Trends and Trendlines

History does not repeat itself. But it does rhyme. - Mark Twain

A trend is a general movement in a particular direction. A market trend is a tendency for security prices to either move up or move down. Sometimes, they move sideways, but the big profits are usually made in either an uptrend, where successive price bars generally have higher highs and higher lows than previous bars, or a downtrend, where successive price bars have lower highs and lower lows than previous bars. A sideways market is often called a whipsaw market, because it is almost impossible to tell which way it is going to go. Some traders try to profit in a whipsaw market by buying at support levels and selling at resistance levels, but profits are strictly limited by trading costs, such as commissions and slippage, and by being wrong often. It is easier to make a profit in an uptrend or downtrend, and the profits are generally bigger. Furthermore, it is obvious that if the market or security is trending, then support and resistance lines, by necessity, will also trend in the same direction. So the first step to increasing trading profits is to recognize the trend.

Why Do Markets Trend?

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The random walk theory of stock prices states that stock prices fluctuate randomly. This is true to some extent, at least in the short term. But there is no doubt that markets and security prices do trend—one only has to look at graphs of prices over time to see that trends are real. But if trends are real, then there is a bias in changing security prices. In an uptrend, it is more likely that prices will rise than fall, and vice versa in a downtrend. So the trend really is your friend. If you knew that a coin was weighted so that heads would come up more often than tails, it wouldn't make sense to bet on tails. Likewise, more profits will probably be made by going long in an uptrend or short in a downtrend than betting against the trend, unless, of course, there are particular fundamental reasons for going against the trend for particular stocks, commodities, or currencies, or other investments.

A common anecdote, true to some extent, is that markets trend because of uninformed traders, who constitute the majority of the traders and have the most money as a group. Therefore, they have the most influence on the market. Uninformed traders are those who don't know the efficient market hypothesis, or what the intrinsic value of securities are, nor any other methods of security valuations, except maybe a few financial ratios, such as the venerable price/earnings ratio. Nor do they much care. They trade based on emotion. When the market is rising, more and more people start investing. They start making money, they tell their family and friends, and become increasingly confident that they will continue to make money. Their family and friends feel like they are missing out, so they, too, invest in the market. But eventually, they run out of money to invest. Everyone who could invest has already invested what they could, and so there is nothing to keep the market going up. Alas, it starts to turn down. At first, most people think the market is taking a breather—it is consolidating—but, no, it just keeps going down. And as it drops further, people increasingly become pessimistic, and as they sell more and more securities, often at a loss, the market drops further, and they become more pessimistic still. Until pessimism has reached its peak, and the uninformed players have sold all of their holdings, most at a substantial loss. Only the informed players who see the market as being cheap prevent it from falling even farther.

No doubt, the above scenario is true to some extent, although it is impossible to quantify the effect. But there is another reason why markets trend—because of the interconnections of the economy. As I sit here writing this in March, 2009, the market indexes have dropped by more than half from their peak in October 9, 2007. Since the peak, the market has been trending downward. Why?

First, it became apparent that many subprime mortgages were defaulting. This didn't hurt most lenders too much at first since they securitized the loans and passed on the credit default risk to the investors of these mortgage-backed securities. The increasing defaults caused credit rating agencies to downgrade mortgage-backed securities, which lessened their value. Then some banks and finance companies started failing, because it became increasingly apparent that banks and finance companies were major buyers of these mortgage-backed securities. With credit rating downgrades, they had to write down the value of these securities, which reduced their own credit rating, and called into question their own viability. So many companies who bought bonds of these distressed companies entered into credit default swaps, which promised to pay the bondholders the principal should the bond issuers default. However, many of the CDS issuers, such as AIG, saw it as easy money, figuring they could collect the premiums and never have to pay out on the swaps. But they did have to pay out, and it became apparent that they would have to pay far more than they possibly imagined, which threatened their existence as a going concern. Then banks started to restrict loans to each other and to others not only because they couldn't be sure who would be impacted by these securities but also because they, too, were being impacted by the bad loans. So they stopped lending to protect their own capital. The price of loans shot up to new highs, both for businesses and consumers. Businesses cut back on new projects and lay off employees so that they could conserve their capital. The unemployment rate reached new highs, which caused consumers to cut back spending to conserve their money, which, in turn, caused businesses to cut back further because of reduced business. Then credit card companies started raising rates and closing accounts because they couldn't be sure who was going to be affected by all of this unemployment. Furthermore, nobody was buying any more asset-backed securities which supplied the backing for auto loans, student loans, and credit cards, which reduced the availability of credit, and, thus, the money supply. This caused consumers and businesses to lower spending even more even as the price of just about everything was falling.

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Now, with unemployment at its highest peak in 25 years, it will be some time before the economy starts growing again. What this shows is that the economy has both inertia and synergism. When the economy moves in a particular direction, most businesses and consumers are affected.

So what happens from here? Right now businesses are cutting costs and people, and people are holding back from making major purchases, such as cars, hurting business even more. But at some point, it will turn around. People can delay purchases to some extent, but eventually they'll have to make them. Slowly, people will start buying more, which will slowly increase business. Businesses will grow, their profits will rise, and so will their stocks as more people become confident. When they see the market rising, then they'll also start investing again. All of this will take time, and that is why the market trends.

When the economy is rising, people have more and more money, causing them to spend more, and thereby increasing business for everyone until it can go no higher—positive feedback. And when it is declining, then negative feedback keeps it declining until it drops no lower. Since the economy cannot change direction quickly, neither do the markets, which are directly affected by the economy.

So recognizing the trend and trading with the trend rather than against it is the key to making the most profit. Go long in an uptrend, go short in a downtrend. Greater profits can be made the earlier the trend is recognized.

The Geometry of the Trend

The trend is never a straight line, but a direction, and sometimes, the trend pauses, and gets stuck in a trading range. Sometimes it reverses for a short time, in what are called retracements, pullbacks, or corrections. The erratic nature of the trend is caused by the fact that the economy does not move at a constant speed, and supply and demand, which determines prices, fluctuates from moment to moment and from day to day. These fluctuations give rise to the short and intermediate trends that punctuate the long trend in the market. So, trends have are fractal—there are trends within trends.

Trendlines

To recognize the trend better and to decide at what prices to enter and exit a trade, traders often draw trendlines. A trendline starts at the beginning of the trend and terminates at the end or wherever the market happens to be currently. To maintain accuracy, trendlines should be updated as new prices become available. When the trend changes, then a new trendline must be drawn to represent the new trend.

There are, however, several ways of drawing trendlines that will have slightly different directions for the same trend depending on how the trendline is drawn and what type of chart is used. A trendline can be drawn so that:

A lowest low at the beginning of the trend is connected to the low of the highest high at the end of the trend, which is usually how trendlines are drawn for uptrends. This also forms a resistance line.

The high of the highest day can be connected to the high of the lowest low day, which is how downtrends are frequently drawn. This also forms the support line.

A prominent high or low at the beginning of the trend can be connected to a prominent low or high at the end of the trend.

Sometimes a low or high can be abnormally large compared to neighboring lows or highs, so trendlines are often drawn using closing prices to give a more accurate picture of the trend.

Linear Regression Line

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Trendlines connecting highs and lows actually flank the true trendline, which is the line that would run through most of the middle of the price bars. The linear regression line, which is unique for any given set of prices, is a line that best approximates the fluctuation of prices in a specific time period as a single line, and its slope is the trend for that time. Specifically, the linear regression line is drawn so that the sum of the differences of each price point—usually the closing price, but other prices can be used—to the line is minimized.

Linear regression lines are time-consuming to calculate manually, but most charting software can calculate it automatically. Spreadsheets, such as Microsoft Excel, can also display linear regression lines.

Linear regression lines are best used to depict an uptrend or a downtrend only. A graph that consists of both an uptrend and a downtrend, or even a trading range will be more horizontal and would not be an accurate approximation of a specific trend.

3-month candlestick chart of Citigroup, created with Microsoft Excel, showing the linear regression line that best characterizes the trend.

Support, Resistance, and Consolidation

During the trend, security prices will usually oscillate between the support and resistance lines. As the price drops to the support line, traders will buy the stock, anticipating a slight rise in price, and when prices rise to the resistance line, traders will sell, anticipating that it will drop back to at least the mean. Support and resistance lines exist even in areas of consolidation or congestion, where the trend is sideways. Eventually the consolidation will begin a new trend or continue the old trend.

Using the Trend to Trade

Although it is generally easy to see the trend from looking at past prices, it is impossible to know when it will end. Therefore, the trend is always used with other indicators, especially for short-term trends. For changes in the long-term trend it is best to keep abreast of the news to see how the economy is doing, since it is the state of the economy that determines the long-term trend.