The basic reason for looking at a price chart is to determine the trend. At a quick glance, we can see whether the market is moving up or down. However, few realize that the real trend is determined by the pattern of rising and declining moves. It is the determination of the ‘real’ trend that provides the information needed in identifying persistent moves.
Why is it important to identify ‘persistant’ moves or trends? Because it is these types of moves that provide the best opportunities for profit. If the trader/investor focused on just the ‘meatier’ parts of market moves, trades would only be taken in the direction of these ‘real’ trends, and the potential for profit would be much higher than opposing the trend.
The basic identifying pattern for trends require the identifying of Swings.
When price bars are formed with higher highs, at some point the last higher high bar will be followed by a bar that does not make a higher high, but makes a lower low. When this happens, the last higher high is referred to as a ‘swing top’.
When price bars are formed with lower lows, at some point the last lower low bar will be followed by a bar that does not make a lower low, but makes a higher high. When this happens, the last lower low is referred to as a ‘swing bottom’.
The basic pattern for a BULL trend is that each price bar is making a higher low. We are not concerned about the highs. If a series of higher lows ends and lower lows begins (Swing Top confirmed), as long as the lower lows do not make a low below the last Swing Bottom low, the trend is still considered to be a BULL trend. With BULL trends, the pattern is one of each Swing Bottom forming its low higher than the last Swing Bottom low. At times, it is possible for a Swing Bottom low to move below the low of the most recent Swing Bottom low, but not below the low of the last two Swing Bottom lows. When a lower low is below the last two swing-bottom lows, this usually signals that the BULL trend has likely ended.
The basic pattern for a BEAR trend is that each price bar is making a lower high AND lower low. Note that there are two indications here rather than just one, as is the case with BULL trends that only looks at the higher lows. When prices make a higher high and higher low in a BEAR trend (Swing Bottom confirmed), it will remain a BEAR trend as long as the high is not higher than the high of the last Swing Top high. BEAR trends have the pattern of lower Swing Tops and lower Swing Bottoms. It is possible for a high to go higher than the last Swing Top high and still be a BEAR trend. However, if the high goes above the high of the last two swing-top highs, then the BEAR trend has likely ended.
Now I stress that these are BASIC trend patterns. Understanding the basics is important as they provide the foundation for more advanced chart studies.
Understanding that the markets tend to move in the direction of the trend much longer than when moving opposite the trend, the trader/investor is in a better position when focusing trades to be executed in the direction of the trend. In addition, but understanding the ‘swing’ patterns that these trends exhibit, the trader/investor will further benefit by entering the trend at the end of these opposing moves.
For example, if the trend is BULLISH, the pattern is one of higher Swing Bottoms. These bottoms mark the end of moves in opposition to the trend. We call these moves ‘corrections’. By entering BULL trends at the end of corrections, that is, at Swing Bottoms, this lowers the risk exposure and increases the potential for profit. Once the Swing Bottom has confirmed, the trader/investor can use the low of the Swing Bottom to place a protective stop-loss (usually one or more ticks below the low).
Basic trend identification, however, is not a stand-alone trading system. In fact, there is no single indication that should be used alone for the purposes of trading. Rather, trend identification is just part of the solution to profitable trading. Other indications should be used along with trend identification to make a success at trading.