Tuesday, November 27, 2012

The END of a Trend

How does a trend come to an end ? This interesting question must be answered. After all, traders and investors are advised to exit when they perceive that the trend is facing a reversal. But what qualifies as a reversal ? Are reversal signals different for day traders, swing traders, position traders & investors ? This note will try to answer these questions.

How does the trend end ?

Trend is defined as a move of prices in any one direction. Prices keep on moving in one direction (up or down) offering opportunities for gains to people who participate in the move with the trend. At some point, sooner or later, all good things must come to an end. So also with a trending move. Technical Analysis provides many ways of identifying the exhaustion of a trend. Some of the methods are difficult, almost impossible to understand, leave alone follow. The simplest, easiest to understand methods are also the ones that are will survive different types of markets. The basic rules were defined by Charles Dow, then elaborated by Hamilton, Rhea, Edwards and Maggie, and, finally by David Fuller (fullermoney.com). My own ideas on trend exhaustion have been formed over a period of time based mainly on my perception of the markets and work of the masters.

Markets are dynamic, therefore signs of trend exhaustion will be different, every time a trend comes to an end. But, the broad patterns will be the same. After all, crowd psychology does not change.

Different Ways for the end of an up-trend

1. Distribution. After a sustained up move, momentum starts falling. Prices still go up, but at a slower pace. There are visible signs of a consolidation at current levels. Since the trend is up, it is assumed that the market will resume its up move after the consolidation is over. But, either through a large down day, or through a series of narrow range bars, prices eventually break down from the consolidation. This is a sign that the trend has reversed.

2. Trend Reversal. The up trend is defined as a series of higher highs and higher lows. After every upthrust, there is a brief corrective dip and prices then move up crossing the previous high. Usually, the dip will stop above the previous low. Eventually, after a dip, prices move up (as before) but fail to cross the previous high. Then a subsequent dip pushes prices lower than the previous low. A pattern of lower highs and lower lows is established thus reversing the uptrend.

3. Inverted V: While everyone is enjoying the upmove, prices suddenly fall, almost like a crash. If the price fall goes below a significant support level, then it is assumed that the up trend has come to an end. The difficult part is to define the 'significant support level'.

Different Ways for the end of a down trend

1. Accumulation. After a sustained down move, momentum starts falling. Prices still go down, but at a slower pace. There are visible signs of a consolidation at current levels. Since the trend is down, it is assumed that the market will resume its down move after the consolidation is over. But, either through a large up day, or through a series of narrow range bars, prices eventually break up from the consolidation. This is a sign that the trend has reversed.

2. Trend Reversal. The down trend is defined as a series of lower highs and lower lows. After every down move, there is a brief corrective rally and prices then move down below the previous low. Usually, the rally will stop below the previous low. Eventually, after a rally, prices move down (as before) but fail to cross the previous low. Then a subsequent rally pushes prices higher than the previous high. A pattern of higher highs and highs lows is established thus reversing the down trend.

3. The V: While everyone is staying away from the market which seems to be in a bear grip, prices suddenly rise, almost like a sudden thunderbolt on a sunny day. If the price rise goes above a significant resistance level, then it is assumed that the down trend has come to an end. The difficult part is to define the 'significant resistance level'.

These simple, easy to understand ideas are valid on all time frames for all types of trading & investing.

3 comments:

Vasant kumar said...

Sudarshanji, Its easy to undestand if things like this would explained with charts as example

MVG said...

We aew currently seeing distribution happening since last ~2 months that will end the current long term upmove and then there will be a medium to long term downtrend coming?

Mustafa said...

Sir Please give a facility of Email subscriptions for your blog posts. It will be easier to follow the posts in email inbox.