Know The Trend, Know The Trade

06/07/10 09:43:52 AM

by Alan R. Northam

Before a decision is made to trade a particular security, the trader must know the longer-term trend.

Security: TWM
Position: N/A

High-probability trades are made in the direction of the longer-term trend, and without knowing anything about this trend, the trader increases his or her chance of failure. Approximately 80% of those who decide to start trading the markets lose all of their trading capital within the first year. To be listed among the 20% of those who succeed in the business of trading, it is necessary to know as much as can be learned about a particular security before ever attempting to trade it. Before you can know whether your trade has a high probability of succeeding, it is necessary to know the long-term trend.

FIGURE 1: TWM, MONTHLY. Chart shows support and resistance lines.

Graphic provided by: MetaStock.

To start our analysis of the long-term trend, I refer to the monthly chart shown in Figure 1, of the ProShares UltraShort Russell 2000 ETF (exchange traded fund) (TWM). This ETF is known as a bear fund. When the major stock markets have entered into a bear market, bear market funds move higher in price. Bear funds make it possible for small traders to trade these ETFs long in cash-only accounts. Upon inspection of the monthly chart, we want to identify all the areas of support and resistance.

The first thing I want to point out is the thick red horizontal line. Before price moved below this line in April 2009, it acted as a line of support to this security as price came down and touched it multiple times before turning upward (see green arrows). However, once price broke down below this line of support, it reversed its role and became a line of resistance. There is a saying in technical analysis that avers that once price crosses below a line of support, "Old support becomes new resistance." However, first it must be tested as a line of resistance; price must move up to and bounce off this new line of resistance. As can be seen in Figure 1, price has not yet moved up to the resistance line. As a result, the trader should be expecting price to move upward to test this new line of resistance.

The next thing to note in Figure 1 is that price has broken out above the downsloping trendline (see trendline 1). This breakout is an indication that the downtrend of TWM has ended. However, a new uptrend has not yet started. Instead, TWM has entered into a shallow downtrend. This change in the downtrend is an indication that the downward momentum of price is decelerating, which normally occurs before a reversal in trend takes place. As a result, the trader should be expecting a trend reversal to occur.

Next, the downsloping line of support has changed to a more shallow slope. This is an indication that traders are starting to settle in on a final line of support for this security. Once both buyers and sellers have become satisfied with a particular support price, the market should turn upward to test the new line of resistance at approximately $60 per share. As a result, traders should be looking for this market to be putting in a bottom and then moving upward to test resistance.

Note also the narrow trading range that has developed between trendline 2 and support 2. This narrow trading range is an indication of low volatility. It is known in technical analysis that a once-high volatility precedes a market top and low volatility a market bottom. Therefore, this low level of volatility is further evidence that a market bottom is being formed and traders should be expecting this market to turn upward.

Finally, the trader should take a look at volume. Note that volume has been increasing in an exponential fashion. Volume is the force behind the move. With volume increasing exponentially the way it has been doing while price remains in a tight trading range, it is like a steamboiler building up pressure. If the pressure gets too high, the boiler will explode and this is what is taking place with this security. Volume is increasing and when it has exerted sufficient force upon this security, price will break out to the upside of its tight trading range. Depending upon the force, which appears as if it could be considerable, behind the breakout this market could explode to the upside and quickly move up to the new resistance line at $60 per share.

While price has not yet broken out of its shallow downtrend, all evidence points to the fact that TWM is putting in a bottom and it is just a matter of time before this security turns upward offering traders a low-risk, high-reward opportunity to profit from this security.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.