Chart analysis for traders: higher highs & lower lows

Most traders have heard about Dow theory and higher highs and lower lows. This article is a quick recap of this very important trading topic.

Highs and lows are major reference points for traders. Especially in daily charts they are regarded as key points. The reason for this is their close link to the trend definition in chart analysis:

1. Higher highs + higher lows define an upward trend.
2. Lower highs +lower lows define a downward trend.

Many traders pay attention to the progress of these points. If the market price succeeds in surpassing yesterday's high, the market is bullish. This is especially true if there is an upward trend on the daily chart, as well. Vice versa, if the market price reverses below yesterday's low, the market is bearish, particularly when complemented by a downtrend in a higher time frame. That same principle applies to all time frames.

A SIDEWAYS MARKET

There is not always a clear sequence of higher or lower highs and lows. In these cases we speak of sideways phases. These phases occur in two distinct types:

• Range contraction: Lower highs + higher lows. This narrows the trading range which is a sign of decreasing volatility.
• Range extension: Higher highs + lower lows. This expands the trading range expands which is a sign of increasing volatility (more interesting!).

TRADING WITH DOW THEORY

Many traders directly work with highs and lows. If, for example, the market is in an uptrend on the daily chart but within the day falls towards its previous day's low, this is an opportunity for a long trade. Traders would usually buy just above the previous day's low. The idea is that in order for the uptrend definition to stay valid, the market has to turn above yesterday's low and rise to higher highs, ideally. The same is true for the short side vice versa.

It is not always that simple, of course. For example, there will, at times, be fake-outs in, for example, the DAX market index. That is, price undercuts the previous day's low or briefly exceeds the previous day's high only to then reverse again. In order to maintain an attractive retrurn/risk ratio, traders have to accept these fake-outs as losing trades. The other option is to work with wider stop distances.

AN EXAMPLE

This example shows higher highs + higher lows on the DAX market index. On May 2, the DAX initially sold off. Just above its previous day's low (first blue line), the market turned. Later on, price rose above its former intraday high (second blue line) and set new all-time highs. There was an upward trend on the daily chart supporting the setup.

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