One of the most correct sayings you will ever hear in trading (very few are correct by the way) is “The trend is your friend.” It is one of the most basic tenants in our seminars and labs, and we even expand on the point to create ‘power trends’. Yet, an amazing number of traders cannot properly identify a trend, when it changes, and when a new one starts. Traders reading our “Daily Trading Letter” are assumed to know this information, as we very often discuss entering a play or staying in a play ‘as long as the trend is intact’.

In order to understand trends, you must first know how we define a pivot. This is because a pivot is part of the definition of a trend. If you have not heard the word before, it is because it often gets left out in the short definition of what a trend is. If you have heard the language of needing ‘higher highs and higher lows’, the word ‘pivot’ is implied in that definition. What we are looking for are ‘higher pivot highs and higher pivot lows’. There are other requirements for a trend also that deal with the moving averages, but we want to focus in these lessons on the illusive topic of pivots.

So, what it is a pivot? It is the ‘V’ (or upside down ‘V’) that forms when the price bars are falling, then turn around and start rallying. It is that bar in between that has ‘higher bars’ on each side. The reverse is true for a ‘high pivot’. If this sounds confusing, a picture is worth a thousand words.

The more bars on each side, the ‘stronger’ the pivot is. That is to say, the more likely it would hold if prices were to retest that area. Technically, we will consider an area to be at least the lowest level of pivot once we have one closed bar on each side of the pivot bar with higher lows (or lower highs for a high pivot). Two bars is better. Two bars with ‘consecutive higher lows (or lower highs) is even better. This is what is shown in the top two diagrams above. They show two consecutive bars, which means each bar has a higher low (or lower high) than the prior bar. The bottom two diagrams show non-consecutive higher lows which means that they are all higher than the lowest bar (the pivot bar) on the ‘low pivot’ but the third bar may be lower than the second bar (and the reverse for the ‘high pivot’).

Next, we put these pivots together to form a trend. An uptrend is a series of ‘higher low pivots’ and ‘higher high pivots’. The numbers 1-3 on the bottom show the series of higher pivot lows. The letters A-C on top show the higher pivot highs.

Naturally, the same is true in reverse for a downtrend. We want a series of ‘lower pivot highs’ and ‘lower pivot lows’. Note, that the red bars are pullbacks in an uptrend. They are not downtrends. It does not matter what timeframe is shown above, it is in an uptrend. There are rallies and pullbacks, but it is all an uptrend on this time frame.

Technically, once we fail to make a ‘higher high pivot’ or a higher low pivot, the uptrend is over. That topic is precisely where we will continue next week.

What is a Trend, Part 2 of 2