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As formed by the random walk, our market model is either cyclic or trending. A moving average is about the only means we have to measure the trend directly. Moving averages are not very helpful because they are always lagging functions. However, we can measure the cycles and know when the market is cyclic.

By reverse logic, if the market is not short-term cyclic, it must be trending. We can identify whether the market is cyclic in a period as short as a half cycle. Cycle analysis, therefore, can be used to spot a trend early in its formulation.

The early identification of a trend then depends on a valid measurement of short-term cyclic activity. There are two ways to do so, either by cycle elimination or by spectrum analysis. Of the two, cycle elimination is by far the easier.

Let's approach the question of cycle elimination using synthesis and then reverse the procedure to establish what we must do to perform the analysis. We can synthesize a theoretical price curve by adding a pure sinewave to a straight trendline. We then examine these two components independently. The average over the period of a theoretical sinewave is always zero, regardless of where we started the average. If we used a moving average with a length the period of the sinewave, then the sinewave is completely removed and we are left with only the straight line trend.

The identification of the trend is that easy. We eliminate the cyclic component when we use the average over the cycle length. We could adjust the average as the cycle length varies and plot the results day-by-day. I call the result an "instantaneous trendline." A fixed-length moving average can suffice during periods when the cycle length is not changing. We expect the price to alternate across our instantaneous trendline because the price has the cyclic component. We expect to see the crossing occur approximately every half cycle. If the price fails to cross the instantaneous trendline, we get a clear signal that the price has moved into a trend mode—that is, the movement in the direction of the trend swamps the cyclic movement so the expected crossing does not occur. When this happens, the price parallels our instantaneous trendline without crossing it.

The instantaneous trendline is a lagging function like a normal moving average. Using the instantaneous trendline method, a trend is identified when the price does not cross or even appear likely to cross the trendline within a half cycle.

Figure 1 is an example of where we identify a trend in the first five days of its move on March 2, 1990 (900302, the cursor location). At this point we have a 10-day cycle, and the price has not crossed the instantaneous trendline within the last five days. The price shows no tendency of trying to cross the instantaneous trendline. Early identification allows us to capture about a 30-point profit, the majority of the move.

We can use this technique to simply trade the trends. However, the profits are even better if we use the trend identification to shift from a cyclic trading strategy to a trend trading strategy. Suppose in our example we had been trading on the basis of cycles. Trading every five days (each half cycle), we would have gone long on 900131, a short-term low. From there we would go short on 900207 (short-term high), long on 900214 (a little early for a short-term low), and short on 900221. Our last short entry would be at about 431, substantially above the 415 price where we first identified the downtrend. We would already have been in a short position on the basis of cycle trading and therefore would exploit the full extent of the trend movement. Shifting between cycle trading strategy and trend trading strategy therefore enhances overall profitability.