The Curious Investor

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In the last post, we went over how to draw proper trend lines. Today, we’ll look at how to use those trend lines to help inform your investing decisions.

Steepness

Trend line steepness gives you a measure of how quickly buying or selling pressure is accumulating. Furthermore, changes in steepness from one short-term (or sometimes intermediate term) trend line to the next, shows the acceleration or deceleration of the major trend that the stock is moving on. See the following example.

Steep trends tend to exist in shorter time periods, while long term trends tend to be less steep. A key to remember in using tend lines is that steep trends rarely last and a break down of a steep trend does not necessarily imply a reversal of a stock’s overall trend. In the case of Mastercard pictured above, a short term graph may have showed the break down of its short term trend in June and July of 2007. A savvy investor who might have noticed that the stock was being punished more by market forces than due to any inherently bad performance on its own, would have made sure to check Mastercard’s long term trend and seen that the stock found buying support exactly where its long term trend predicted allowing him to hold his position with confidence and profit as a new near term uptrend was established.

Time Frame

The above example is also a good reference for the case of understanding the time frame in which you are doing your analysis and making sure it is congruent with your investment horizon. A person hoping to profit off of a short term trade between March and July of 2007 would have weighed the short term reversal pictured at the end of July 2007 very heavily and would have done well to sell to take profits. Someone with a long term outlook would have taken heart in seeing Mastercard find support at its longterm trend line and likely would have bought more as the stock began trending up again.

Reversals

So, what exactly is a reversal and how does on spot a reversal? As we discussed, an uptrend is defined as a series of increasing lows followed by increasing highs. A down trend is defined as a series of decreasing highs followed by decreasing lows. The trend line ends when the corresponding high or low does not follow the pattern described above. That does not mean that the trend has necessarily ended. A reversal is not fully confirmed until we see that the corresponding low or high has instead turned into the new leading indicator.

To be more clear, in the case of a reversing up trend. We go to “alert” status at the point that we see that our increasing lows did not correspond to an increasing high. If upon this next cycle we find a low lower than the low prior to it, we have a confirmed reversal of trend. The same logic applies to down trends but in a different order. Basically, what you can see here is that a break of the trend line does not necessarily mean that the trend is about to reverse, but more just that the current line no longer provides necessary support (in the case of an uptrend) or resistance (in the case of a downtrend). Here’s an example of some trend reversals.

Here, I have outlined uptrends in green and downtrends in red. As you can see, ROG’s major uptrend is not fully broken until the end of December 2006, though the accelerated uptrend is broken down quite resoundingly in October/November of 2006. In August of 2007 till November of 2007, we see what may possibly be a trend reversal. The lower lows have stopped and we have seen two highs successively higher than each other. At this point, we are testing the newly established short term up trend. Should the stock bounce up, we will have a rather bullishly confirmed uptrend, but should it break down and through it is possible that a less negatively sloped, long term down trend is in the makings.

As you can tell, trend line analysis for timing peaks and troughs in price movements is an inexact science. It can give a general idea of where a peak or trough is to exist, but never gives absolute signals. In fact, often the signals are dictated by the trend line’s drawer’s proclivities in drawing the lines in and of themselves. That is why other technical indicators are often used - i.e. volume, moving average analysis, etc. - to confirm and signal actual trades. The trend lines instead are used as intermediate confirmation of these signals’.

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