Contents in this article [hide]
- 1) Price action analysis
- 2) The slope of trendlines
- 3) ADX
- 4) Moving averages (MA)
- 5) RSI
- 6) Bollinger Bands ®
- Knowing the strength of a trend is the backbone of any trading method
Trading is all about understanding what your price charts are telling you. Being able to read market structure, sentiment and the balance between bulls and bears is vital to make the right trading decisions. Understanding if a trend is gaining or losing momentum is important if you are trying to make decisions about whether support and resistance levels are likely to hold or break, if a trend will continue, or if a reversal can be expected any time soon.
In a different article, we talked about how to understand the direction of a trend; this article explains how to read the trend strength from your charts. The following 6 concepts, tools and indicators can help you make sense of price action and provide insights about market structure.
1) Price action analysis
Trend waves – length, steepness and smoothness
The first point lays the groundwork for all that follows and it describes the basics of price movement. The way price moves during uptrends and downtrends can tell you a lot. The chart below shows a downtrend with a series of lower lows. At the same time, you can see that the bearish price waves are much smoother and the bullish pullbacks are less smooth.
Secondly, the steepness of the bearish price waves decreases and they become shallower as the trend continues. Steep price waves indicate trend strength whereas shallow price waves signal a lack of strength. Also, the size of the trend-waves is important to understand. The chart below shows that the bearish trend-waves become smaller.
The blue circled area highlights the first period bears faced strong opposition and price wasn’t able to move further down as smooth. This price behavior is in sharp contrast to previous price action. In a strong and healthy downtrend, the bearish trend-waves do occur mainly uninterrupted.
Pullbacks during a trend
The next screenshot highlights the importance of putting the size of pullbacks into context. The first green shaded area shows the first larger pullback during the ongoing downtrend. Before that, the pullbacks were relatively small which signaled strong momentum to the downside. A large pullback can foreshadow a broken market structure and it provides first indications about losing trend strength. Finally, price failed to make lower lows altogether which had been foreshadowed by the increasing size of pullbacks against the downtrend.
- Highs and lows are the classical trend concept. How fast highs and lows move is the clue about trend strength
- The length of trend waves tells you how much power the trend has
- How smooth price can travel during trend waves is another important trend strength concept
- How deep retracements move during pullbacks can tell a lot about the balance between buyers and sellers
2) The slope of trendlines
Trendlines are a great trading tool because they provide instant information about the strength of a trend. First, you have to pay attention to the angle of a trendline because the angle shows you exactly how strong the trend is. In an uptrend, a small angle means that the new lows are not moving up as fast. However, once the angle becomes too large, it often signals a trend (Boom) which is not sustainable.
An increase in the angle of trendlines means that price is gaining momentum and price is making higher highs faster. Finally, a break of a trendline signals a broken market structure. A break can either mean a decrease in the momentum of a trend or a complete trend reversal.
- The slope of trendlines describe trend strength
- An increasing slope in an uptrend shows a trend with rising momentum
- A decreasing slope shows fading momentum
- The break of a trendline is the final signal of a trend reversal
The ADX measures trend strength and it is non-directional which means that it cannot tell you which direction price is going – it only tells you if the trend is gaining or losing momentum.
The chart below shows a downtrend and the first down-movement shows a lot of strength in the ADX by making a new high and absolute on the ADX. The next two bearish moves were much smaller and not as strong and the ADX confirmed it by showing lower highs. The last move on the far right showed a very choppy and narrow movement and the ADX went dipped at that point, price had entered a range.
- A rising ADX shows gaining trend strength
- New highs on the ADX signal a healthy trend
- Lower highs on the ADX signal losing strength
- A “hook” on the ADX shows a sudden shift in trend strength
- A flat or an ADX heading down signals a range
4) Moving averages (MA)
The relation of price to the MA and the slope
Moving averages are a great trading tool because they provide a variety of different information at once. First, the slope of a moving average is important. When price is above the MA and the MA is moving up it signals a strong trend with prices rising faster than the historical averages. The further price can pull away from a moving average, the stronger the current trend is.
The MA crossover – sentiment shifts
The combination of a smaller and a larger moving average measures sentiment shifts in price. The screenshot below shows a chart with a 50 and a 100 MA. When the small MA crossed above the larger MA it signaled a shift in sentiment to the upside because recent prices were moving above the average of the longer term price structure. Conversely, when the shorter MA crossed below the larger MA it signaled a sentiment change to the downside because recent price started trading below the longer-term average.
The space between MAs – momentum information
Finally, the bigger the space between the two MAs, the stronger the trend is becoming because recent price is pulling away from the long-term average faster. The size of space between the two MAs provides information about momentum. The MACD or the Ichimoku indicators are both based on the differences between short term and long term average price structure.
- Generally, price above a moving average signals an uptrend [read about Marty Schwartz’s trading tips]
- When the short-term MA crosses above the long-term MA, it signals a bullish trend shift
- When the space between the two MA increases, momentum increases as short-term prices pull away fast from the longer-term average price
The RSI is another indicator that measures strength. It is similar to the ADX but the RSI is directional. In a healthy uptrend, the RSI makes new highs and higher lows. In a downtrend, the RSI makes new lows and lower highs. In a range environment, the RSI moves sideways between 30 and 70.
The screenshot below shows that the first uptrend was initiated by a RSI divergence (higher lows on the RSI and lower lows on price – a momentum divergence). During the following uptrend, the RSI made higher highs and higher lows. After the uptrend, price moved down for a while but not with a lot of strength and the RSI stayed mostly between 30 and 70 (dotted arrow). The next uptrend-phase also started after a RSI divergence and the RSI started making higher lows again until, just recently, another divergence signaled the end of the uptrend.
- During an uptrend, the RSI makes higher highs and higher lows
- A flat RSI ranging between 30 and 70 indicates a lack of momentum
- An RSI divergence shows a momentum divergence and it is often a reversal sign
6) Bollinger Bands ®
Bollinger Bands can be combined with other momentum indicators but they are also a great tool by themselves. The screenshot below shows a healthy uptrend and the Bollinger Bands showed that as price stayed above the middle Band; price “grinding” higher between the middle and the outer Band is a typical trend signal.
A trend is usually broken once price crosses the middle Band. A price spike outside the outer Band which immediately reverses back into the Bollinger Bands can often signal a change in trend direction.
- In an uptrend, price moves higher between the middle and the outer band
- A break of the middle band often signals a trend reversal or the lack of momentum
- A price spike through the outer bands and an immediate reversal indicates a sentiment shift
Knowing the strength of a trend is the backbone of any trading method
Understanding trend strength and being able to read the balance between bulls and bears is a very important skill every trader has to develop. And although each of the 6 described tools and concepts can be very helpful, you should pick 1 (maximum 2) of to avoid confusion and indicator redundancy.
The trading tools and concepts described are not a standalone system by themselves, but they should build the backbone of any trading methodology.