Trend-friendly Tools

The obvious starting point for this discussion is to define what is meant by a trend. In terms of technical analysis, a trend is a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not – trendline analysis to establish support and resistance levels.

Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature. While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price formations that have their own predictive significance.

Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and minor levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.

A more objective indicator of whether a market is trending is the directional movement indicator system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.

As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.

The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.