Dow Theory and Trends (8): Definition of Trends and Three Classifications

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       Smiling proudly at the stock futures exchange, smashing Wall Street! Hello everyone, welcome to the Technology Paradise, I am Lao Zou, the owner of the park. Because I was busy with the US election, I postponed the course "Dow Theory and Trends". As the dust of the general election has settled, the impact of this farce in the United States on the global economy has gradually diminished. As the saying goes, "Give God what is God's, Caesar's what is Caesar's, and leave the rest to Trump to tell jokes"! Today, we continue the previous lesson.

       In previous lessons we have briefly outlined the more important aspects of Dow Theory. Starting today, the content we explain is derived from the Dow Theory, such as the standard definition of the trend concept, the division of the three types of trends and the three stages of trends, the principle of mutual verification and mutual deviation, the interpretation of trading volume, And the usage of percentage retracement and so on.

  Let's start with trends.

      Three directions

  In the market research method of technical analysis, the concept of trend is absolutely the core content. All the tools used by chartists, such as support and resistance levels, price patterns, moving averages, trendlines, etc., have the sole purpose of assisting us in estimating market trends so that we can trade in the direction of the trend. In the market, "always trade with the trend", "never go against the trend", or "the trend is a good friend", etc., are already clichés. So we have to spend some time defining and categorizing trends.

       In a general sense, a trend is the direction in which the market is going. However, for practical application, we need a more specific definition. Under normal circumstances, the market does not go straight in any direction. The market movement is characterized by twists and turns. Its trajectory resembles a series of successive waves, with fairly obvious peaks and valleys. The so-called market trend is formed by the direction in which these peaks and troughs rise or fall in turn. Whether these peaks and troughs are sequentially ascending, descending, or extending horizontally, their direction constitutes the trend of the market. Therefore, we define an upward trend as a series of successively rising peaks and troughs, a downward trend as a series of successively descending peaks and troughs; a horizontal extension trend is defined as a series of successively extending horizontal peaks and troughs, see chart 1.

Chart 1:

  The three trends we mentioned are rising, falling, and horizontal extension are well-founded. Many people are accustomed to thinking that the market has only two trend directions, either rising or falling. But in fact, the market has three directions of movement - up, down, and sideways. As far as a conservative estimate is concerned, at least one-third of the time, the price is in a horizontally extended form, which belongs to the so-called trading range, so it is quite important to understand this difference. This horizontal stretch shows that the market has been in equilibrium for a period of time, that is to say, in the above price range, the forces of supply and demand have reached a relative balance (we have explained that the Dow Theory uses a horizontal line to describe this class price form). However, while we define this flat market as a sideways trend, the more general term is "no trend".

  Most technical tools and systems are trend-following in nature and are primarily designed to follow rising or falling markets. When the market enters this flat or "trendless" phase, they often perform poorly or not at all. It is precisely during this period of horizontal market expansion that technical investors are most vulnerable to setbacks, and those who use trading systems also suffer the greatest losses. As the name implies, for a trend-following system, there must first be a trend to follow before it can function. Therefore, the root cause of the failure is not the system itself, but the investors, who made mistakes and applied the system designed to work under trending market conditions to a market environment without trends.

  Investors in foreign exchange futures have three choices-buy first and then sell (be long), sell first and then buy (short), or wait and see. When the market is rising, it is of course the best policy to buy first and then sell. And when the market is down, the second option is the first choice. As a matter of course, the third option—hands and feet—is usually the wisest when the market is going sideways.

      Three types of trends​

  Not only do trends have three directions, but they can often be divided into three types, which we have covered in previous lessons. These three types are primary trends, secondary trends, and transient trends. In fact, in the market, from a very short-term trend covering a few minutes or a few hours to a very long-term trend lasting 50 or even 100 years, there are countless large and small trends coexisting and acting together at any time. However, the classification of trends by most technical analysts is limited to the above three, so the definitions of various trends among different analysts are of course somewhat confused.

  For example, in Dow Theory, major trends are actually for those older than a year. Because foreign exchange futures investors operate in a shorter time range than stock investors, in the futures loan market, we tend to think that longer than six months is the main trend. Dow defines the secondary trend (or medium trend) as one that lasts for three weeks to several months, which is probably appropriate in the term loan market. As for short-term trends, it is usually defined as those shorter than 2 to 3 weeks.

       Each trend is a component of the longer-term trend above it. For example, an intermediate trend is a correction within a major trend. In a long-term uptrend, a market that pauses its advance, corrects for a few months, and then resumes its advance is a good example. And this mid-trend itself is often composed of shorter-term waves, showing a series of short-term rises and falls. We have repeatedly emphasized that each trend is a component of its longer-term primary trend, and at the same time it is itself composed of shorter-term trends.

figure 2:

  In the chart, as shown by points 1, 2, 3, 4, the adjacent peaks and troughs rise in sequence, so that the main trend is an uptrend. The corrective phase between points 2-3 represents a corrective minor trend that is part of an up major trend. But please note that the change between points 2-3 is also composed of three smaller twists and turns A, B, and C. At point C, the analyst may judge that the primary trend is still up, but the secondary and short-term trends are down. At point 4, all three minor trends are up. Trends come in various time scales and it is extremely important to understand how they differ on the time scales. If someone asks you how a certain market is trending, unless you know what time period the person is talking about, it is very difficult, if not impossible, to answer. Maybe you have to follow the method of dividing the three types of trends above, and come to a checkpoint.

  Trends are often interpreted differently by different investors, so there are quite a few misunderstandings. For long-term investors, price changes over the course of days or even weeks may not matter. In the eyes of day traders, a rise that lasts for two or three days constitutes a major uptrend. Therefore, when we discuss the market, it is particularly important to figure out the time scale of the trend and confirm whether both parties are referring to the same concept.

  Generally speaking, in the term loan market, the focus of most trend-following methods is actually the middle trend, that is, the one that may last for several months. The short-term trend is mainly used to choose the time to enter the market. In moderate uptrends, brief pullbacks can be used to initiate long positions. While in a moderate downtrend, short rallies can be used to open short positions.

      Support and Resistance

  In the previous discussion of trends, we said that price movement is made up of a series of peaks and troughs, the direction in which they rise and fall in turn determines the trend of the market. We will now give appropriate names to these peaks and troughs, while also introducing the concepts of support and resistance.

       We call the trough, or the "low point of the upward bounce", a support, which is represented by a certain price level or a certain area on the chart. The term is a no-brainer. Beneath it, buyer interest is strong enough to hold off pressure from sellers. As a result, the price stops falling here and turns back to rebound upwards. Usually, a support level is identified after the low of the previous upward rally is formed. In the chart below, points 2 and 4 represent the two support levels in an uptrend, respectively.

image 3:

Figure 4:

  Resistance, also expressed as a certain price level or chart area. Contrary to support, above it, selling pressure blocks the advance of buyers, so the price turns from rising to falling. Resistance levels are usually marked by the previous peak. In the chart above, points 1 and 3 are two resistance levels respectively. Figure 2 shows an upward trend. In an uptrend, support and resistance levels show a gradual increase. Figure 3 shows a downtrend in which both peaks and troughs are successively lower. In this downtrend, points 1 and 3 are support levels below the market and points 2 and 4 are resistance levels above the market.

       In an uptrend, the resistance level means that the upward momentum will take a break here, but after that it will be broken upwards sooner or later. In a downtrend, the support level is not enough to sustain the market's decline for a long time, but it can at least make it a temporary setback.

       Well, today we have learned the definition and classification of trends, and have a preliminary understanding of the concepts of support and resistance. So, what role will support and resistance play in a trend? This, Lao Zou will save it for the next class to explain to everyone, let's see you tomorrow.

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Last updated: 09/04/2023 14:58

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