Traders generally understand what is meant by “this stock is in a trend”. However, looking at the stock charts below, we find that all trends are not alike. In fact, within the same stocks’ chart we can find a variety of price patterns that appear to be trends, but are they? It would be useful to know how to define a trend so that the same set of rules is always used to decide if various up and down stock movements are trends or not.
To establish a trend, a trader might simply look at the overall direction of the stock price and decide that it is trending up, down or moving sideways. However, this is not very useful assuming a trader wants to apply a trading strategy that is rules based and be able to compare the trader results over time.
According to Dow theory, a stock is trending up if it achieves higher highs and higher lows as the price swings up and down, and overall, the price is higher after the swings are completed.
Dow theory contains a raft of rules that define a trend. For instance, a series of up bars or candles must be followed by at least one down bar or candle in order to form a peak. A series of down bars or candles must be followed by at least one up bar or candle to form a trough. Then, to confirm a trend, Dow theory requires at least three troughs through which a trend line can be drawn. Once this is done, an uptrend has been identified.
The chart (right) shows peaks and troughs. The stock swings up and down within an overall upward movement. It’s obvious which way the price is moving, but a trend line would be difficult to draw on the chart shown right because the troughs don’t form a straight line.
In the second chart a trend line has been drawn to illustrate the difference when troughs are in sufficient alignment. Note that in this approach at least three troughs are used to validate the trend line. Notice also that once price crossed below the trend line at the top right of the chart, a trade exit signal was given. In this case, the simple trading rule was ‘exit if price closes below the trend line on two consecutive days.
Drawing trend lines is more complicated than this blog can explain in a few words. The point is to know that the techniques can be learned with a little effort and that trend line exits can be highly effective at capturing profits.
