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Qualifying Trends: A Technical View

The classic definition of trends is limited. I've expanded that definition with the concept of suspect and confirmed trends.
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By L.A. Little of Technical Analysis Today.

Robert Edwards and John Magee first published

Technical Analysis of Stock Trends

in 1948. In technical trading circles, this book has come to be known as the bible of technical analysis. It is probably the most definitive book on pure technical analysis as it pertains to strictly reading chart patterns.

In their book, Edwards and Magee define trends. I refer to their definition of trend as the classical definition. In my work, their definition isn't sufficient, and as a result,

I have expanded upon that definition

with the concept of suspect and confirmed trends. Let me explain.

Trading With the Trend

The classical definition looks at price only when defining an uptrend. For example, an uptrend is defined as a series of higher highs and higher lows based on price. To see this on the chart, here's a recent example of a short-term uptrend on

Alcoa

(AA) - Get Alcoa Corporation Report

based on the classical definition.

In this chart, you can see on the left-hand side a series of higher highs and higher lows -- an uptrend according to the classical definition of trend.

Here's the same chart with the downtrend called out. One can easily see a series of lower lows and lower highs.

Given the generally accepted technical analysis notion that you typically want to trade in the direction of the prevailing trend, then you would want to be long while the trend is higher and short when it is lower. Simple enough, right?

Well, not quite. Let's assume you were long Alcoa from the $10 area. When should you exit the trade? In other words, looking at the chart and using the classic definition of a trend, when would you take all or partial profits? Unfortunately, with the classic definition, you would be unaware that the trend had changed until you witnessed a series of lower highs and lower lows.

Look at the chart again. You wouldn't know until you had a break of the previous swing low. That break occurs when Alcoa trades to $12. If you used this signal to exit, you would be exiting at exactly the wrong time when the trend is about to turn and become bullish again.

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The Notion of Suspicion

What you need is a warning bell, a sign that the trend is no longer as strong as it previously was. Trends typically don't change on a dime. There are usually warning signs prior to the change and the market issues them most of the time. Those warning signs surface at the swing points and are detected via an examination of volume.

If you examine the volume characteristics of the previous swing point and compare it with the volume of the bar that closes over or under the previous swing point, then you can make the market prove the trend each time a new swing point is created. A trend can thus be qualified:

  • 1. If volume expands when a new swing point is registered, then the trend is confirmed.
  • 2. If volume contracts when a new swing point is registered, then the trend is suspect.

Using this method, the market provides you with an early warning system regarding the quality of the trend. Look again at the Alcoa chart using this enhanced definition of trend.

Using this enhanced definition, when Alcoa traded over the previous swing point it was quite clear that volume contracted. When that happens, the uptrend becomes suspect. That is your early warning sign. That is a signal that you should take full or partial profits depending on your trading plan and time frame.

Financials and a Very Suspect Trend

Over the past three days we have examined

three regional financial concerns

.

Wells Fargo

(WFC) - Get Wells Fargo & Company Report

and

FBR Capital

(FBCM)

had supportive chart patterns

, while

Marshall & Ilsley

(MI)

did not

. I had qualified my bullishness of Wells and FBR primarily because they are regional banks and the

Regional Bank HOLDRs

(RKH)

exchange-traded fund is currently a very suspect uptrend (RKH is a good proxy for the sector).

Not only is the trend suspect, but it is suspect over and over again -- four times and counting. If you are long stocks represented by this sector and have yet to take profits, you are living on borrowed time.

This chart is the poster child for one last concept regarding suspect trends. When you get a warning sign, it doesn't mean that the suspect trend cannot continue; it's just a warning sign. Like most things in life, warning signs don't always result in immediate pain.

As you well know, nothing is guaranteed when it comes to trading, and suspect trends are no different. They do, however, allow you to take precautions and to exercise money management in a prudent manner.

To consistently profit in the markets, you have to put the odds in your corner every chance you get, and qualifying trends is a proven method to do just that.

So, until next time, keep trading the charts!

L.A. Little is an author, professional trader and money manager who writes daily on

tatoday.com

, a free educational site for traders and investors. He has been featured in Stocks & Commodities magazine and is the author of

Trade Like The Little Guy

.