Spotting Trend - Peak and Trough Analysis

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Peak and Trough Analysis 

Peak and Trough Analysis is a useful tool to identify when a security is trending or is in a period of consolidation.  Spotting trend is important for trend traders as many trend traders will only trade when there's a definite trend to be seen.  Trading in a trend tends to let your profits run and is usually more predictable than range trading.  However many traders do trade in ranges and we'll study this and other types of trading in future sections.  Peak and trough analysis is also useful to gain points of entry to the trade, especially if combined with other technical indicators.  Again, we'll delve deeper into technical indicators in future sections.

As we've seen in our section on Dow Theory price action never goes up or down in a uniform manner, it zigzag's.  This zigzag motions forms the peaks and troughs in charts.  In an up trend each new peak is higher than the previously observed peak and each new trough is higher than the last observed trough.  In a down trend each new peak is lower than the previously observed peak and each new trough is also lower than the last observed trough.  This is what defines a trend - higher highs (peaks) and higher lows (troughs) for the up trend and lower highs and lower lows for the down trend.

Some charting software will highlights peaks and troughs for traders (%-zigzag indicator), but spotting them yourself is possible.  To do so, one must bring up your chart focusing on primary trend and simply highlight all the significant highs and lows. After a while you'll get used to spotting them... This should indicate whether you're in a long term trend, or not. Your primary trend is determined by your trading horizon, i.e. if you are a day trend trader (in and out of a trade within a day or thereabouts) you may want to focus on a primary trend of a few months. A trend traders will then usually only trade in the direction of the long term trend.

In our Forex example of the USD/JPY cross-pairing, a down trend looked like it had started in May 2010 and finished in Nov 2010, but by highlighting the main peaks and troughs with arrows we can see the circled red arrows indicated there weren't lower lows until June 2010.  The down trend actually started in June 2010 with consecutive lower highs and lower lows.  Trend trading would have been difficult prior to June 2010, as technically the price may still have been in a range.  

Peak and Trough Analysis

Combining Peak and Trough Analysis with other trend spotting technical indicators like moving averages is ALWAYS wise in forming trading strategies.  It's also wise to make sure the timeframe isn't too short, so remember to use Multi-Timeframe Analysis to figure out the markets general direction. 

Be aware that if the trend journeys into a consolidation range, it can do so for quite some time.  In general a range can last between 33% and 66% of the length of the trend, but not in all cases.  Don't be fooled thinking that the trend will reverse after this consolidation period either.  The trend can continue on it's merry way after this consolidation.  We'll go on to talk about consolidation chart patterns in later sections.

Other Methods of Spotting Trend

Some define trend as a deviation from a range as indicated by Bollinger bands. For others, a trend occurs when prices are contained by an upward or downward sloping 20-period Moving Average. Others will utilise The Average Directional Index (ADX) to identify trend. All of these indicators can be found under Module 3 in our course. We've also written an article in Mod 4 Charting Tools called Using MACD to Help Draw Trend which is worth a look. 

Trend Traders

Regardless of how one defines trend, the goal of trend trading is the same - join the move early and hold the position until the trend reverses. The basic mindset of trend trader is "I am right or I am out?" The implied bet all trend traders make is that price will continue in its present direction. If it doesn't there is little reason to hold onto the trade. Therefore, trend traders typically trade with tight stops and often make many probative forays into the market in order to make the right entry.

By nature, trend trading generates far more losing trades than winning trades and requires rigorous risk control. The usual rule of thumb is that trend traders should never risk more than 2% of their capital on any given trade.  Module 7 has more on Managing Money

To Sum Up

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

More...


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Peak and Trough Analysis 

Peak and Trough Analysis is a useful tool to identify when a security is trending or is in a period of consolidation.  Spotting trend is important for trend traders as many trend traders will only trade when there's a definite trend to be seen.  Trading in a trend tends to let your profits run and is usually more predictable than range trading.  However many traders do trade in ranges and we'll study this and other types of trading in future sections.  Peak and trough analysis is also useful to gain points of entry to the trade, especially if combined with other technical indicators.  Again, we'll delve deeper into technical indicators in future sections.

As we've seen in our section on Dow Theory price action never goes up or down in a uniform manner, it zigzag's.  This zigzag motions forms the peaks and troughs in charts.  In an up trend each new peak is higher than the previously observed peak and each new trough is higher than the last observed trough.  In a down trend each new peak is lower than the previously observed peak and each new trough is also lower than the last observed trough.  This is what defines a trend - higher highs (peaks) and higher lows (troughs) for the up trend and lower highs and lower lows for the down trend.

Some charting software will highlights peaks and troughs for traders (%-zigzag indicator), but spotting them yourself is possible.  To do so, one must bring up your chart focusing on primary trend and simply highlight all the significant highs and lows. After a while you'll get used to spotting them... This should indicate whether you're in a long term trend, or not. Your primary trend is determined by your trading horizon, i.e. if you are a day trend trader (in and out of a trade within a day or thereabouts) you may want to focus on a primary trend of a few months. A trend traders will then usually only trade in the direction of the long term trend.

In our Forex example of the USD/JPY cross-pairing, a down trend looked like it had started in May 2010 and finished in Nov 2010, but by highlighting the main peaks and troughs with arrows we can see the circled red arrows indicated there weren't lower lows until June 2010.  The down trend actually started in June 2010 with consecutive lower highs and lower lows.  Trend trading would have been difficult prior to June 2010, as technically the price may still have been in a range.  

Peak and Trough Analysis

Combining Peak and Trough Analysis with other trend spotting technical indicators like moving averages is ALWAYS wise in forming trading strategies.  It's also wise to make sure the timeframe isn't too short, so remember to use Multi-Timeframe Analysis to figure out the markets general direction. 

Be aware that if the trend journeys into a consolidation range, it can do so for quite some time.  In general a range can last between 33% and 66% of the length of the trend, but not in all cases.  Don't be fooled thinking that the trend will reverse after this consolidation period either.  The trend can continue on it's merry way after this consolidation.  We'll go on to talk about consolidation chart patterns in later sections.

Other Methods of Spotting Trend

Some define trend as a deviation from a range as indicated by Bollinger bands. For others, a trend occurs when prices are contained by an upward or downward sloping 20-period Moving Average. Others will utilise The Average Directional Index (ADX) to identify trend. All of these indicators can be found under Module 3 in our course. We've also written an article in Mod 4 Charting Tools called Using MACD to Help Draw Trend which is worth a look. 

Trend Traders

Regardless of how one defines trend, the goal of trend trading is the same - join the move early and hold the position until the trend reverses. The basic mindset of trend trader is "I am right or I am out?" The implied bet all trend traders make is that price will continue in its present direction. If it doesn't there is little reason to hold onto the trade. Therefore, trend traders typically trade with tight stops and often make many probative forays into the market in order to make the right entry.

By nature, trend trading generates far more losing trades than winning trades and requires rigorous risk control. The usual rule of thumb is that trend traders should never risk more than 2% of their capital on any given trade.  Module 7 has more on Managing Money

To Sum Up

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

More...


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