Trend Trading Guide | Option Alpha

The trend is the general direction of price movement. The trend describes the slope of the price movement. A trend can be up, down, or level.

Trend is the direction of price while momentum is the strength of the trend’s movement.

Time series analysis

Time series analysis is the process of reviewing a series of data points to identify trends. Time series analysis may utilize statistical models or simple rate of change calculations. Time series momentum describes the persistence of trends from one period to the next.

Time series analysis seeks to identify and profit from the persistence of trends.

For example, if a security’s price trended up for one month, a momentum-oriented investor would expect the security to build off that momentum and rise in price again the second month.

Trendlines

Trendlines are drawn on charts to show the past direction of price and identify significant levels on a price or indicator chart.

In uptrends, trendlines are drawn by connecting the lowest points in a trading range.

In downtrends, trendlines are drawn by connecting the highest points in a trading range.

Moving averages can also be used to display trends. 10, 50, and 200-day moving averages are popular tools used by investors to determine if a security is in a short-term or long-term trend. When the security crosses the moving average line, it signals a trend reversal.

Breakouts

A breakout is a price movement through a level of significance on a price chart or indicator. A breakout is a rise above a resistance level or a drop below a support level.

Breakouts are a continuation of price movements in a particular direction. The price levels of significance for a breakout are typically distinguished by trendlines or support and resistance lines.

Support and Resistance with Breakout Visual Example

Support lines are drawn at a level where price has previously been tested and reversed higher. Resistance lines are drawn at a level where price has previously tested and reversed lower. Price action is typically supported or rejected because buyers and sellers have placed orders at these key levels.

The more times a support or resistance line is touched, the more likely it is to produce a breakout in the future because buy or sell orders are filled with each test.

When price moves out of a trading range (i.e. price moves from below to above a downward trendline), this is referred to as a breakout. Breakouts can be traded across time frames (monthly, weekly, daily, intra-day) and in a variety of ways.

Breakouts tend to follow the prevailing trend’s direction. For example, if a security in a long-term uptrend consolidates into a range, such as a flag pattern, the breakout typically continues to the upside.

Volume is often used to confirm a breakout. For example, a breakout on above-average volume is more significant than a breakout on below-average volume.

Some strategies follow breakouts while other strategies fade breakouts in anticipation of mean reversion into the previous trading range. Traders who fade breakouts are often contrarians, as they hope to profit by trading against the trend and popular opinion.

Failed breakouts could signal a change in trend or a lack of momentum. Traders may use additional indicators to analyze momentum, such as MACD, RSI, ADX, and more.

Investors often use trend and momentum together for trading signals. Once a trend is identified with a technical indicator or trendline, momentum can be monitored to determine if the trend is gaining or losing strength. Decreasing momentum typically preempts a reversal.

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FAQs

Why is time series analysis important?

Time series analysis describes the process of reviewing a series of data points to identify trends. Time-series momentum describes the persistence of trends from one period to the next. Time series analysis seeks to identify and profit from the persistence of trends.

For example, if a security’s price trended up for one month, a momentum-oriented investor would expect the security to rise in price again the next month.

What are the four main components of a time series?

Time series is made up of four components: seasonal, trend, cyclical, and random variations. Seasonal variations that demonstrate patterns within a defined timeframe. Trend variations that behave in a somewhat predictable pattern. Cyclical variations that typically coincide with the business cycle. Random variations that display no predictable patterns.

How do you find a trend breakout?

A breakout is a price movement through a level of significance on a price chart or indicator. A breakout is a rise above a resistance level or a drop below a level of support. Breakouts are a continuation of price movements in a particular direction.

The price levels of significance for a breakout are typically distinguished by trendlines or support and resistance lines. Trendlines are drawn on charts in technical analysis to show the past direction of price and to identify significant levels on a price or indicator chart. In uptrends, trendlines are drawn by connecting the lowest price points in a trading range. In downtrends, trendlines are drawn by connecting the highest points in a trading range.

Support lines are drawn horizontally at a level where price has previously tested and reversed higher. Resistance lines are drawn horizontally at a level where price has previously tested and reversed lower. Price action is typically supported or rejected because buyers and sellers have placed orders at these key levels.

When price moves out of a trading range (i.e., price moves from below to above a downward trendline), this is referred to as a breakout.

How do you trade a trendline breakout?

Trendlines are drawn on charts in technical analysis to show the past direction of price and identify significant levels on a price or indicator chart.

In uptrends, trendlines are drawn by connecting the lowest price points in a trading range. In downtrends, trendlines are drawn by connecting the highest points in a trading range.

When price moves from below to above a downward trendline, or from above to below an upward trendline, this is referred to as a breakout. Traders who trade trendline breakouts will typically place orders above or below the trendline when price breaks out to follow price in the breakout direction.