Identifying a Trend
Identifying the current trend and the change in a trend is where money is made by traders. If you look at any price chart, you will see trends, but what is a trend, why does it occur, and how can you identify it?
Prices will either move in trends (that is, price movements that tend to go one way for a period of time), or between defined ranges. What you see depends on how much you zoom into price action. The shorter term the perspective you look at, the fewer trends you will see. Why is this? It is because of market noise.
Noise is random price movements that obscure the underlying trend. If you look at tick data (the shortest possible price interval), it will be difficult to see the trends because the magnitude of the random price movements is similar to that of the trends.
As you “zoom out”, trends will become more evident. If you look at a 5 year price chart for gold, the long term trend will be obvious. If you look at tick data, it is hard to see even the short term trends.
Since noise is the enemy, you will need a way of removing the random price movements to reveal the underlying data. The trend identification method outlined in the charting section is one way of removing random noise. One other way that traders do this is using a moving average.
A moving average is simply the average of the last x days (where x is typically 10 or 20, or even 200 days). This smooths the bumpy price action to show the underlying trend.
The only problem is that moving averages lag the market by about 1/2 x. So for a 20 day moving average, the lag is 10 days. This is a problem if you are a trader, because the signals will all be late.
Fortunately, there are now more advanced algorithms that can be used. These are based on noise filtering technology developed for radio, military uses and electronics. We will discuss these more in future postings.
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