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 for various durations. 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 will 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 (although trading costs have become less significant recently with zero-cost trading being offered by many brokers), 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?
The random walk theory of stock prices states that stock prices fluctuate randomly. True in the short term. But markets and security prices do undoubtedly trend — one only has to look at graphs of prices over time to see that trends are real and mostly upward. But if trends are real, then changing security prices are biased. In an uptrend, prices will more likely rise than fall, and vice versa in a downtrend. So the trend really is your friend. If you knew that a coin was weighted to prefer heads over tails, it wouldn't make sense to bet on tails. Likewise, more profits will be made by going long in an uptrend or short in a downtrend than betting against the trend, unless, of course, particular fundamental reasons prescribe going against the trend for particular stocks, commodities, currencies, or other investments.
A common anecdote, somewhat true, is that markets trend because of uninformed traders, who constitute the majority of the traders and have enough money as a group to influence 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, they become increasingly confident that they will continue to make money. Their family and friends feel like they are missing out (FOMO), so they, too, invest in the market. But eventually, they run out of money to invest. Worse yet, many people start borrowing money to invest. Everyone who could invest has already invested what they could, and so there is nothing to keep the market 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 declining. 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 their holdings, most at a substantial loss. Only the informed players who see the market as being cheap prevent it from falling even farther. This scenario may be true, but it is impossible to quantify the effect. Certainly, it is plausible.
Trends also exist because the economy moves in cycles. When it rises, it keeps rising until economic output is maximized. Economic trends persist because of feedback. When the economy flourishes, employment rises, personal spending rises, which in turn increases business activity, which in turn, increases employment even further. As consumer confidence increases, people start borrowing more, then spending more, which increases economic activity even more. But eventually people get too far into debt, forcing them to decrease spending, which begins a contractionary phase of economic decline, that also becomes reinforcing. People spend less, businesses lay off people, so people cut their spending even more, and so on. As people repay their debt, money is transferred from poor people, the borrowers, to richer people, the lenders, transferring money from people with a higher propensity to consume to those with a lower propensity to consume, contracting the economy. People delay spending even for those things that are necessary, such as elective surgery. Eventually, as consumer debt is paid off and as delayed spending increases delayed demand, and as the government increases spending, as it usually does to improve the economy, the economy starts rising again, leading to the same feedback cycles that continue the economic cycles. Each cycle usually lasts at least several years.
Another factor influencing economic activity is the money supply. As the supply of money increases, people tend to spend more, which increases economic activity. When the money supply decreases, then the economy declines. Central banks control the money supply to maximize economic output and decrease unemployment. Therefore, a good indicator of a market trend would be the intentions of the central bank. In the United States, the central bank is the Federal Reserve and they periodically publish their intentions.
Because the economy is interconnected, there are many market indicators, because when the economy declines it lowers all boats, as they say, and when it increases, it lifts all boats, because the economy is the underlying ocean, the force that determines the level of the economy and, therefore, the market trend.
Another factor causing the market to trend is the enormous amount of money paid into the general investment funds, such as exchange traded funds and mutual funds. Because many of these funds are based on indexes, inflows into the funds will increase the prices of many stocks in those indexes, while outflows from these funds will have the opposite effect, decreasing prices. Naturally, economic conditions will influence whether there is a net inflow or net outflow from these funds.
Of course, events occur that affect some parts the economy positively and others negatively. During the Covid-19 pandemic, companies selling consumer staples, such as Procter & Gamble, did very well during the pandemic, since people were forced to stay home. By contrast, the travel industry was decimated, because travel was severely restricted to slow the spread of the pandemic. Another good example of how the economy can affect trends is by considering the Great Recession, when the stock market peak in October 2007, then declined for the next 18 months. 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 they 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 must 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 laid off employees so that they could conserve their capital. The unemployment rate skyrocketed, which caused consumers to reduce spending to conserve their money, which, in turn, caused businesses to cut back further because of reduced business. Then credit card companies raised rates and closed accounts because they couldn't be sure who would become unemployed. 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.
After 2009, the economy and the stock markets have increased steadily until at least 2021, though there were still ups and downs. Many stock indexes have increased 3 to 4 times from their lows in March 2009. What this shows is that the economy has both inertia and synergism; it takes time for it to turn up or down, which is why trends exist and persist. When the economy moves in a particular direction, most businesses and consumers are affected.
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, though not directly.
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, and if you are willing to take some risk, go short in a downtrend. Greater profits can be made the earlier the trend is recognized.
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 an economy that does not move at a constant speed, but erratically, 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 are fractal — there are trends within trends.
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. When the trend changes direction, 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 forms a support line (aka floor).There is usually increased market demand at support levels that will make it less likely, in the absence of any changes in fundamentals, that the price will fall further.
- The high of the highest day can be connected to the high of the lowest low day, which forms the resistance line (aka ceiling). Many technical traders sell at what they perceive to be resistance lines, increasing the likelihood that the price will not rise further absent changes in fundamentals.
- A prominent high or low at the beginning of the trend can be connected to a prominent high or low 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. Many technical traders use price channels, percentage envelopes, or bands, such as Bollinger bands that use standard deviations to draw the support and resistance lines.
Linear Regression Line
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.
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.
Trading the Trend
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.