WHAT ARE TRENDING MARKETS?
There can be little doubt that getting on the right side of trending markets is one of the most satisfying and profitable ways to trade. Once your position is comfortably onside, you can shift your stop to lock in gains and then let the market’s momentum do the rest. But what is difficult is identifying that a trend is developing early enough to take full advantage of it. By their very nature, trends can last for a long time. But no one can be sure in advance if a market is about to move in a particular direction for any length of time. There can also be big moves against the trend which can scare out even the most experienced trader. After all, a sharp sell-off following weeks of rising prices could signal a reversal. Yet if played well, such counter-trend moves can provide fresh entry points if you missed the first move or for traders to add to a winning position.
WHAT ARE UPTRENDS AND DOWNTRENDS?
With trending markets typically, a trend is highlighted by a set of parallel lines, sloping upwards in an “uptrend” and downwards in a “downtrend". Identified through charting analysis. In an ideal world the lower line will link up a succession of low points which identify support. The upper line indicates resistance. Now there are a number of technical indicators which can help you identify if a market looks like trending in a particular direction. The most popular are moving averages, Moving Average Convergence-Divergence (MACD) and the Relative Strength Indicator (RSI). We’ll look at moving averages and the MACD in more detail in a separate blog.
But here we’ll use the RSI to help identify possible turning points which can then be used to set up a drawing tool called Andrews’ Pitchfork. The Pitchfork is really useful in that it can highlight potential areas of support and resistance which will help to mark areas to buy and sell. These two lines are drawn above, below and equidistant from a “median” line. This is a line of linear regression which Dr Andrews (the creator of the Pitchfork) calculated that prices regress to for about 80% of the time.
TRENDING MARKETS: S&P500 EXAMPLES
Here’s a section of a chart showing the S&P500 from 2012 to 2013. We can immediately see a few peaks and troughs although there does appear to be an upside bias to price direction. So, what I want to do now is confirm if this upside bias exists.
To identify trending markets In the chart below I’ve added the Relative Strength Indicator (RSI) which appears beneath the chart. I’ve also circled some points where the S&P appears overbought or oversold, and where this is confirmed to some degree by the RSI. As a general rule of thumb, a market is considered to be overbought when the RSI is above 70 (the red dotted line) and oversold when it is below 30 (the blue dotted line).
Now I can use these three points to draw on an Andrews’ Pitchfork. The pitchfork is drawn on to a chart by identifying a recent and significant high-low-high, or as in this case a low-high-low pattern. You work from left to right and once the points are chosen we see three parallel lines extend out to the right.
The following chart shows what happened next. As we can see the S&P500 was most definitely in a long upward trend. We can also see that it spent most of its time trading between the median line as resistance and the lower line as support. So we should be trading this market in the direction of the trend that is to say from the long side. We should be looking to buy on dips which test support but be constantly aware of money and risk management so that we have some protection should the price break to the downside.
Some traders believe that a trade should be reversed if the price breaks below or above the support or resistance lines of the pitchfork. But apparently Dr Andrews preferred to add in fresh parallel trend lines until there was a significant price breakdown.
Personally, I wouldn’t look to reverse a position on a break of support or resistance. But I’d be very happy to book profits either by physically closing out the position, or letting my stops do the work for me. As we can see from this final chart, sometimes the counter-trend drawdown can be sharp and significant.