How To Perform Technical Analysis Of Stock Trends

We saw that stock market trends provide critical insights into future stock price movements. Understanding market trends allows us to see beyond the obvious, and sometimes, prevents us from making crucial mistakes. But what is the point in simply understanding and not being able to spot such trends for yourself? In order to reap these benefits, it is important to be able to first spot market trends and then, decode them. In this section, we will try to do exactly this.

We will seek answer to two important questions:

How to identify market trends? How to understand market trends?

Different Types Of Market Trends

While spotting a market trend, we need to understand which kind of trend it is. So, let’s start by understanding the various types of market trends. Technical analysis theory classifies market trends on two grounds – market direction and time period.

Types Of Market Trend Classification

• Market Direction:

On the basis of the market direction, a trend may be an upward or downward trend. We have already discussed this classification in the previous section.

In an upward stock market trend, it is better if you buy more shares. This is because the price is expected to rise in the future. So, you can profit by selling at a higher price in the future. In investment lingo, they are called bullish trends. Downward trends are conducive to selling one’s existing holding of a stock. They are called bearish trends. This is because the price is going to fall further. Alternatively, if you are a buyer in the market, you may want to wait before the price falls further.

• Time Period:

Classification on the basis of time series can be traced back to the articles that Charles H. Dow wrote in the Wall Street Journal between 1900 and 1902. His ideas, though never formally compiled into a theory, are referred to as the Dow Theory. The theory is commonly regarded as the cornerstone of technical analysis. According to it, three types of market trends exist.

• Primary Trend:

This is the longest and the most important trend of the three. This is because it has the ability to influence the other two trends. Basically, the primary trend sets the tone for the other two trends. A primary trend generally lasts for one to three years. That said, it can go beyond this timeframe sometimes. Unless there is a clear sign of a trend reversal, the primary trend is considered to be the main trend. A primary trend may be in the form of a constant increase in stock prices for a period of one to three years.

In such a case, peaks would be constantly higher than previous ones. (A recap, this is when the stock price touches higher highs consecutively.) Similarly, a primary trend may also be marked by a constant fall in stock prices for multiple years.

• Minortrend:

A minor trend is a phase within a secondary trend. It is to a secondary trend, what a secondary trend is to a primary trend. In other words, it is a short-term movement that is contrary to the direction of the secondary trend. However, it lasts for an even smaller duration. Its duration typically ranges from a few days to a week. As such, if the secondary trend is a two month-long downward movement, its minor trend would be an upswing that would only last a few days at best.

• Secondary Trend:

A secondary trend is a temporary price movement in the contrary direction to the primary trend. It is hard to find a one-to-three year phase in history during which stock prices only went up without a single decline. This is because of secondary trends.

Let’s look at an example. Suppose stock prices constantly moved up for a period of 2 years. However, during these two years, there was one phase during which stock prices constantly declined for three months.

This phase will then be called the secondary trend. Similarly, if the primary trend is a fall in stock prices, the secondary trend would be a short-term rise in stock price.

Each primary trend contains many secondary trends within it. A secondary trend normally lasts for three weeks to three months. It is a weaker trend than a primary trend. This is because it cannot reverse the primary trend and lasts for a smaller period. If the primary trend is upwards, a secondary trend may be able to cause a temporary downward movement.

However, it cannot cause a decisive downward movement that would last for years. For example, markets are bullish about the potential of the Indian economy. So, the market is primarily moving up. Yet, there are phases when markets fall because say, lacklustre corporate earnings or because a particular reform Bill is not passing in Parliament. This causes a secondary trend.

All the three stock market trends give us useful information about stock prices. They tell us what the markets are thinking. However, only primary and secondary trends are of real value to you. This is because the effect of a minor trend is never too long or too deep. For this reason, you should not pay too much attention to it, as long as you are convinced about the primary trend. A secondary trend, in contrast is of some value, even if you are convinced of the primary trend. This is because it takes prices in the contrary direction to the primary trend.

In case the secondary trend is a downturn, you may use it to buy more stocks at cheap prices and benefit when the primary trend returns. In contrast, if the secondary trend is an upswing, it means that the primary trend is downwards. You may use the secondary trend to sell whatever stocks you own because prices are going to fall further and for an extended period.

Advantages And Disadvantages

Technical analysis of stock trends can prove highly beneficial as an investment technique.

Some of its benefits are:

• Less Prone To Mistakes:

Trend analysis is completely based on the study of chart patterns. This limits your input and makes your analysis highly verifiable and less prone to misinterpretations. In contrast, fundamental analysis is conducted using copious amounts of data. An analyst has to use his objectivity to draw conclusions out of these. This makes his work more prone to slippages and misinterpretations.

• Complete Analysis:

In trend analysis, all conclusions are drawn from historical trends. All the information is available on the screen right in front of you. That’s all you need for understanding market trends. Contrastingly, in fundamental analysis, deductions are based on extensive information, collected from a variety of sources. Unless one is aware of all this information, no meaningful conclusions can be drawn. In other words, technical analysis is simpler and cleaner.

• Free Of Assumptions:

Fundamental analysts make a lot of assumptions about growth rates, market shares, interest rates etc. while analysing stocks. For technical analysts, no such assumptions are needed. This makes technical analysis of stock trends much more realistic.

Despite these advantages, technical analysis of stock trends is not a flawless approach.

Some of the disadvantages that haunt it:

• Potentially Misleading:

Understanding market trends based on technical analysis can potentially mislead you. This is particularly true in unusual cases such as floods, droughts and other calamities that cannot be predicted by assessing past trends. All these have an influence on stock prices but are beyond the scope of technical analysis.

• History Doesn't Always Repeat:

Predicting the future based on past events means believing that history will repeat itself. This can be a very dangerous assumption. As the famous saying goes ‘change is the only constant. Businesses are redefining themselves, technology is transcending horizons. How can we continue using an approach that disregards all this and only clings on to history?

• Only Useful For Old Stocks:

The fundamental requirement of trend analysis is that a stock should have a long trading history. Only then can you analyse past patterns and comment about the future. This makes trend analysis unviable for evaluating new development. For example, in the 1980s and 90s, the US was witnessing a tech boom. Stock markets in the country were taken to new heights by IT companies that had just come up. Since these companies didn’t have a long trading history, sworn technical analysts were unable to apply their skills and benefit from one of the biggest booms ever.

How To Identify Each Trend

We have now come to the most important part of this section. It is all too well to know about different types of market trends. However, without knowing how to spot trends early, there can be no practical purpose. Most investors lose money because they don’t know how to identify market trends early. It is easy to pick some stocks in an uptrend. Everybody is talking about rising stock prices, one may read about them in the newspapers, and so on. However, how can you tell when to exit these investments? Both uptrends and downtrends reverse. Unfortunately, not many people are able to call these reversals and take adequate action.

Here is how you can identify market trends soon enough and act upon them. For the present conversation, we will exclude minor trends because they are not too significant in the grand scheme of things.

• Primary Trend:

Let’s reflect back on our conversation in the previous section. An upward trend is marked by an upward sloping graph, with increasing tops and bottoms. If this continues to happen, it is an indicator of a primary uptrend. Conversely, a downward sloping graph, with lower peaks and lower bottoms is an indicator of a primary downtrend.

The beginning of a primary trend is hard to trace. This is because it will always go opposite to the dominant trend. In other words, an upward trend will always come after a long downward spell and a downward trend will always come after a long upward spell.

As a result, there is always a possibility for investors to confuse it for a secondary trend and not a new primary trend. Let’s suppose you are in the middle of a long period of falling stock prices. You conclude that it is a primary downward trend. All of a sudden, peaks and troughs start rising. You could easily think that it is a secondary upward trend (because peaks and troughs are moving in the contrary direction). How can you be convinced that what is happening is actually the coming in of a new primary (upward) trend?

• Secondary Trend:

Spotting a secondary trend is somewhat simpler. This is because you know that the primary trend has reversed. It only remains to be seen whether it is due to a temporary secondary trend, or a longer, new primary trend.

Let’s say that the primary trend is currently upwards. This would mean that peaks and troughs are constantly getting higher. A secondary trend now would mean a short term downtrend. This can be spotted if the peaks, instead of becoming higher than before, start getting lower than before. Simultaneously, troughs would start falling instead of rising. If this were a major, long term fall, troughs would have fallen to a historical low. However, if they don’t fall so much, the trend is only a short term downtrend, namely a secondary downtrend.

In the chart below, the stock price has been rising continuously. So we know that we are in a primary upward trend. The bottom has been highlighted by the first line in the month of October. After that, each of the three peaks is higher than the previous. The next two peaks are, however, constantly lower. This means that we are in a downtrend. To confirm this, we need to look at the troughs. Look at how the troughs have also started falling. However, they stop falling before touching the October low. This means the downfall is temporary. A double bottom here confirms this. Thus, this is a secondary trend and not a reversal of the original primary uptrend. See how the price starts appreciating from this point.