Making money from an uptrend is where most traders, and nearly all investors, focus their attention. While money can be made when stock prices are moving sideways or even down, most traders by default look for uptrends. This makes sense, since there is an inherent upward bias in the stock market; it has been rising overall since the New York stock exchange began operations back in 1898. Over shorter time frames, that bias isn't always apparent, which means traders need to understand uptrends, how they are established, signs they are reversing, and the limitations of charting uptrends. Understanding these concepts allows traders to participate in uptrends and hopefully profit, and avoid some of the capital draw downs from the downtrend that inevitably follows every uptrend.
What Is an Uptrend?
An uptrend is more than just a rising stock price; it needs to be defined.
Price moves in waves or swings. During an uptrend the waves higher are larger than the waves lower (pullbacks), this allows the price to make headway to the upside. Stock prices don’t move relentlessly in one direction for long, instead price follow a three steps forward, two steps back, three steps forward type structure.
How Is an Uptrend Established?
Since prices advance through a push higher, pullback, push higher structure, an uptrend is in place when a stock’s price is making higher-wave-highs and higher-wave-lows. This shows the price is advancing to the upside and establishes the uptrend.
Stock charts are used to monitor these conditions. The low of a major price wave should be above the prior major wave low. Similarly, the high of a major price wave should be above the prior major wave high. When these conditions aren’t met, it is a warning sign that the trend may start to reverse (next section).
Uptrends have varying degrees of strength. Some may move at 45 degrees, some less and others may move almost vertically. With a near vertical trend the space between former high and new highs (and former lows and new lows) can be quite vast.
Uptrends begin and persist for different reasons; the main reason is speculation. If traders (cumulatively) believe the price will continue to advance, they buy the stock in a self-fulfilling prophecy. Eventually, however, traders lose trust in the trend, and more and more stop buying, and begin to sell instead. This shift converts the uptrend to a downtrend.
The stock market exists to provide capital to corporations; the stock price is therefore tied to the outlook for that corporation. While traders speculate, their decisions to do so are often driven by their outlook for the company, outlook for the economy, factors that could affect the stock price, as well as their outlook on government and foreign policy.
The combined decisions of all traders on these matters are reflected in the price trend using stock charts.
How Is an Uptrend Reversed?
If an uptrend is composed of higher swing highs and higher swing lows in price, when these conditions are not satisfied the trend could be reversing.
The time frame being watched here is important though. For a trader who wants to trade every see-saw move in the market, any failure to make a new high, or a lower low may be cause for speculating on a reversal. This could be done on a 5-minute chart, hourly chart or daily chart. Investors, on the other hand, are likely only going to look at major swings on a daily or weekly chart, and they won’t worry about small moves that make a lower high or lower low.
Figure 3 shows Pandora Media (NYSE:P) in a steady rise. The price action is a bit choppy, but overall the price is making higher highs and higher lows. The price then shifts, making lower lows and lower highs. When the price makes a major lower low and major lower high, the uptrend is over. It is time to exit long positions and potentially look for short position entries.
Monitoring an uptrend for higher highs and higher lows is a sound method for discerning if the uptrend is intact. Other methods include using trendlines. During an uptrend a trendline connects the swing lows of an uptrend. If the price breaks below the trendline, it is a warning sign that the trend is weakening. This doesn’t mean the trend has reversed, it is just an advance warning that the trend is slowing. Use price action (highs and lows) to confirm trendline breaks and reversals.
Charting Uptrends: Limitations
Trend analysis is subjective. While the trend is easy to see in hindsight, in real-time we don’t know if a price will make a higher low until the price actually makes a higher low and then begins to move higher. We don’t know if the price will make a higher high until it does.
Trend analysis requires focus and adapting to conditions as they develop. It is also possible to get tricked. The price may make a lower high followed by a lower low, indicating the uptrend is over, but then the uptrend may in fact continue.
To help avoid being lured out of trend trades by these “false” moves, zoom out to a longer time frame. Instead of looking at one year of historical price data, look at two or three years, for example. When looking at two years of data, does the trend look different? From the larger perspective, you may notice that a lower low you were concerned about is only a small pullback on the longer-term view, and therefore not a reason to liquidate your position. Other times, the signal to liquidate will be valid.
Ultimately, trends are great while they last, but we can’t predict with great accuracy when they will end. We can see the trend ended once we have a number of lower highs and lower lows in place, but we can’t anticipate with certainty when that will occur.
The Bottom Line
Uptrends are moves higher in price, created by a two-steps-forward-one-step-back structure. When this occurs, the price makes higher highs and higher lows. Trends can be steep or shallow, but the same principles apply. Reversals occur across different time frames and perspectives, when the price fails to make higher highs and higher lows, and instead does the opposite. Monitoring price action and a trendline alerts traders to when the trend may be reversing. While we can see that a trend has reversed based on these tools, they don’t predict the reversal in advance; therefore, traders must be alert and adapt to changing market conditions as they arise.