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The key is to see where the price is compared to this 100-period moving average and most importantly, what’s the direction of this moving average. If the moving average is trending up, basically that defines the current trend as up and the trend is stronger if the prices are above this 100-period moving average. If the moving average is trending down, the price trend is also down and of course, if the moving average is trending sideways, that makes the price trend also sideways. Now, that seems quite simple, but the point is that the simple things usually work best.

DEFINING THE MARKET’S STRENGTH

Once you define the market trend, it is important to define its strength. To do that I use another moving average which is much faster than the 100-period moving average. I prefer to use the 21-period moving average. And if we have an uptrend (with the price above the rising 100-period moving average) and the price is also above a rising 21-period moving average, you have a strong uptrend. The opposite goes for a strong downtrend.

The trend is weak when the 21-period moving average trades sideways or in the opposite direction of the 100-period moving average. For example, if the prices are above the rising 100-day moving average but the 21-day moving average is trading either sideways or down, then the uptrend is considered weak.

With all this in mind, we have 5 categories of market trend:

  • Strong Uptrend
  • Weak Uptrend
  • Sideways Market
  • Weak Downtrend
  • Strong Downtrend

EXAMPLES

Let’s look at some examples to further clarify this methodology:

Chart 1 tells us a lot. First, you can see when the major turning points occur. They are not right at the top and at the bottom but a bit later when the 100-week moving average (blue line) flattens out and then changes its trend. In 2007 the trend changed from up to down and in the fall of 2012 the trend changed from down to up. Note that the market had gone though a sideways transition (what we call a basing pattern) for months before it turned up in late 2012 and broke higher. Only when the 100-week moving average turned up, the prices followed with an upside breakout!

Regarding the trend strength: I have not marked these periods on the chart, but you can easily see that there are periods when the prices are not only below the declining 100-week moving average, but also below a declining 21-week moving average (red line). And then after the trend turned up, there was a strong uptrend until June of 2013 when the prices dipped below their 21-week moving average for the first time. Note however, that the trend of the 21-week moving average at the moment is still up, which means that the current sideways consolidation from the May 2013 top will likely be resolved by an upside breakout and another strong advance. And the best thing is that only technical analysis can provide you with clear levels to know when you are wrong. A move below the early August low will make the uptrend on the weekly chart a weak one and will suggest a more prolonged consolidation with slight downside bias first.

HIGH PROBABILITY TRADES

What else can we learn from Chart 1? As you can see I have marked the sell signals from the weekly Stochastics indicator. Now, you can use this approach with every favorite indicator that you use. Why have I marked only the sell signals?

First, let me explain something that I follow as a general rule. It comes from my desire to find high probability trades – trades when the odds of succeeding are much higher than any other normal trade.  During a downtrend, the high probability trades are those when we consider a short position when small recovery rallies develop. But the question is what is the right time to enter short during these recovery rallies. One way is to look at the other indicators that you follow and trade based on the signals that they give. But you trade only the sell signals when the prevailing trend is down. Returning to the chart above, you can see that the sell signals from the weekly Stochastics have all resulted in nice moves lower. I have not marked the buy signals from this indicator as I simply ignore them during a downtrend. If you look at the buy signals, you will see that some of them were successful and others – not. Thus, by following only the signals that are in line with the general market direction, one can improve significantly the effectiveness of a particular technical indicator.

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