Technical Analysis Basics Explained: Understanding Trends and Moving Averages
Learn how to identify stock market trends using moving averages to help add context, support decision making, and complement other forms of analysis.
Sir Isaac Newton developed the laws of motion to understand and describe the relationships between an object, the forces acting on it, and its motion. One of these laws is the law of inertia, which states that an object at rest stays at rest. An object in motion stays in motion with the same velocity and direction unless acted upon by an opposing force.
Technical analysis of stocks borrows from the law of inertia to understand and describe the relationships between a stock price, buying and selling of the stock, and its motion. In describing motion, investors borrow another physics term, “momentum," which, as in physics, is the quantity of motion. The “forces” acting on a stock are buying and selling. And the “motion” of a stock is usually called a trend.
Trends can form in three directions: up, down, or sideways. These trends, or ways of describing a stock’s motion, are among the technical analysis basics.
Defining Trends in Stock Prices
A common way to define trends in stocks is by analyzing a chart of historical prices. In particular, investors look at and relate highs and lows in prices to help identify trends.
There are three basic types of stock trends: up, down, and sideways. I like to use candlestick charts, because each candle shows the period’s open, close, high, low, and trend in a single image. That simplicity can help when learning how to identify trends. An uptrend is typically defined as a series of higher highs and higher lows. And what’s the opposite of an uptrend? You guessed it; a downtrend. A downtrend is typically defined as a series of lower highs and lower lows.
What if there’s no clearly defined trend? Some would call that a sideways trend, which is typically defined as a series of roughly equal highs and lows.
In just about any stock, on a long enough timeline, you’re likely to see periods of each type of trend. See figure 1.
FIGURE 1: IT’S TRENDY. Example of a stock with clearly defined periods trending up, down and sideways. For illustrative purposes only. Past performance does not guarantee future results.
Applying Trends to Investing
Simple enough. But now that you know how to identify trends, what’s next? Let’s look at a few foundational assumptions of technical analysis:
- A stock’s current price is accurate and reflects all public knowledge
- Historical patterns in stock prices repeat
- Stock prices move in trends
The risk with assuming that patterns repeat and prices move in trends is hindsight bias. That simply means you may see an event as having been predictable—but only after the event actually happened. Think about this for a moment and look again at the trends above. It’s easy to identify trends after the fact. But were the patterns identifiable in real time? Were the trends predictable before all the prices were actually plotted on the stock charts? Maybe not.
So, before applying trends to investing decisions, it’s important to understand the limitations and risks of technical analysis. Some investors overlook these risks and attempt to apply trends as a standalone strategy to make investing decisions. Some investors think all that’s needed for success in the markets is a chart. Unfortunately, it’s more complicated than that.
The great value of applying trends, and technical analysis in general, is context. Applying trends to investing can supply valuable information and support for investment decisions.
For example, suppose you find a beaten down energy stock. After reviewing the fundamentals, like earnings and sales, you conclude that the company might experience a turnaround. However, after checking the chart, you observe a steady pattern of lower highs and lower lows. Maybe the market knows something you don’t. Maybe the time to buy isn’t right. That’s what the trend on the chart is indicating, and that’s one of the values of applying trends. The right time might be when the trend reverses and a series of higher highs and higher lows unfolds. At that point, the uptrend might agree with your fundamental analysis, providing context and support for your decision.
Trend Analysis for Investors
How can investors find this context and use trend analysis to help support decision making?
As opposed to traders, investors typically hold investments for long periods of time—months or several years. So when it comes to applying trend analysis to investing, it’s important to use a chart and time frame that aligns with investing.
One time frame investors might start with is a weekly chart. Charting stock prices on a weekly basis can provide investors with enough information to make investing decisions, but with less noise than is usually associated with shorter time frames like daily and especially intraday time frames.
On a weekly chart, investors can choose to apply moving averages to help identify series of higher highs and lows, or lower highs and lows. A moving average is just like it sounds: an average of historical prices over a specified interval that updates with each new data point.
Some investors might use two moving averages (MAs) to help identify trends. For example, in figure 2, I’ve applied 13-week (blue line) and 52-week (purple line) simple moving averages to a weekly chart of the S&P 500 Index (SPX). There are about 13 weeks in a quarter and 52 weeks in a year, so these MAs measure quarterly and yearly averages of the SPX. Now, don’t get hung up on these intervals—feel free to experiment with different moving average lengths. But for now, notice how higher highs and lows usually unfold when the 13-week MA is above the 52-week, and vice versa.
FIGURE 2: APPLYING MOVING AVERAGES. The 15-year chart of the S&P 500 Index (SPX) above shows how moving averages can offer additional context to overall trends. For illustrative purposes only. Past performance does not guarantee future results.
Here’s how these two moving averages can help identify trends. When the 13-week moving average is greater than the 52-week moving average, the SPX is in an uptrend. When the 13-week is less than the 52-week moving average, the SPX is in a downtrend.
The idea is to maximize profits when the SPX is in an uptrend. But when the SPX is in a downtrend, the idea is to limit losses.
There are a couple of examples of how this works in figure 2. Look at the uptrends from early 2012 to mid-2015, and another one from 2016 to 2018. The SPX has continued to make new all-time highs throughout these two periods.
Now look at early 2008, the time of the global financial crisis. This downtrend took the SPX from about 1500 to 1000 before the 13-week crossed back above the 52-week moving average.
One of the risks in using two moving averages is when the SPX is in a sideways trend. Look at mid-2010, late 2013, and mid-2015 to 2016. These are times when this strategy might have resulted in missed profit opportunities and even losses. Again, there are limitations and risks in trend analysis.
Identifying trends using technical analysis is not an exact science; it has flaws, and it’s not a standalone investing strategy. But technical analysis basics such as trend analysis can help add context, support your decision making, and complement other forms of analysis like fundamental, macroeconomic, and psychological.