Almost all technical trading strategies rely, at their core, on a simple observation: prices tend to move in trends, trends that occasionally reverse or return to the mean. From this single insight has grown the vast majority of technical trading strategies, that can normally be categorised as either ‘trend following’ or ‘mean reversion’. Some studies indicate trend following strategies have a slight edge, but even if you exclusively use following strategies you must be aware that sometimes trends fail and reverse. Any edge you can gain in identifying these points will improve your win rate and strategy success.
Trend basics
Before delving into identifying failing trends, it’s important to have a solid understanding of how trends work. As mentioned earlier, an uptrend consists of higher highs and higher lows, indicating a bullish market sentiment. On the other hand, a downtrend comprises lower highs and lower lows, signalling a bearish market sentiment. By analysing price charts, using technical indicators, and considering fundamental factors, traders can determine the prevailing trend in a given market. Within each trend there will be smaller fluctuations in either direction, themselves trends, that form together the larger directional trend. Even in a strong uptrend, small downtrends will appear that revert towards the mean.
Trend lines
Trend lines are powerful tools that help traders visualise and confirm trends. They are drawn by connecting the swing highs in a downtrend or the swing lows in an uptrend – never both in the same trend. As a trend progresses, the price should respect the trend line by bouncing off it or showing support/resistance near the line. However, when a trend starts to fail, the price may pull away from its expected high, failing to trouble the resistance line. This can be seen as indicating a potential reversal or weakening of the trend. Traders should carefully monitor trend line breaks as they can provide early signals of a failing trend.
Volume
Volume analysis can provide valuable insights into the strength or weakness of a trend. In an uptrend, increasing trading volume confirms buying interest and supports the continuation of the trend. However, if trading volume starts to decline as the price moves higher, it may indicate a lack of conviction from buyers and a potential failing trend. Conversely, in a downtrend, increasing volume during price declines suggests selling pressure, while decreasing volume may indicate a weakening bearish trend.
Price and Volume Divergence
Divergence occurs when the price of an asset and a volume or momentum indicator move in opposite directions. It can be a reliable signal of an impending trend reversal or failure. By comparing the price chart with oscillators such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD), traders can identify instances where the price is making higher highs or lower lows while the indicator is making lower highs or higher lows. This normally occurs when volume drops as the resistance level is approached, indicating a weakening in market sentiment. This bearish or bullish divergence suggests that the trend may be losing strength, providing an opportunity to consider exiting or adjusting positions.
Monitor Support and Resistance Levels
Support and resistance levels play a crucial role in trend analysis. These levels represent areas where the price has historically shown a tendency to reverse or stall. In an uptrend, the price should find support at higher levels, indicating that buyers are still interested in the asset. However, if the price breaks below key support levels, it may signify a failing trend and a potential reversal. This strategy works in both bull and bear markets, in the latter of which breakout above resistance could indicate weakening bearish momentum, and an upwards mean reversion.
Moving Averages
Moving averages are frequently used technical indicators that smooth out price data to identify underlying trends, with a lesser effect of random fluctuations linked to position movements. Traders often employ different time periods of moving averages, such as the 30-day and 50-day moving averages, to analyse long-term and short-term trends and predict the relative strength of long-term and (often conflicting) short-term trends. When the short term moving average crosses below the long term, it can indicate the start of a downtrend, or a mean reversion in an uptrend. This is a useful method for identifying trade failures.
Volatility
Increasing volatility, especially when accompanied by decreasing price momentum, can indicate a trend’s weakness. High volatility can suggest that market participants are uncertain about the direction of the trend or that a trend reversal may be imminent. Traders should closely monitor volatility levels and use volatility indicators, such as Bollinger Bands or Average True Range (ATR), to identify potential failing trends.
Timeframe Convergence
Analysing trends across multiple timeframes can provide a comprehensive view of the market. When trends align across different timeframes, it increases confidence in their validity. However, if a trend is strong on shorter timeframes but weakens or reverses on higher timeframes, it may suggest a failing trend. Traders should compare trends on various timeframes to identify inconsistencies or confirm the strength of a trend. Always be careful when comparing charts with different timeframes, as some trends may not be visible on certain charts. For example, it is hard to see long-term underlying trends on intraday charts.
Conclusion: Gauging Market Sentiment
Market sentiment, the overall attitude or emotions of market participants, has a significantly impact on trend failure. If market sentiment shifts from bullish to bearish or vice versa, it may indicate that the prevailing trend is losing steam, and traders are preparing themselves for a full reversal. Traders can gauge market sentiment through various means, such as news sentiment analysis, social media sentiment, or market surveys. Keeping an eye on changing market sentiment can provide valuable insights into potential failing trends; often major mean reversions or reversals are triggered by adverse news or weakening economic data.
The art of identifying trends includes noticing their weakness, and trading accordingly. What to do when you’ve identified a failing trend depends on your current portfolio: if you are long on a failing uptrend, it may be wise to adjust stops or even exit the trade. If you have no position, consider trading against the weakening trend, with a stop loss at or near the mean. Do not assume a weakening trend will fully reverse: most downward fluctuations simply move back towards the mean before resuming another trend. Only if you are confident that a new, opposing trend is likely to take shape should you enter into a contrarian trade against the trend. The difficulty of getting this right is largely the reason why trend followers usually outperform mean reversion traders.
How Rakuten can help
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