Trends, Retracements and Reversals



There is a section on the Yahoo home page called “Trending Now.” Its purpose is to highlight the searches that are currently increasing in popularity. Apparently at this moment (December 13, 2011 at 7:17 AM Est.) the number one trending story is “Men in Black 3.”  Really?  “Men in Black 3?” Call me skeptical but I wonder if there is any type of manipulation going on here? The rest of the top 10 are as follows: 2. Michelle Duggar, 3. Pau Gasol, 4. Noomi Rapace, 5. iPhone 4S, 6. Eli Manning, 7. Iraq War, 8. Personalized Christmas ornaments, 9. Gift Cards, 10. Global supply chain.

Sorry, I have to step away to help my kids get ready for school. Back in a minute.

Ok, I’m back. Hold on...I just refreshed Yahoo’s home page and the “Trending Now” information changed.  The list now reads: 1. G.I. Joe: Retaliation, 2. God particle, 3. GPA calculator, 4. Noomi Rapace, 5. iPhone 4S, 6. Men in Black 3, 7. Iraq War, 8. Personalized Christmas ornament, 9. Gift cards, 10. Global supply chain. Some of the earlier trends have totally disappeared, like Michelle Duggar and Pau Gasol, and others have changed position, like Men in Black 3, and still other topics have made the list that were not their earlier. I guess this just goes to show that trends can change.

When we are looking a social media and pop culture it seems that trends change by the minute. I read recently that the seniors leaving collage this year believe that email is dead. It is essentially the snail mail of the 21st century and has been replaced by texting. Waiting for an email response just takes too long. As I get older, it takes me longer to identify trends, and I often miss the signals that they are coming to an end. Just ask my kids – they will agree with me.

When it comes to the stock market some people suffer from the same difficulties. They cannot see the market trends and have a tough time seeing the signals that those trends are coming to an end. This is a critical skill in the trading world. The truth is that everything is trending. It does not matter if you trade stocks, currencies or futures, in some timeframe there will be an observable trend.

In this blog we are going to discuss the definition of a trend, and more importantly how to recognize the difference between a “Retracement” and a ”Reversal.”

What is a Trend?

To make things easy let’s work with only bullish (upward moving) trends in the beginning. Our foundation is going to be the definition of a bullish trend. A bullish trend is “a series of higher highs and higher lows.” If a stock, or the market in general, is trending in a bullish fashion it does not mean that every tick must be to the upside. There will movements both up and down within a bullish trend. The slide below may be a bit too symmetrical but it is a good visual of a bullish trend.



As long as a higher high is generated above the previous high, and the most recent low remains above the previous low, the chart is showing you a Bullish Trend. In the chart below you can see that real life may not be as symmetrical, but the higher highs and higher lows still stand out. (CMN is not a buy sell or hold recommendation, it is being used as an example only to learn to identify bullish trends. The Chart is from The Wizard)  



Trading with the trend is the safest way to trade

If a stock is in great demand, the trend will be up. Consider the trend as the path of least resistance. The traders that decide to trade against the trend will constantly feel like they are running on a treadmill, never getting anywhere; like they are driving the wrong way on a one way street; like they are swimming upstream. You get the point, right? Understanding that trading with the trend is the safest way to trade is a huge step towards becoming a successful trader. This is why at The Wizard I only teach trading strategies that agree with the trend.

In “Technical Analysis of Stock Trends  9th Edition” pg. 51, Edwards, Magee, and Bassetti wrote “Clearly the way to reduce market risk to zero is to be out of the market. Less obviously, or perhaps blatantly, the second most important way to reduce risk is to be right the trend …

Retracements - the right time to enter a position

Stocks, and the market in general, can become tired of moving in the same direction. It takes a lot of work and money to send a stock to higher highs. When the price gets too high, buying pressure runs out when the money dries up. When demand dries up, price begins to fall and causes the chart to head south. This causes the stock to become more appealing to prospective buyers who believed the stock has potential to move higher but were waiting for a better opportunity. As the price becomes more appealing at a lower point, these new buyers step in creating demand and once again the price begins another leg higher. What I have just described is a “retracement.” Retracements are healthy functions of a solid trend and they are the proper time to enter a position on a trending stock.



How to recognize when a trend is unhealthy

If a trend continues too long in the same direction (over extended), it runs the risk of a collapse. When trends collapse investors lose big-time.  




Reversals: How to know when a trend is over.

If the definition of a trend is “a series of higher highs and higher lows,” then, logically speaking, the trend has to be over when the stock has failed to establish a higher high and sets a lower low. Keep this statement in mind:

              “You cannot have a lower low in the definition of a bullish trend.”



In the slide above, you can see that after the retracement (healthy part of a trend) the stock was unable to push to a higher high. Instead the stock establishes a lower high. A lower high is unhealthy, but it is not the end of the bullish trend. (It is possible that after setting a lower high the stock could retrace again, never setting a lower low, and then push above the previous high to a higher high). The nail in the coffin of a bullish trend is the establishment of the lower low. Once the lower low is in place your trend is over. This is called a “Reversal.”

In the chart below, notice that green lines have been placed at the previous high and the previous low. The stock looks as though it may be setting a lower high in place but we cannot be sure at this point. In order for the bullish trend to remain intact, the stock price will need to move beyond $28.50 to establish a new high. If instead, it is unable to establish a new high, and move below the previous low of $23.89 the bullish trend is over. Why? “Because you cannot have a lower low in the definition of a bullish trend.”



Every trader fights their emotions. Using logical rules to identify trends, retracements and reversals can help you get a grip on and help prevent you from making decisions on those emotions.

Regards,
Chris Irvin
The Wizard

Disclosure:  No Positions Mentioned are held by Chris Irvin

In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

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