I like to consider myself a swing trader and, in the extraordinary circumstances of a strong weekly trend, a position trader. I enter trends on reaction by using technical analysis to:

Types of Trends
Contrary to what a lot people think, technical analysis is the art of trend following rather than one of predicting prices and turning points. Trend following remains the single most popular strategy for making huge profits in the stock markets. A trend is a series of rising or declining prices over any length of time.

An up trend is a market that sees consistently higher prices over time. A downtrend is a market that sees consistently lower prices over time. At any given time, the market comprises three trends: The primary, secondary and minor trends.

Primary trends can be a series of rising prices or declining prices. Primary trends can last from one to several years. Secondary trends are intermediate corrective trends to the primary trends. These reactions last from one to three months and retrace one-third to two-thirds of the primary trend. Minor trends are short-term movements lasting from one day to three weeks.

Is the Market Trending or Trading?
Market movements are characterized by two distinct types of phases. In one phase, the market shows trending movements either up or down. Trending movements have a directional bias over a period of time. In the second phase, the market shows trading range movements or consolidation, where the market shows no consistent directional bias and trades between two levels.

These two different phases of the market require the use of different types of indicators. Trending markets need trend-following indicators, such as moving averages, the MACD, and so forth. Trading-range markets, on the other hand, need oscillators, such as the RSI, stochastics, and so forth, which use overbought and oversold levels. So, identifying the phase of the market is extremely critical to the methodology the trader needs to follow.

The Average Directional Movement Index
The average directional movement index (ADX) fills this need to identify the trending or trading phase of the market. J. Welles Wilder developed the ADX — to my mind, his most useful and least-understood invention. The ADX defines the degree of directional movement, not the direction. The directional movement system is a trading system based on the use of ADX that gives timing information based on the strength of the underlying trend.

The following table can serve as a quick guide for interpreting ADX levels:

Let's take an example of an S&P500 weekly chart. As the ADX starts above 15, the market starts trending down.

Now, on the lower time frame (i.e., the daily time frame), we look for overbought regions to identify a low risk entry point into the weekly downtrend. This methodology works on all time frames. There are three methods for doing this:

Method 1: The RSI
The RSI is an oscillator which provides overbought and oversold levels on a particular time frame. As we earlier identified a strong weekly downtrend, low risk entries can be achieved by shorting overbought levels in the RSI. From the chart underneath, it is clear the 4 out of the 5 entries were successful. These entries were successful because the trend on the weekly time frame was very strong.

Method 2: Stochastics
Stochastics are another oscillator that provides excellent overbought and oversold levels on all time frames. Again, the main trend is identified on the weekly. Out of the 6 entries, 4 proved successful and 2 failed, but, overall, this strategy proved extremely profitable.

Method 3: 20 DMA
The 20 DMA offers a broad view of the market. The price staying above 20DMA shows a short-term uptrend, and the price staying below 20 DMA shows a short downtrend. If there is a weekly downtrend, when the price corrects above the 20 DMA on the daily and comes back below it, it provides a low risk entry. The 6 entries suggested by this indicator led to 5 profitable entries and one failed entry into the downtrend.

Remember: Markets move sideways 80% of the time and trend only 20% of the time. Yet, I have found that entering trends on reaction, one of the oldest techniques for making money in the markets, is also a profitable one. Perhaps, you will too.

*Reprinted (and modified) with permission from Ashwani Gujral