Before understand trendline , first we have to know about market trends
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What is market trend?
As we discussed an earlier section, stock prices can be volatile in the short term. They don’t necessarily move in a straight line. However, as you zoom out and look at slightly long-term price patterns, you will discover a better defined market trend.
In general understanding, a trend is the broad upward or downward movement of a stock’s price over time. Upward movement is called an uptrend, while those which move lower over a period of time are said to be in a downtrend. Investors have a tendency of buying stocks that are seemingly in an uptrend and selling the ones in a downtrend.
However, stock prices move in a zig-zag manner. In technical analysis, we don’t identify a trend simply based on how far up or down a stock price has moved over a period of time. We concern ourselves with the specifics–how much the stock rose when it moved up, and how little it fell in a downtrend. In other words, we look at how high the share price touched – the top or how low did it fall – the bottom
Now, let us look at the three types of market trends :
In an uptrend, both the peaks (tops) and troughs (bottoms) of a stock chart keep increasing successively. So, every day or so, the stock price touches a new high and falls lower than it did previously. Don’t be mistake; this need not be a lifetime high. It could be the highest the stock touched in the past few days, weeks or months too. This steady rise in tops and bottoms indicates that the market has a positive sentiment. It expects the stock has a higher chance to appreciate more than depreciate. So, more investors buy, thus driving the price higher. Similarly, each time the stock falls, investors see it as an opportunity to buy even more. They don’t wait for it to fall to the previous level. They buy the stock before that. This arrests the fall.
Let’s suppose a stock has moved as follows over the previous seven weeks—Rs 60, Rs 52, Rs 63, Rs 55, Rs 65, Rs 57 and Rs 69. As we can see, each peak—Rs 60, Rs 64, Rs 65 and Rs 69—is higher than the previous. Similarly, each trough is also higher than the previous. This is a classic uptrend.
In contrast, some uptrends are marked by prices falling more each time and rising less. We will touch upon this later in this segment. Although the stock might still go up, its growth comes at a very high risk for you.
A downtrend is a pattern, where a stock is falling constantly. Not only are successive peaks lower, successive troughs are also lower. This means that investors in the market are convinced that the stock will fall further. Each little rise in the stock’s price is used by investors to sell their existing quota of shares. No further buying takes place at these levels. Such a stock must not be bought, no matter how much its price has fallen—especially if you are short-term investor. If you are a long-term investor, you may want to wait until the stock price falls further.
In a sideways trend, a stock doesn’t move notably in either direction during an extended period. Peaks and troughs continue to be constant and there is no significant move to decide whether to buy a stock or not.
How to identify market trends
We have already described the different kinds of market trends. Now, let’s see how to identify market trends with the help of an example.
Suppose the price of a hypothetical stock at the end of each of the previous six weeks was Rs 35, Rs 38, Rs 27, Rs 40, Rs 24 and Rs 41. The price chart of such a stock would look something like this:
If you look closely, you will discover that every time the stock falls, it falls by a greater percentage than it did on the previous occasion. Each of the three troughs of the stock chart—Rs 35, Rs 27 and Rs 24 are successively lower than the previous. Similarly, every time the price rises, it rises less than before. Notice how gradual the increase from Rs 38 to Rs 40 and then to Rs 41 is.
A first-hand observation would suggest that the stock has done well because it has appreciated from Rs 35 to Rs 41. However, a closer look will reveal that the quality of the appreciation has been low.
In this case, the stock has only appreciated by about 17% overall. However, along the way, it has fallen by as much as 40% on one instance. Why would somebody risky such a big loss for such a mediocre return? This is why understanding market trends is important.
An analysis of market trends in this way is referred to as trend analysis. A key aspect of technical analysis is a ‘trendline’
In order to perform effective technical analysis, it is critical for you to understand what is a trendline. A trendline is a line that connects all the troughs or all the peaks in a stock chart with each other. A trendline that connects the peaks helps you chart the growth that a stock has displayed over a period.
A trendline that connects the troughs helps you track the risks inherent in the stock. You may even use a combination of the two trendlines to see the general trend of a stock’s price over a specific period of time. The combination of two trendlines is called a channel.
It takes two or more points to draw trendlines, and a third point to confirm the actual trend is true. And the more points used to draw the trendline, the more validity attached to the support or resistance level represented by the trendline.
The most important feature of trendlines is its angle and slope. As the steepness increases, the validity of the support or resistance level decreases. In other words, if the stock price breaks a steep trendline, it may or may NOT be a valid change in trend.
On a sideways trend, a break above or below support or resistance usually means that it is the real deal.
For trend trading, the longer the timeframe of the trend, the more important the trendline. Trendlines on a weekly chart identifies a more important trend then the daily trendline.
Trading volume plays an important role when trend trading.
- if volume expands when stock prices move in the direction of a trendline, it confirms that trendline
- if volume shrinks when prices pull back to a trendline, it also confirms the trendline
- if volume expands when stock prices return to a trendline, it warns of a potential price break
- if volume shrinks when prices pull away from a trendline, it warns that the trendline is in danger