Trading 101: Trend Analysis with Basic Charting Tools
In our previous post dealing with swing trading we laid off the basics off trends in financial markets, and now we are going one step further. Getting to know the simplest charting tools will help you in analyzing trends, refining entries and exits, and building more sophisticated strategies. What’s more, these easy-to-use tools will be helpful not just in trading, but in your long-term investment decisions as well.
For those who hear the terms “charting” and “charting tools” first, charting is the name of the analysis of price charts which contain the price history of financial assets, while charting tools are various drawings like trend-lines, chart patterns, support and resistance levels, and other visuals that traders use for their decisions.
We will get to all the different chart types (and later the hundreds of indicators that are out there), but for now, this is more than enough to progress. In fact, as you will see, keeping your analysis simple should be one of your most important long-term goals as a trader.
The Role of Charting Tools and Indicators
Before we get into the tools themselves, it’s crucial to note that charting tools and most trading indicators have one very important thing in common; they don’t add additional information to the price (and volume) data that’s already available on a basic price chart. This means that they are not some sort of magical forecasting methods. That said, by visualizing the data in different ways, they can uncover hidden, or hard to understand tendencies in the price history of an asset, making them very useful in practice.
OK, but why do traders need that information? Well, the basic premise of technical analysis is that by studying the price history of an asset, we can predict the probability of the direction of future price movements.
The word probability is very important here because, without it, it’s easy to misunderstand technical analysis and charting tools. The key is that these methods don’t predict the future (because that’s not possible), but they help you in taking the position with the highest probability. Indicators will also be of great help in this process, providing simple and convenient ways of discovering ongoing trends, cycles, and waves in the price action.
The Structure of Trends
As we have seen previously, prices move in advancing and declining waves (or swings) that are separated by swing highs and swing lows. The most basic tools of trend analysis are trend lines, which simply connect these swing highs and swing lows. On the chart below, you can see that these trend-lines give traders a good idea of the”angle” of a certain price movement.
Rising and falling trend-lines in the EUR/USD currency pair
The trend-lines connecting swing lows and swing highs usually form a trend-channel that defines the movement of an asset for the period of the trend. Because trends can be broken down into smaller waves on shorter time-frames, there are most of the times several “active” trends in motion for every asset. You can see those different trends (the lower time-frame trends drawn with red) on the chart below:
Rising and falling trend-lines on different time-frames
For our example, we deliberately chose trends that are not perfect (notice the small deviations from the trend-lines), as trend-lines are rarely precise enough to base exact trading decisions on them; they are more for roughly estimating the angle of the trend and the end of the price waves.
Cycles and Trend-Lines
You might ask the question that how it’s possible to spot a meaningful swing low or swing high on a given time-frame. The answer lies in cycles, which we indicated on the next chart. The swings on a time-frame tend to be roughly similar in length, giving you a good estimate for the length of the coming cycles. Using this, when a trend is established (after you identify a higher high and a higher low, or a lower high and a lower low), you simply project the length of the first wave (Cycle 1 on the chart) to get the possible points for the next swing lows (the vertical purple lines on the chart).
Cycles and swing lows in a rising trend
Again, these tools are not 100% precise, but they can help you immensely in your timing decisions. The major swing lows in our example were roughly around the projected cycle lows, and they were confirmed by the break of the lower time-frame trend lines. This is how a larger time-frame trend develops from shorter time-frame trends and major swings. In a rising trend, swing lows are more important, but the same logic can be applied for swing highs as well.
Trend-lines provide great value in several swing trading and other types of strategies as secondary signals. Secondary trading signals are signals that are less reliable but often come earlier, than primary signals, such as higher highs or higher lows. If the price reaches a trend-line it often means that the lower time-frame trend is close to its end, while a trend-line break is often a sign of the weakening the prevailing trend. These might provide the perfect opportunities for profit taking, switching to a more aggressive stop-loss level, or conversely, re-entering into a full position.
Let’s look at this in practice on the next chart:
Secondary trend-line signals in a rising trend
For this example let’s assume that you are already bought the asset in question, so we can fully understand the role of secondary signals. As soon as we established the trend-lines by identifying the higher high and the higher low, we can start using those for trading.
As you can see, this trend gave 3 clear profit taking points when the price touched the upper trend-line and two re-entry points when the price touched the lower boundary and broke above the declining shorter-term trend-line. It also gave an early warning to exit the whole trade before the price finally broke below a major swing low, providing a swing trading exit. This last signal is a good example when a trend-line break can serve as a primary signal—a clear break of a long-term trend often proves to be the end of a move or at least the start of a major correction.
Some of you might already know about trends that are not exactly like the ones we discussed so far. Trends in financial markets can’t always be described by straight lines. Why? There could be several reasons for that—the cause of the trend might not be stable, the trend might attract more and more traders causing an acceleration in the trend, or conversely, a negative trend might cause a quickly spreading panic among the holders of the asset, leading to a swift collapse.
Whatever is the reason, these so-called parabolic trends are great opportunities for traders. As the moves accelerate, profits can pile up quickly if you are positioned correctly. That said, identifying these trends is not always easy, and the jump in volatility usually causes troubles for beginners, especially if they try to trade against these powerful moves. For those reasons, we will dedicate a whole post for these trends; until then here is a recent example of a parabolic move:
A recent parabolic short-term advance in gold
Now that we introduced trends, the most important analysis tools for traders, in our next posts on we will take a look at some other crucial elements of charting, which complement and refine your trend analysis. Support and resistance levels, chart patterns, and special candlesticks will be on the menu.
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