Chapter 1

THE BASIC PRINCIPLE OF TECHNICAL ANALYSIS-THE TREND

From Charles D. Kirkpatrick II and Julie R. Dahlquist, Technical Analysis: The Complete Resource
for Financial Market Technicians, 3rd Edition
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Learning Objective Statement

• Define what is meant by a trend in technical analysis

• Explain why determining the trend is important to analysts

• Identify primary, secondary, short-term and intraday trends

• Describe the basic beliefs behind the art of technical analysis

• Define “fractal” as used in describing price action.

Technical analysis is based on one major assumption: Freely traded, market prices, in general, travel in trends

One the basis of this assumption, traders and investors hope to buy a security at the beginning of an upward trend
at a low price, ride the trend and sell the security when the trend ends at a higher price.
Although this strategy sounds simple, implementing is exceedingly complex.

What length of the trend are we discussing?

The trend in stock price since the Great Depression?
The trend in gold prices since 1980?

Trend exist in all lengths, from long term trends that occur over decades to short term trends that occur from
minute to minute.
How does the technical analysis make money?

By determining whether the trend is beginning or ending. The money is made by “jumping” on the trend as
early as possible.

The basic strategy to make money using technical methods includes

• ”The trend is your friend”-Play the trend.

• Don’t lose- Control risk of capital loss.

• Manage your money - Avoid run.

What is a trend?

A trend is a directional movement of prices that remains in

effect long enough to be identified and still be profitable.

1) An upward trend, or uptrend, occurs when prices reach

higher peaks and higher troughs.

2) A downward trend, or down-trend, is the opposite: when

prices reach lower troughs and lower peaks.

3) A sideways trend or flat trend occurs when prices trade in

range without significant underlying upward or downward
movement.
Identifying trends

There are a number of ways to identify trend.

Linear least-squares regression

The technique is not of much use to the technical analyst for
trend analysis. The regression model depends on the
sizeable amount of past price data for accurate results. By
the time enough historical price accumulates, the trend is
likely changing direction.

Another method of identifying trends is to look at a graph of

prices for extreme points, tops and bottoms, separated by
reasonable time periods, and to draw lines between these
extreme points. The lines are called trend lines.
Types of Trends
Methods of determining a trend begins and ends are the
same regardless of the length of the trend.

This ability for trends to act similarly over different

periods is called their fractal nature.

Fractal patterns exist in nature along shorelines, in

snowflakes and elsewhere.

For example, a snowflake is always six sided- having six

branches. Each branch has a particular, unique pattern
made of smaller branches. The same shape carries to
even smaller branches off each larger branch.

The trading markets are similar in that any period we

look at – long, medium, or very short – produces trends
with the same characteristics and patterns as each other.
The trend length of interest is determined solely by the
investor’s or trader’s period of interest.

Charles H. Dow is known as the “father” of technical analysis

(continued…)

Shorter trends make up longer trends, any analysis of period of interest must include analysis of the longer and
shorter trends around it.
For example, the trader interested in ten-week trends should also analyze trends longer than ten weeks because a
longer trend will affect the shorter trend.
Likewise, a trend shorter than ten weeks should be analyzed because it will often give early signals of a change in
direction in the larger ten-week trend.

For identification purposes, technical analysis have divided trends into several broad, arbitrary categories.

1) Primary Trend – measured in months or years.

2) Secondary or Intermediate Trend – measured in weeks or months.
3) Short-term Trend – measured in days.
4) Intraday Trend – measured in minutes or hours.
 Other Assumptions Of Technical Analysts

• Technical Analysts assume that price is determined by the interaction of supply and demand. As basic
economic theory teaches when demands increases, price goes up and vice versa.
One of the factors that determine supply and demand is buyer and seller expectations. (You don’t buy a stock
unless you expect it to rise in price.)

• Technical Analysts assume that price discounts everything. Price discounts all information, related to
security or otherwise, as well as the interpretation of expectations derived from that information.
Technical analysts believe that the current price fully reflects all the possible material information which
could affect the price. The market price reflects the sum knowledge of all participants, including traders,
investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts,
fundamental analysts and many others.

• Third, an important corollary to the notion that markets trend is the technical analyst’s belief that
prices are non random.
Technical Analysts believe that prices may move in trends and that the study of past prices can be used to
forecast future price direction.
 (continued…)

• Technical analysis assumes that history, in principle, will repeat itself and that humans will behave
similarly to the way they have in the past in similar circumstances.
This similar behavior tends to form into patterns that have predictable results. These patterns are almost never
identical and are thus, subject to interpretation, with all its own bias problems, by the technical analyst.

• Technical Analysts also believe that, like trend lines, these patterns are fractal.
Each investor has a specific period of interest in which he or she operates. Interestingly, regardless of period,
patterns occur with similar although not identical, shapes and characteristics. Thus, an analyst who is watching
five-minute bar charts will observe the same patterns that an analyst watching monthly bar charts will see. A
pattern in a five-minute bar chart, for example, is the result of other traders within five minute bar chart
horizon. Monthly traders would have very little effect on five-minute bar chart.

• Technical analysis is also based on the notion that emotions are affected by earlier emotions through
emotional feedback.
If I buy a stock today and its price rises, I am happy to tell others to buy the stock, or others see its price rising
and also buy it, thus causing the price to rise further.
Summary

• The interaction of supply and demand determine price.

• Supply and demand are affected by investors emotions and biases, particularly fear and greed.

• Price discounts everything.

• Prices trend.

• Recognizable patterns are form within trends.

• Patterns are fractal.