One of the most fundamental and most important tasks for an investor is to identify the trend correctly as it enables us to position ourselves in correct direction, that is, whether we would go for a buy or sell or don't do anything.
In an earlier post on trends, we talked about the short term, medium term and long term trends and also told that at one point of time infinite number of trends are happening simultaneously based on timeframe you select.
So, if so many trends are occurring simultaneously, it becomes overwhelming to identify a trend and whether the trend we have identified is a short term, long term or medium term trend.
In this post, you will learn about ways you can identify trends correctly.
Let's get started.
A trend in a stock can be identified by following ways-
1. Visually by observing the chart
In one of the post while discussing trends, we learned that an uptrend is characterized by higher highs and higher lows on the chart and a downtrend by lower highs and lower lows.
By observing such a pattern in a chart, you can identify whether a stock is in an uptrend, downtrend or no trend.
Let's see it in a couple of charts.
In the chart above, on the left-hand side, you can see price movements marked with lines in blue. Notice that the stock is making higher highs and higher lows, as depicted by letters H and L suggesting the stock is in an uptrend for that period. On the right-hand side, I have marked the price movements with lines in black. Notice that price movements are making a lower high and lower low suggestive of a downtrend.
In this monthly chart of TATAMOTORS, you can see the stock to be in downtrend in left-hand side characterized by lower highs and lower lows (Black lines). On the right-hand side, blue lines show the stock to be in an uptrend, characterized by higher highs and higher lows.
2. How to use Moving Average to find trend?-
Moving averages are technical tools that smooth the price movements of a stock over a period and enable us to see the trend behind the price move clearly. I have already written a post on moving averages discussing the calculation and practical uses of this tool and would like you to go through that post if you are unfamiliar with this indicator.
Price above a moving average suggests the trend for the period is up, conversely, price below a moving average suggests the stock is in downtrend for that period.
For example, a price above 21 period MA means for the last 21 period the trend is up. Similarly, a price below 21 period MA suggests the trend for the last 21 period is down.
Moving averages also allow us to see the different trends based on time period- the shorter term trend, the medium-term trend and longer-term trend by changing the period for which a moving average is being calculated.
For example, a 21 period MA gives us an idea about a shorter term trend. So, if price is above 21 period MA, the shorter term trend is up and if price is below this MA the shorter term trend is down.
Similarly, a 50 period and 200 period MAs reflect the medium term and longer-term trend, respectively.
Let's understand this idea with the help of a couple of charts.
I have marked the 21, 50, and 200 period Simple moving averages in the chart above by green, yellow and red lines, respectively. Notice that, at point A the price of the stock is below 21, 50 and 200 MAs. This means the stock is in a short term, medium term and long-term downtrend. However, at point B, the stock is comes above 20 period MA, suggesting a short-term uptrend but the price is below 50 and 200 MA, suggesting a medium term and long-term downtrend. Similarly, at point C the stock is in short term and medium term uptrend (As price is above 21 and 50 period MA) and long-term downtrend (as price is below 200 period MA).
Can you find the short-term , medium-term and long-term trends at points D,E and F?
Based on what you have learned above, can you find the trends at points A-G in the above chart?
Choice of Moving averages- While 21, 50 and 200 period moving averages are widely used to visualize the short, medium and long-term trend don't take these numbers as gospel. You can change these numbers based on your own trading style.
For instance, some swing traders use 11, 21 and 35 period moving averages to envisage different trends based on time period.
3. Trend confirmation using Relative Strength Index (RSI)-
While RSI is a momentum indicator that shows the speed with which the prices are rising or falling, it also gives an idea about the trend behind those price moves.
A study conducted on NSE stocks found that RSI can be used to identify the trends accurately. The study discovered that RSI level of 50 can be used to find longer-term trend and RSI levels of 60-40 can be used to find the shorter term trend.
RSI above 50 suggests the stock is in long-term uptrend while a level above 60 suggests the stock is in a shorter term uptrend. Similarly, RSI level below 50 is suggestive of a downtrend and RSI below 40 indicates a shorter term downtrend.
Let's see this with the help of a chart.
In the chart above, the RSI is mostly below 50 level, suggesting a downtrend.
4. Trend confirmation using Moving Average Convergence Divergence (MACD) -
MACD is an oscillator and a momentum indicator that reflects the pace of price movements, however, this technical tool can also be used to gauge trend.
MACD line above 0 suggests that the trend is up, while MACD value below 0 implies the stock is in downtrend. Let's examine the charts below to see how MACD functions as a trend indicator.
In the chart above, the first arrow from left shows MACD crossing above 0 suggesting the trend has changed to uptrend. The second arrow shows the MACD coming below 0, indicating the trend now is a downtrend. Finally, the third arrow shows the MACD going above 0 once again, suggesting an uptrend.
Can you find trends at the points marked with arrows in this chart?
5. By using Ichimoku Cloud-
Ichimoku cloud is one excellent indicator that gives many informations about a stock, like momentum, support and resistance, trend reversal and trend direction. Though initially this indicator might look perplexing but once you get used to it, it becomes easier to use it.
To visualize trends through ichimoku cloud you need to observe the price of a security in relation to the cloud. We say a stock is in an uptrend if the cloud is green and the price is above it; similarly, a price below a red cloud suggests a downtrend.
Let me demonstrate this in a chart.
The arrow on the left, in the above chart, shows the price is above the green cloud of Ichimoku cloud, suggesting the stock is in an uptrend. The arrow on right, shows price below the red cloud indicative of a downtrend.
While there can be several other indicators and methods to get an idea about trends but the ones I mentioned are the most commonly used. I use Moving Averages a lot to visualize trend behind the price movements because of its simplicity and ease of use, however, I also use other methods to confirm the trend suggested by MA.
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