Stock prices generally trend in one direction or the other. When there is more demand for shares than there is supply, the stock will trend higher. In a downtrend, supply outweighs demand, forcing the stock to trend lower. It is important to understand individual stock trends as well as the trend of the market in general.
A stock can be in the midst of multiple, simultaneous trends. Sound confusing? It’s not. A stock may be in a long-term uptrend, an intermediate-term downtrend and a short-term uptrend. (FYI: We loosely define long-term as greater than one year, intermediate-term as more than two months but less than a year, and short-term as two months or less.)
For long-term investors, the long-term trend is most important. But when you’re ready to take action (buy or sell), the short- and intermediate-term trends can be extremely important. To assist you in identifying how a stock is trending you should use a trendline.
Trendlines help you determine the prevailing trend of a stock. If a stock is advancing, a trendline should be drawn as a straight line that connects at least three successively higher bottoms. When that line is broken, the uptrend has run its course and the stock will either move sideways or begin a downtrend of unknown duration and severity. (See figure 1.)
When dealing with a downtrend, the trendline should connect at least three successively lower tops. As long as the stock’s price remains below the trendline, the downtrend remains in effect. (See figure 2.)
If a stock decisively breaks through a trendline, the odds favor a reversal in trend. And as we discussed above, depending upon which trend you’re analyzing (long-, intermediate- or short-term), the ramifications of a trend break could be significant. If a long-term trend has been broken, it’s more significant than a short-term trend break.