Here we show excerpts from our introduction to Technical Analysis, including explanations of basic concepts, such as signals and price patterns, and details of key TA indicators.
Part 6: Thursday 11 March 2010
It should be clear that the breaking of a trendline does not necessarily mean the end of a trend. Instead, we have a three stage process for a change of trend.
1. A trendline is broken.
2. The trend stops making higher peaks in an uptrend (or lower troughs in a downtrend but we will use the uptrend case to explain).
3. Price moves below the preceding trough (in an uptrend).
This defines a change of trend from uptrend to downtrend.
A problem exists with this in that the analyst cannot be sure that stage two has occurred until stage three happens. At best, suspicions may mount that stage two has occurred only after a significant fall towards stage three. Also, it may be the case that the lower trough occurs first (as is the case above). The analyst then needs to see a lower peak and for final confirmation, another lower trough before a reversal from uptrend to downtrend occurs.
This is all very well as a textbook theory but in the real world can involve substantial loss. Therefore augmenting this trend analysis with momentum studies (dealt with in subsequent articles) can help avoid some of these losses.
The trendlines above only touch the price bars twice. Should price touch and rally from an up trendline, that is said to validate the trendline and more notice should be taken of it.
At times, a trendline will be broken slightly, perhaps on an intraday basis before recovering. In this case, that should validate the trendline rather than question it.
There is no hard and fast rule as to what level of penetration is needed before a trendline is questioned. It requires judgement, this is an art not a science.