The goal of technical analysis, first, is to define the trend. I will show a few different methods for defining the trend in the coming pages. There are countless ways to define a trend but, in my view, keeping it as simple as possible should be the number one goal.
The second goal is to determine the strength of the trend. The strength of the trend is defined by its momentum. In other articles, I show a few different ways to determine the strength of a stock’s trend. The momentum of a stock can be determined by comparing the most recent price legs, or by using momentum indicators such as MACD, ADX or RSI.
The final goal is to ascertain how long the trend has been in place. Knowing the length of the trend is vital because the longer a trend lasts, the higher the probability for a significant correction or a reversal to take place. Below is a stock chart. I have erased the name, dates and time frames from the chart. This is just a set of open, high, low, close bars and a simple 18 moving average (magenta) along with a simple 40 moving average (blue). An 18 simple moving average (MA) takes the last 18 closing prices, adds them together and divides by 18. When plotted each day, we get a smoothed history of the closing prices over time. A simple 40 moving average (MA) is plotted the same way only using the past 40 closes in the calculation. Most investors that have read anything about moving averages are familiar with moving average crossover signals. Simply put, a crossover signal takes place when the 18 MA line crosses above or below the 40 MA line. These crossovers can be helpful in defining the trend of the stock. In addition, the slope of these MA lines, rising or falling, and the degree to which they are rising or falling also help with determining the strength of the trend. Regardless of whether these bars have developed over minutes or years, the pattern should be read the same way. Identifiable patterns take place whether these bars are hourly, daily, weekly, or monthly. The three arrows show where a crossover occurs AND the slope of the MA lines are in agreement with the crossover signal. This is where the trend is defined as positive or negative based on these parameters.
The slope of the moving averages (18 and 40 MA) and the price structure will change if I switch from a daily chart to a weekly chart, but the process of analysis is identical.
When evaluating a stock chart, the investor must know his or her own risk tolerance in order to determine what time frame is suitable. Generally, the longer the time frame, the larger the initial risk taken in each investment. However, the degree of accuracy typically improves. While minor swings may be manipulated at times, the long-term trend cannot be altered.