Definition of Trend

Figure 4.1c Example of a sideways trend with horizontal peaks and troughs. This type of market is often referred to as "trendless."

Figure 4.1 d Example of a downtrend turning into uptrend. The first portion to the left shows a downtrend. From April 1996 to April 1997, the market traded sideways. During the summer 1997, the trend turned up.

TREND HAS THREE DIRECTIONS

We've mentioned an uptrend, downtrend, and sideways trend for a very good reason. Most people tend to think of markets as being always in either an uptrend or a downtrend. The fact of the mat­ter is that markets actually move in three directions—up, down, and sideways. It is important to be aware of this distinction because for at least a third of the time, by a conservative estimate, prices move in a flat, horizontal pattern that is referred to as a trading range. This type of sideways action reflects a period of equi­librium in the price level where the forces of supply and demand are in a state of relative balance. (If you'll recall, Dow Theory refers to this type of pattern as a line.) Although we've defined a flat market as having a sideways trend, it is more commonly referred to as being trendless.

Most technical tools and systems are trend-following in nature, which means that they are primarily designed for markets that are moving up or down. They usually work very poorly, or not at all, when markets enter these lateral or "trendless" phases. It is during these periods of sideways market movement that tech­nical traders experience their greatest frustration, and systems traders their greatest equity losses. A trend-following system, by its very definition, needs a trend in order to do its stuff. The fail­ure here lies not with the system. Rather, the failure lies with the trader who is attempting to apply a system designed for trending markets into a nontrending market environment.

There are three decisions confronting the trader—whether to buy a market (go long), sell a market (go short), or do nothing (stand aside). When a market is rising, the buying strategy is preferable. When it is falling, the second approach would be cor­rect. However, when the market is moving sideways, the third choice— to stay out of the market—is usually the wisest.

TREND HAS THREE CLASSIFICATIONS

In addition to having three directions, trend is usually broken down into the three categories mentioned in the previous chap­ter. Those three categories are the major, intermediate, and near term trends. In reality, there are almost an infinite number of trends interacting with one another, from the very short term trends covering minutes and hours to superlong trends lasting 50 or 100 years. Most technicians, however, limit trend classifica­tions to three. There is a certain amount of ambiguity, however, as to how different analysts define each trend.

Dow Theory, for example, classifies the major trend as being in effect for longer than a year. Because futures traders operate in a shorter time dimension than do stock investors, I would be inclined to shorten the major trend to anything over six months in the commodity markets. Dow defined the intermediate, or sec­ondary, trend as three weeks to as many months, which also appears about right for the futures markets. The near term trend is usually defined as anything less than two or three weeks.

Each trend becomes a portion of its next larger trend. For example, the intermediate trend would be a correction in the major trend. In a long term uptrend, the market pauses to correct itself for a couple of months before resuming its upward path. That sec­ondary correction would itself consist of shorter waves that would be identified as near term dips and rallies. This theme recurs many times—that each trend is part of the next larger trend and is itself comprised of smaller trends. (See Figures 4.2a and b.)

In Figure 4.2a, the major trend is up as reflected by the ris­ing peaks and troughs (points 1, 2, 3, 4). The corrective phase (2- 3) represents an intermediate correction within the major uptrend. But notice that the wave 2-3 also breaks down into three smaller waves (A, B, C). At point C, the analyst would say that the major trend was still up, but the intermediate and near term trends were down. At point 4, all three trends would be up. It is important to understand the distinction between the various degrees of trend. When someone asks what the trend is in a given market, it is difficult, if not impossible, to respond until you know

Figure 4.2a Example of the three degrees of trend: major, secondary, and near term. Points 1,2,3, and 4 show the major uptrend. Wave 2-3 represents a secondary correction within the major uptrend. Each secondary wave in turn divides into near term trends. For example, secondary wave 2-3 divides into minor waves A-B-C.

Figure 4.2b The major trend (over a year) is up during 1997. A short term correction occurred during March. An intermediate correction lasted from August to November (three months). The intermediate correction broke down into three short term trends.

which trend the person is inquiring about. You may have to respond in the manner previously discussed by defining the three different trend classifications.

Quite a bit of misunderstanding arises because of different traders' perceptions as to what is meant by a trend. To long term position traders, a few days' to a few weeks' price action might be insignificant. To a day trader, a two or three day advance might constitute a major uptrend. It's especially important, then, to understand the different degrees of trend and to make sure that all involved in a transaction are talking about the same ones.

As a general statement, most trend-following approaches focus on the intermediate trend, which may last for several months. The near term trend is used primarily for timing purpos­es. In an intermediate uptrend, short term setbacks would be used to initiate long positions.