📈 Trends: higher highs, higher lows and how trends end

🎯 In 30 seconds: A trend is the direction price has been moving, judged by its swing points. An uptrend makes higher highs and higher lows. A downtrend makes lower highs and lower lows. Anything else is a range. Trendlines and channels help you see the slope, and a trend is usually considered over when price breaks its last higher low (or last lower high). Research finds trends persist more often than chance in many markets, but it is a tendency, not a law, and individual stocks are noisy.

What a trend is

Technical analysis is the study of price and volume to make trading decisions. The first question it asks about any chart is simple: which way is this going?

Prices never move in a straight line. They zigzag. Each zigzag leaves behind two kinds of turning points:

• Swing high: a peak where price stopped rising and turned down. A common definition is a bar whose high is above the highs of the two bars on each side.
• Swing low: a trough where price stopped falling and turned up. The mirror image: a bar whose low is below the lows of the two bars on each side.

Line up the swing points and the trend appears:

• Uptrend: each swing high is higher than the last (higher highs) and each swing low is higher than the last (higher lows).
• Downtrend: lower highs and lower lows.
• Range (sideways): highs and lows roughly level, or mixed. Price is bouncing between a ceiling and a floor. Ranges are common, and many charts spend long stretches in them.

This definition is old. It goes back to Charles Dow, the founder of the Wall Street Journal, whose ideas about trends became known as Dow Theory. It is still the backbone of most trend analysis because it is objective: you can check it with a ruler.

Trends depend on the time frame

A stock can be in an uptrend on a weekly chart, a downtrend on a daily chart and a range on an hourly chart, all at once. None of these is wrong. They describe different time frames.

So always say which chart you mean. "The daily trend is up" is a useful statement. "The trend is up" is not. Using multiple time frames shows how to combine them, and Chart basics covers bar sizes and scales.

How to draw a trendline that means something

A trendline is a straight line connecting swing points in the direction of the trend. In an uptrend you draw it under the swing lows. In a downtrend you draw it over the swing highs.

1. Find two clear swing lows (for an uptrend), with the second one higher than the first and some time between them. Two points touching each other do not make a trend.
2. Connect them and extend the line to the right. The line now projects where support might be in the future.
3. Wait for a third touch. Any two points make a line. A third swing low that bounces near the line is what makes it a trendline worth watching.
4. Be consistent about wicks. Draw through the lows of the candles (including wicks) or through the closes, and stick with one method. Mixing them lets you draw whatever you want to see.
5. Use a log scale for long trends. Over months or years, a stock that grows at a steady percentage rate curves upward on a normal (linear) scale. On a log scale it plots as a straight line, so the trendline is fair.

A channel is a trendline plus a parallel line on the other side of price. In an uptrend the parallel line is drawn through the most prominent swing high. Some traders take partial profits near the upper channel line and look for entries near the lower one. Price often overshoots or falls short of both lines, so treat them as areas, not exact prices.

Steepness matters. A very steep trendline gets broken quickly, often by a normal pause rather than a real reversal. Trends that last tend to have moderate slopes and regular pullbacks.

Worked example: projecting a trendline

Hypothetical numbers. A stock makes a swing low of $53.00 on day 16 and a higher swing low of $57.50 on day 34. You connect them.

On day 52 the stock pulls back to $62.20 and bounces. That is the third touch, so the line now carries more weight.

Now say you buy at $65.00 on day 55 after the bounce. Where does the trade go wrong? The uptrend is defined by its higher lows, so the logical place for a stop is just under the latest higher low, say $61.90. Your risk is $65.00 minus $61.90, or $3.10 per share.

If your account is $10,000 and you risk 1% per trade ($100), you can buy $100 / $3.10 = 32 shares (rounded down). That rule is covered fully in Position sizing and Stop losses. The point here: the trend structure tells you where you are wrong, and that is often more useful than any prediction about where price will go.

How trends end

Trends end in a few typical ways. Knowing them stops you from holding on long after the evidence changed.

• A lower high. In an uptrend, a rally that fails below the previous high is the first crack. It is a warning, not yet a reversal.
• A break of the last higher low. When price then closes below the most recent higher low, the pattern of higher lows is gone. By the swing-point definition, the uptrend is over. It may become a range or a downtrend.
• A trendline break. Price closes clearly through the trendline. This often happens before the swing structure breaks, so it is an earlier but less reliable signal. Many trendline breaks just turn a steep trend into a slower one.
• Sideways exhaustion. Rallies get smaller and pullbacks get deeper until the swings flatten into a range.
• A shock. A news event, like an earnings miss, can gap price straight through every level at once. See Breakouts and gaps.

Why trends happen, and what the evidence says

Nobody knows for certain why prices trend, but researchers have proposed reasons. Investors may react slowly to news, so prices adjust in steps rather than all at once. Then, as a move gets going, people chase it. Clusters of stop-loss orders just beyond obvious price levels can also push a move further once those levels break, which a New York Fed study of currency orders documented.

The evidence that trends persist more often than chance is fairly strong for broad markets over months. A study of 58 liquid futures markets (stock indexes, currencies, commodities and bonds) found that returns over the past 1 to 12 months tended to continue, then partly reversed over longer horizons. A later study extended this kind of trend-following test back to 1880 and found it profitable over the following 110 years taken as a whole.

Three honest limits:

• Those results are for diversified baskets of markets, not one stock. A single stock's chart has far more noise, and company news can end a trend overnight.
• Trend strategies are built to accept many small losses. They depend on a few big trends to pay for all the false starts. That is hard to sit through. See Trend following.
• Very short-term moves often reverse. Over days to weeks, stocks show some tendency to snap back rather than continue. "Trend" depends heavily on the time scale. Does technical analysis work? goes through the research.

So "the trend is your friend" is a reasonable default, not a promise. It tells you which side to favor, and the swing structure tells you when you are wrong.

Trends and the other tools

Almost every tool in this section is a different way of measuring trend:

• Support and resistance marks the levels where swings tend to stop.
• Moving averages smooth price so the direction is easier to see, at the cost of lag.
• Momentum indicators measure how fast the trend is moving, and can show it slowing before the swing structure breaks.

Try it

1. Open the Index dashboard and pull up a daily chart of the S&P 500 for the last six months.
2. Mark every swing high and swing low using the two-bars-on-each-side rule. Label each one HH, LH, HL or LL.
3. Write down the trend: up, down or range. Then draw a trendline through two swing lows (or highs) and see if a third touch followed.
4. Repeat on the weekly chart. Did you get the same answer?
5. Add three stocks to your Watchlist and check their trend once a week for a month. Note each time a trend ended and which signal came first: the trendline break, the lower high, or the break of the higher low.

When you want to trade it, use the paper portfolio first, with your stop under the last higher low.

Sources

• Moskowitz, Ooi and Pedersen: Time series momentum (Journal of Financial Economics, 2012), author PDF
• Hurst, Ooi and Pedersen: A Century of Evidence on Trend-Following Investing (Journal of Portfolio Management, 2017)
• Federal Reserve Bank of New York: Osler, Currency Orders and Exchange-Rate Dynamics (Staff Report 125)