Technical Analysis 101 with Stocks Down Under: Price Trends and Trend Reversals

Behzad Golmohammadi Behzad Golmohammadi, June 28, 2022

Price trends are one of the most important tools in our technical analysis arsenal. In this article, we’re going to show you how to find price trends in stock charts and you’ll see how they can be used to make trading and investment decisions. 

 

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As we mentioned in our first Technical Analysis 101 article, the purpose of using technical analysis is to make a more informed assessment of sentiment on a stock. Price trends are very effective in showing the prevailing sentiment on a stock. 

 

Uptrends and downtrends 

When a stock price is experiencing higher highs and higher lows, we say that the stock’s price is on an uptrend and we should be able to draw an upward trendline on the price chart by connecting the ascending lows (see the left side of the chart below). 

The fact that the market could push the price above previous highs, where there’s natural profit-taking activity, is an indication of enthusiasm on the side of buyers and signals a bullish sentiment on the stock. 

On the other hand, when a stock price is experiencing lower lows and lower highs, we say that the stock is on a downtrend and we should be able to draw a downward sloping trendline on the price chart by connecting the descending highs (see middle section of the chart below). 

With a similar interpretation used for uptrends, but in an opposite manner, the fact that sellers can overcome the natural bargain buying pressure at the lows and push the price even lower shows us the higher enthusiasm on the side of sellers compared to enthusiasm on the side of buyers of this stock and it signals a bearish sentiment on the stock. 

 

The following chart shows how to draw trendlines and find trend reversals. 

 

Price trends

Select Harvest (ASX: SHV), Daily Chart in Semi-log Scale (Source: Metastock)

 

Finding trend reversals 

The reason why we use higher lows in an uptrend and lower highs in a downtrend to draw the trendlines instead of higher highs and lower lows is that we are interested in using trendlines to find potential trend reversals and support and resistance levels. When we find the trend on a stock price, the presumption is that the trend tends to last until the price breaks the trendline. 

Therefore, a strategy to use price trends to make trading or investment decisions is to draw the trendline and in an uptrend to buy the prices near or at the trendline and sell when the uptrend breaks, i.e. when the share price falls below the trendline 

Similarly, in a downtrend sell at the prices near or at the trendline and buy when the downtrend breaks. 

 

Nothing is set in stone 

Be aware that trendlines only suggest Potential support or resistance levels. It is important to know that these levels are only indicative of a potential for the price to return back to the direction of the trend and there’s no certainty. Whenever the price reaches the trendline there will be two possible scenarios for the next move in the price. 

 The first one is the default scenario that the price has not yet reached the equilibrium level where there will be a balance of enthusiasm between buyers and sellers. In this case the price will return to the direction of the prevailing trend and continues to move in the direction of the trend.

The second share price scenario after reaching the a trendline is to break through the trendline. This will be an indication of a pause in the trend and a possible trend reversal. 

 

There are other technical analysis tools that can be used to assess the likelihood of each scenario. Price divergence with momentum indicators, such as RSI (Relative Strength Index), is commonly used for this purpose. 

In our next Technical Analysis 101 article, we are going to discuss some of the most popular momentum indicators and we’ll show you how to use them in conjunction with price trends to make more profitable entry and exit decisions. 

 

Moving averages and price trends 

Moving averages are more commonly used in trading algorithms to find price trends. This is because moving averages are calculated by using simple mathematics whereas finding trendlines on a chart will require advanced machine learning algorithms and image recognition technologies, which makes the process inefficient for many algorithmic trading strategies.  

A simple moving average (SMA) is calculated by taking the arithmetic average of a set of prices during a given number of trading sessions. An exponential moving average (EMA) is a weighted average of the same prices with a higher importance given to the more recent prices and therefore it’s more responsive to the changes in the price.  

5, 10, 20, 50, 100 and 200 days are the most commonly used periods to calculate moving averages. The choice of the time periods depends on the trader’s investment horizon and the overall strategy. Shorter time periods are used for short-term trading and longer time periods are used for long-term investments. 

 

Using moving averages to find trend reversals 

Crossovers of two moving averages are used to find reversals in price trends. If a short-term MA crosses above a longer-term MA and remains above that MA for at least three trading sessions, an uptrend has begun and if the opposite happens, a downtrend has started. 

We use 5-day and 20-day EMAs most commonly as we have found the signals produced by these EMAs to be best-suited to our investment horizon and decision-making process. You can see on the Select Harvest chart above that the 5-day and 20-day EMAs crossovers signalled the start and the end of the trends at about the same time as the trendlines. We can become more confident in the validity of a trend or change in the trend when signals from moving averages and trendlines confirm each other. 

 

In our next Technical Analysis 101 article, we will discuss momentum indicators and how they can be used to make trading and investment decisions in conjunction with trendlines and other technical analysis tools that we have so far introduced.  

 

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