Determine Trend Strength before you buy by using Moving Averages!
October 29, 2011
The indices blasted higher Thursday. And volume was particularly impressive. Additionally banks led the charge higher, which has become a pattern as of late. And maybe most importantly, all major indices tested the infamous 200 day moving average during Wednesday's session.
Technicians, technical analysts and traders use charts to analyze a wide array of securities and to forecast future price movements. While having a favorite style of chart is important, traders will tell you that knowing when to buy or sell a position is what really separates a successful trade from an unprofitable trade.
Very often the direction to take on a trade will depend on the trend. Basically, price can be doing only one of three things when evaluated over a given time period: trending up, trending down or moving sideways. Traders want to be buying in an uptrend and selling in a downtrend as determined by the trend strength.
Trend is defined as the general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend. Trading in the direction of strong trends certainly reduces risk and massively increases your profit potential.
Quantifying Trend Strength
Therefore, trend strength helps traders identify the strongest and most profitable trends to trade. The values are also important for distinguishing between trending and non-trending conditions.
As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, you should be very cautious about taking any positions that rely on the trend going in the opposite direction.
A trend can also apply to interest rates, yields, equities and any other market which is characterized by a long-term movement in price or volume.
Therefore trend analysis is.....
an aspect of technical analysis that tries to predict the future movement of a stock based on past data. Trend analysis is based on the idea that what has happened in the past gives traders an idea of what will happen in the future.
There are three main types of trends:
• Intermediate and
Trend analysis tries to predict a trend like a bull market run and ride that trend until data suggests a trend reversal (e.g. bull to bear market). Trend analysis is helpful because moving with trends, and not against them, will lead to profit for an investor.
Within the three types of trends in the market, there are a myriad of different kinds of trends, and it is the recognition of these trends that will largely determine the success or failure of your long and short-term investing.
Some of the Methods Used to Define a Trend Strength
• Average Directional Index.
The ADX 14 is a popular indicator used to help determine trend strength. The ADX is based on the moving average of price range expansion over a defined time period which is typically done over 14 bars. The ADX indicator does not show direction; it simply highlights the trend strength whether in an up trend or down trend. It is said that the higher the ADX is, over a static 25 line plotted on the indicator, the stronger the trend is.
• Bollinger bands.
A strong trend often crosses the higher or lower Bollinger band. This can show us that price is trending strongly and we can look to buy/sell pullbacks.
• Moving average direction.
A simple moving average shows the average trend direction and trend strength.
• Moving average crosses
Do not look to buy the moment a moving average cross happens, as this gives a heads-up indication to the overall trend. The time to buy is when pullbacks, etc., occur after the moving average crossover.
Trend Lines Help Determine Trend Strength
In addition to the direction of the current price movement, trend lines also show the strength of the current price movement. The trend strength of the price movement is not as important as the direction, but it is useful in determining if the trend is likely to continue or not. The trend strength is shown by the angle of the trend line, with a steeper angle representing a stronger trend, and therefore a higher probability of the price continuing in the same direction.
When the angle of the trend line is steep (perhaps greater than 30 degrees), the strength of the current price movement is high, and the price should continue in the same direction for the immediate future (perhaps bouncing off of the trend line a couple of times). The chart above depicts this action.
When the angle of the trend line is shallow (perhaps less than 30 degrees), the strength of the current price movement is low, and the price may not continue in the same direction for very long (perhaps reversing through the trend line). The chart below displays this trend.
Trend Strength Not Trend Line Strength
Note that the angle of the trend line shows the strength of the trend (the price movement), not the strength of the trend line. A shallow trend line that shows a weak trend, may still be a strong trend line, and could cause the price to move sideways rather than reverse its direction completely.
Moving Averages – A Very Popular Evaluator
Moving averages is one of the most accepted methods used by traders to evaluate trend strength due to its simplicity. Moving averages smooth out a data series and make it easier to identify the direction of the trend.
Definition of a Moving Average
A moving average is the average price of a security over a set amount of time. By plotting a security's average price, the price movement is smoothed out. Once the day-to-day fluctuations are removed, traders are better able to identify the true trend and increase the probability that it will work in their favor.
Therefore a Simple Moving Average (SMA).....
is the most common method used to calculate the moving average of prices. It simply takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation.
A 10-day simple moving average is calculated by adding the closing prices for the last 10 days and dividing the total by 10.
This smoothes the plotting of a data series and makes it easier to spot trends in three ways:
1. If the moving average is rising, the trend is considered up. If the moving average is declining, the trend is considered down.
2. Another trend identifying method is to compare the price to the moving average. If the price is above the moving average, the trend is considered bullish. If the price is below the moving average, the trend is considered bearish.
3. A third way to spot the trend strength is to compare a short term moving average to a longer term moving average. If the shorter moving average is above the longer moving average, the trend is considered bullish. If the shorter moving average is below the longer moving average, the trend is considered bearish.
Disregarding sideways non-directional sessions, any real directional push in price tends to last longer than most traders believe it can or will. There are many instances of traders/investors who have lost badly due to the fact that they have fallen victim to the too-common mistake of persisting to sell a grinding rally or buy a waterfall decline. The market itself doles out our highest-price lessons on trading.
Trial & error spells disaster! Going against a trend strength, be that it be minutes, hours or days in duration, has ruined more traders than any other single factor. Respecting trend strength or weakness, particularly price, when clearly visible on its own percentile of range grid, is one excellent way to flow with the market instead of fighting it.
Find friendly trends -- the best profits come from trading the strongest trends and avoiding range conditions. The ability to quantify trend strength is a major edge for traders.
If you want the trend to be your friend, you'd better not let moving averages become a stranger!