Trader Education: Determining Market Direction With Technical Analysis
[Original article source: Profit Buddies]
We all know that it’s impossible to truly forecast the future, but with use of technical analysis, we can observe prevailing market direction and attempt to ride the wave.
So why do we care about the current market direction? Well, think of trading like swimming in a river, you can swim with the current or against it; in either case you are performing the activity of swimming, but swimming with the current is much easier, and you’ll probably be more successful getting to where your going.
When determining the trend there are three possible outcomes; up, down, and sideways. The good news here is that we start this process with a 33.3% chance of being right, even if we were to randomly choose one of the three potential outcomes. To better our chances of being right, we’re going to add a few simple steps to our process.
To start our observation we must decide on a timeframe, are we trading short-term trends where we will be in and out of a position quickly (like a few days to a few weeks), medium-term trends where we may maintain a position from a few weeks to a couple of months, or are we investing for the long-term with a buy-and-hold strategy. Once we’ve determined our timeframe, this is the length of the trend we want to study.
The first step in assessing the trend is absurdly simple… pull up your favorite charting software, or surf on over to your favorite financial website and pull up a chart of your favorite stock. Next, set the chart timeframe to the timeframe we determined above. Finally, compare the first price on the chart to the last price on the chart (or if the chart allows, draw a straight line from one to the other); the price will either be trending up, down, or relatively sideways. Simple enough right? We could stop here but in nearly every instance of technical analysis we want to use some sort of confirming indicator.
The confirming indicator we’re going to use today is volume; the amount of daily trading in a certain index, sector, security, etc. In many cases, the charting package or financial website chart will already have a volume chart displayed below the price chart. Spotting the trend in volume is the same as for spotting the trend in price; simply compare the first value on the volume chart with the last value on the chart… unfortunately in many cases the trend won’t be as clear, especially for longer timeframes.
To summarize the use of these two indicators together, let’s explore all the potential outcomes.
Price up and volume up = strong upward trend
Price up and volume down = upward trend that may turn downward
Price up and volume sideways = weak upward trend
Price down and volume up = strong downward trend
Price down and volume down = downward trend that may turn upward
Price down and volume sideways = weak downward trend
Price sideways and volume up = sideways trend that may turn upward
Price sideways and volume down = sideways trend that may turn downward
Price sideways and volume sideways = sideways trend
At this point we have determined the trend for a single stock, but this isn’t really the whole process that should take place. Ideally this process would be done with the equity you are interested in, followed by the sector that the equity belongs to, and finally to the index the sector is in. As above, explore all of the potential outcomes of up, down, and sideways results. Doing this type of research and comparing the results will give a much better indication of the strength and direction of the trend.
The method we’ve discussed in this article for determining market trends is simple, easy to use and understand, and intended as a starting point for beginning investors. There are countless other methods and technical indicators we could use or add to the charts, but we’ll leave those for another day.
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