October 27, 2006

Stocks And Shares - Two Basic Tests For A Powerful Trendline Trading Strategy

Tip! In order to get the most out of your investment experience, it’s important to recognize patterns in the performance of certain stocks so that you can get a better feel for how long their occasional fluctuations might last and help you to decide whether or not you should sell the stock or see it through until prices rise again.

One of the most fundamental and basic principle of gauging a stock behavior is to study the trendlines of a stock.

If you observe a stock, you will find that the prices move in trends. Quite often, a series of ascending bottoms in a rising market can be joined together by a straight line, just as can the tops of an ascending series of rally peaks. These lines are called “trendlines” and the area between the two trendlines is also known as the trend channel. Channels may trend up, down or sideways.

By drawing lines connecting market highs and market lows, you can often determine a trend channel. A trend reversal is often indicated when a market changes direction and break out of its trend lines.

Tip! You should have a good reason why you like the stock before purchasing. Some major things to keep an eye on are stocks in very strong markets.

For example, a trendline joining a series of troughs is eventually penetrated on the downside. Once this downward penetration of the trendline is sighted, you may expect a bearish market to be forthcoming. If the reverse occurs, we can expect a bullish situation.

So far, our assumption is that once there is a move away from an established trendline, or a breakout, a trend reversal is imminent. However, experienced traders would know such simplistic assumptions are in fact dangerous and even cause misleading moves or “whipsaws”.

How shall we avoid this then?

Before we can conclude that an outbreak is valid and decide on future trading signals based on such trendline outbreaks, it is important to test the outbreak.

It would be to your advantage to await a 3 percent penetration of the boundaries in terms of price before finally concluding that a signal is indeed confirmed.

Another method to test the validity of the outbreak is to examine the volume characteristics that accompany the outbreak. There is a common practice by many traders to place total emphasis on price alone and neglect volume. This is indeed a serious flaw in any trading strategy to neglect volume.

The general principle is that volume moves together with the trend. This means that as prices of a stock increase, there should be an accompanying increase in volume. Anything that does not confirm this rule will create a “divergence” and is a warning sign that the prevailing trend is probably in the process of reversing.

This rule will help you avoid being caught by misleading signals. It may be a simple rule, but its application will eventually prove to be one that will bring substantial benefits to filter out weak misleading signals.

By using the principles of trendlines and using the penetration test of 3% or the volume principle, you will be able to identify the trend of any stock and decide whether the impending signal is indeed weak or is a whipsaw.

Tip! Of course, the fluctuations of cyclical stocks tend to make some investors shy away from making a major commitment to what tend to be at best a form of seasonal investment. Individuals who are looking for good short-term investments often consider these fluctuations to be more of a godsend, however, and are much more willing to invest larger sums during the low point of the cycle in hopes of reaping greater rewards when the value of the stock shares peaks.

Peter Lim is a Certified Financial Planner and is the Author of “Swing Trading for Gigantic Profits” http://signaldot.poolofwisdom.com/swingbook.phtml.
For free trading resources, visit his website on Swing Trading at http://www.online-guides.info.

Filed under Stocks by sdira