II. The Trend is your Friend
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The concept of a trend is absolutely essential to the technical approach to market analysis. All of the tools used by the chartist - support and resistance levels, price patterns, moving averages, trend lines, etc. - have the sole purpose of helping to measure the trend of the market for the purpose of participating in that trend. In a general sense, the trend is simply the direction of the market, which way its moving. But we need a more precise definition with which to work. First of all, markets don't generally move in a straight line in any direction. Market moves are characterized by a series of zigzags. These zigzags resemble a series of successive waves with fairly obvious peaks and troughs. It is the direction of those peaks and troughs that constitutes market trend. Whether those peaks and troughs are moving up, down or sideways tells us the direction of the market. An uptrend would be defined as a series of successively higher peaks and troughs; a downtrend is just the opposite, a series of declining peaks and troughs; horizontal peaks and troughs would identify a sideways price trend.
The troughs are called support. It indicates a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. As a result, a decline is halted and prices turn back up again. Usually a support is identified beforehand by a previous reaction low. Resistance is the opposite of support and represents a price level or area over the market where selling pressure overcomes buying pressure and a price advance is turned back. Usually a resistance level is identified by a previous peak. In an uptrend, the support and resistance levels show an ascending pattern, while in a downtrend, the support and resistance levels are descending. In an uptrend, the resistance levels represents pauses in that uptrend and are usually exceeded at some point. In a downtrend, support levels are not sufficient to stop the decline permanently, but are able to check it at least temporarily. A solid grasp of the concepts of support and resistance is necessary for a full understanding of the concept of a trend. For an uptrend to continue, each successive low must be higher than the one preceding it. Each rally high must be higher than the one before it. If the corrective dip in an uptrend comes all the way down to the previous low, it may be an early warning that the uptrend is ending or at least moving from uptrend to a sideways trend. If the support level is violated, then a trend reversal from up to down is likely.
Most technical tools and systems are trend-following in nature, which means that they are primarily designed for markets that are moving up or down. They usually work very poorly, or not at all, when markets enter these lateral or 'trend less' phases. It is during these of sideways market movement that technical traders experience their greatest frustration, and systems traders their greatest equity losses. A trend-following system, by its very definition, needs a trend in order to do its stuff. The failure here lies not with the system. Rather, the failure lies with the trader who is attempting to apply a system designed for trending markets into a non trending market environment.
There are three decisions confronting the trader - whether to buy a market (go long), sell a market (go short), or do nothing (stand aside). When a market is rising, the buying strategy is preferable. When it is falling, the second approach would be correct. However, when the market is moving sideways, the third choice - to stay out of the market - is usually the wisest.