apparent from economic or other fundamental news that a price trend has begun, technical trend indicators can be useful. Trend lines on a bar chart or a moving average of a futures
market can often signal the start of a trend before it’s generally recognized. From a trading standpoint, going with the trend has advantages. For one, it can be more forgiving than going against a trend. Timing doesn't have to be perfect since trading in the direction of the trend increases the odds of the market moving in your favor. Also, since there’s often a fundamental "story" to go along with a trend (e.g., interest rates changes, tight supplies, strong demand), it’s possible to follow a trend with a fair degree of confidence. Deciding when to exit a position also tends to be easier with trend following methods; it makes sense to exit a position, either as a loser or a winner, when the trend changes. Although markets often exhibit trends, the majority of the time — estimated at about 75% — they are in a non-trending state. Prices tread water, showing little or no direction. In fact, even when markets trend, they pause to consolidate along the way, settling into two-sided phases called trading or consolidation ranges (Example 2.2).

Counter Trends

While directionless market behavior is frustrating to trend followers, it presents opportunities for traders who prefer to trade against the trend. Counter-trend traders utilize technical indicators that forecast when a trend might be running out of steam or about to change direction.

Many people find counter-trend trading appealing. Since markets spend most of their time moving back and forth, there can be more trading opportunities when trading against a trend rather than with one, and favorable trading conditions can last longer. For every trader who looks to embrace a bullish or bearish fundamental story and capture a big trend move, there’s another who is skeptical that prices will keep moving in one direction.

Although the overall risk in counter-trend trading is the same as trading in the direction of the trend, risk control is more problematical with a counter trend approach. This is because even though traders can expect a higher percentage of winning to losing trades with counter-trend trading, the average profit per trade is generally much smaller than with a trend following strategy. As a result, traders must focus on keeping risk (i.e., losses) to a bare minimum. That sounds easy to do but isn’t, because closer stop loss points paradoxically increase risk by increasing the number of losing trades.

Overall, trend and counter-trend traders make up the yin and yang of trading. Trend followers take fewer but much larger average profits to go along with more numerous but acceptable losses. Counter-trend traders take more numerous but smaller profits while fighting to keep risks to a minimum. However, before any trading — trend or counter trend — can commence using technical analysis, price data must first be organized into a useful format, which takes us to the next section.

Consolidation Patterns

Consolidation patterns comprise the majority of patterns on a chart because prices often spend most of their time consolidating — moving between support and resistance. It's a market’s job to find equilibrium between the supply and demand or bullish and bearish forces, and during that process, prices often settle into a two-sided trading phase. In fact, there can be long periods of time when supply and demand forces are pretty evenly matched and prices stay trapped between support and resistance. Even during a trend, prices reach periodic equilibrium levels, having discounted the latest news or shift in opinion, and pausing to wait for more input.
Contrary forces, such as profit taking and countertrend speculative activity, also tend to increase if there is no fresh news to reinforce bullish or bearish fundamentals. These forces offset the trend forces and result in indecisive price action.

A trading range forms when market forces are in balance. Buying surfaces at approximately the same level, keeping a floor under prices. Selling develops at approximately the same overhead level, putting a ceiling on the market. Horizontal lines drawn across the lows and highs define a trading range (examples 3.5, 3.6). Volume often declines as the trading range progresses because traders lose interest. Breakouts from trading ranges often are accompanied by a jump in volume and price volatility (i.e., greater and faster price movement) as traders take notice and re-enter the market. Trading wise, a breakout from a trading range can signal the start
of a trend (examples 3.5, 3.6). Unfortunately, there is no sure-fire way to tell when a trading range is about to end; however, sometimes a continuation pattern, to be discussed later, will form just prior to a breakout.

Trend Lines

Support and resistance that become established at approximately the same price level result in horizontal support and resistance lines. However, if a market is in an uptrend, prices find support at increasingly higher levels. In fact, an uptrend is defined as a series of higher lows and higher highs. Therefore, an uptrend line connecting two or more support points slants higher. A downtrend line is the opposite. Two or more resistance points connected in a downtrend result in a downward slanting trend line (Example 3.7).

Trend lines provide useful projections of future support in an uptrend and future resistance in a downtrend. Like horizontal support and resistance levels, the longer a trend line remains intact, the more important it is, because the more likely traders are to respect it and react accordingly (buy against support, sell against resistance). And,
when a trend line is broken it can signal a change in trend.