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The proper application of technical analysis requires an understanding of two related concepts: price trends and their inevitable breakdown. Both bear directly on nearly every aspect of the chartist’s work, and hereunder we attempt to explain the most important aspects of both.
Price Movements
Technical analysis is based on the notion that price movements follow trends. The trading strategies that follow from this understanding are based firmly on the “inertial” notion that once a trend is established, it will continue in the same direction until it reverses.
That said, there’s also an understanding that several trends can be in play at any given moment.
There is, for instance, the long-term or “secular” trend that can play out over years, or even decades. Within that framework, there’s also an intermediate trend that lasts anywhere from one month to a year or more, zigging and zagging within the grand, overarching secular bull or bear market.
Finally, there’s the short-term trend that cuts up and down on an irregular basis – say, anywhere between a few minutes and a few days. This last current is generally considered too difficult to predict, even by veteran chart watchers. In fact, it’s a widely understood rule that the longer the trend analyzed, the more predictable it is.
Trend Lines
The following charts indicate how technicians mark trends, both bullish and bearish. Have a look at the solid red lines in each:
This is a daily chart of gold miner Goldcorp (NYSE: GG) over the course of eight months. As you can see, there’s a single, distinct trend in evidence over the period, and it’s decidedly bearish. Because of the length of the decline, it would classify as an intermediate trend.
The chart below shows the same company for a year’s duration. In this case, however, the trend is bullish.
In both cases, the tiny zigs and zags that constitute the short-term trends are highlighted in blue. Most traders would have a very difficult time making money off these random and apparently incoherent meanderings.
Expanding the Time Horizon
Look now at a long-term (five-year) chart for the same stock, which maps out its multi-year, secular trend. Here, one can also see the shorter-term, multi-month squiggles that represent the intermediate-term turns in trend, again marked in blue.
Trend channels, such as the one marked in red above, are another means of charting the existing trend. These configurations aid traders in setting bets within the existing longer-term trend.
How is that done?
Well, as you can see, once the price strikes the upper end of the trading channel it generally ricochets back toward the lower, offering potentially key timing points for either closing out an existing initiative or launching a new one.
Breakdowns
Whenever an existing trend line or trend channel is breached, traders should be wary of a potential change in direction, and would be well advised to close out open initiatives and/or reverse and open new ones.
Here’s a look at a chart of the United States Natural Gas Fund (NYSEArca: UNG):
This chart is a textbook illustration of market timing based on a broken trend line. Closing a short position (or opening a long) as the price broke above the upper edge of the price channel (blue arrow) would have produced tremendous profits.
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