In this series of Articles we are going to analyze the equity markets from various perspectives & will attempt to come up with actionable trading ideas. Today, we begin by addressing a basic query on technical analysis: What at all are we trying to find out when we open a chart?
In conventional analysis, price is plotted as a time series and it is said to have three components, namely: trend, volatility & seasonality. (The fourth component is of course: Noise.) In this issue, we give a brief account of the first component: The Trend.
Trend is the general direction of the market. We usually break up trends in various timeframes like Weekly, Daily, Hourly or a 5-minute time frame & sometimes even lower. This time-wise breakup of trend gives the trader an opportunity to choose his own reward/risk ratio by selecting a timeframe within his comfort. Generally, lower timeframes have lower risk but higher randomness.
Why should trend analysis be one of the primary objectives of technical investigation? The reason behind it is really simple as follows: A conservative trader generally attempts to enter the market where the reward-to-risk ratio is greatest, which happens at the end of a pull-back phase within a bigger uptrend. But unfortunately, even with today’s highly sophisticated computation techniques, it is nearly impossible to nail the market at the end of a retracement phase. Thus, the trend assumes more significance. If the general direction of the market is analyzed properly, longer term trend will become a friend of the trader to push prices higher & offer the trader a happy exit, no matter if there was an initial set back after entry.
A major characteristic of trends is that once developed, they are more likely to continue in the same direction for a long time than reverse, i.e., even after a considerable rise in price (that is required to identify the new trend), there is generally enough opportunity left to trade in the direction of the trend for a profit. If it were not the case, studying technical analysis would have been useless.
