Trend is perhaps one of the most important concepts in technical analysis. Under normal circumstances, market participants tend to make similar decisions and a trend may persist for some time. The following are a few additional concepts that every CFA level I candidate is expected to understand before sitting the exam.
The two Aspects of Trend
We say the market is in an uptrend when the price consistently goes to higher highs and higher lows. As the price of a security increases, the subsequent new high attained is higher than the one preceding it. Similarly, each time the price retraces, the new low attained must be ‘higher’ than the prior low. Behind an uptrend lies demand that’s higher than supply. Therefore, market participants are willing to pay higher and higher prices as they compete for the same asset. Such a scenario may happen over a period of time.
Experts say the market is in a downward trend when an asset consistently makes lower lows and lower highs. As the price of a security decreases, the subsequent new high must be lower than the preceding high. Similarly, each time the price retraces, the new low must be lower than the preceding low in the trend period. Behind a downtrend lies supply that’s overwhelming demand. Therefore, market participants are willing to exit long positions and accept declining prices.
Support and Resistance
Support refers to a low price range in which further decline in price can be averted by some buying activity. It’s the direct opposite of resistance, which is a price range in which further increase in price can be averted by some selling activity. In addition to trend, support and resistance are also linked to human psychology, particularly the tendency of buyers and sellers to find common ground about the price of a security.
Change in Polarity
The change in polarity principle asserts that once breached, a support level becomes a resistance level. Similarly, resistance levels become support levels once breaching has occurred. For instance, assume the price of a certain security never rises beyond $15 over a long period of time and actually begins to decline whenever it reaches this level. If the price finally “breaks” the $15 ceiling by a significant amount, the new point to which the price rises effectively becomes a support level.
Reading 13 LOS 13c:
Explain uses of trend, support, resistance lines, and change in polarity.