TRENDLINES
posted under
Philosophy of Technical Analysis
by ceecabolos
Now that we understand support and resistance, let's add another building block to our arsenal of technical tools—the trendline. (See Figures 4.6a-c.) The basic trendline is one of the simplest of the technical tools employed by the chartist, but is also one of the most valuable. An up trendline is a straight line drawn upward to the right along successive reaction lows as shown by the solid line in Figure 4.6a. A down trendline is drawn downward to the right along successive rally peaks as shown in Figure 4.6b.
Drawing a Trendline
The correct drawing of trendlines is a lot like every other aspect of charting and some experimenting with different lines is usually necessary to find the correct one. Sometimes a trendline that looks correct may have to be redrawn. But there are some useful guidelines in the search for that correct line.
First of all, there must be evidence of a trend. This means that, for an up trendline to be drawn, there must be at least two reaction lows with the second low higher than the first. Of course, it always takes two points to draw any straight line. In Figure 4.6a, for example, only after prices have begun to move higher from point 3 is the chartist reasonably confident that a reaction low has been formed, and only then can a tentative up trendline be drawn under points 1 and 3.
Some chartists require that the peak at point 2 be penetrated to confirm the uptrend before drawing the trendline. Others only require a 50% retracement of wave 2-3, or that prices approach the top of wave 2. While the criteria may differ, the main point to remember is that the chartist wants to be reasonably sure that a reaction low has been formed before identifying a valid reaction low. Once two ascending lows have been identified, a straight line is drawn connecting the lows and projected up and to the right.
Tentative Versus the Valid Trendline
So far, all we have is a tentative trendline. In order to confirm the validity of a trendline, however, that line should be touched a third time with prices bouncing off of it. Therefore, in Figure 4.6a, the successful test of the up trendline at point 5 confirmed the validity of that line. Figure 4.6b shows a downtrend, but the rules are the same. The successful test of the trendline occurs at point 5. To summarize, two points are needed to draw the trendline, and a third point to make it a valid trendline.
How to Use the Trendline
Once the third point has been confirmed and the trend proceeds in its original direction, that trendline becomes very useful in a
variety of ways. One of the basic concepts of trend is that a trend in motion will tend to remain in motion. As a corollary to that, once a trend assumes a certain slope or rate of speed, as identified by the trendline, it will usually maintain the same slope. The trendline then helps not only to determine the extremities of the corrective phases, but maybe even more importantly, tells us when that trend is changing.
In an uptrend, for example, the inevitable corrective dip will often touch or come very close to the up trendline. Because the intent of the trader is to buy dips in an uptrend, that trend-line provides a support boundary under the market that can be used as a buying area. A down trendline can be used as a resistance area for selling purposes. (See Figures 4.7a and b.)As long as the trendline is not violated, it can be used to determine buying and selling areas. However, at point 9 in Figures 4.7a-b, the violation of the trendline signals a trend change, calling for liquidation of all positions in the direction of the previous trend. Very often, the breaking of the trendline is one of the best early warnings a change in trend How to Determine the Significance of a Trendline
Let's discuss some of the refinements of the trendline. First, what determines the significance of a trendline? The answer to that question is twofold—the longer it has been intact and the number of times it has been tested. A trendline that has been successfully tested eight times, for example, that has continually demonstrated its validity, is obviously a more significant trendline than one that has only been touched three times. Also, a trendline that has been in effect for nine months is of more importance than one that has been in effect for nine weeks or nine days. The more significant the trendline, the more confidence it inspires and the more important is its penetration.
Trendlines Should Include All Price Action
Trendlines on bar charts should be drawn over or under the entire day's price range. Some chartists prefer to draw the trendline by connecting only the closing prices, but that is not the more standard procedure. The closing price may very well be the most important price of the day, but it still represents only a small sample of that day's activity. The technique of including the day's price range takes into account all of the activity and is the more common usage. How to Handle Small Trendline Penetrations
Sometimes prices will violate a trendline on an intraday basis, but then close in the direction of the original trend, leaving the analyst in some doubt as to whether or not the trendline has actually been broken. (See Figure 4.9.) Figure 4.9 shows how such a situation might look. Prices did dip under the trendline during the day, but closed back above the up trendline. Should the trendline be redrawn?
Unfortunately, there's no hard and fast rule to follow in such a situation. Sometimes it is best to ignore the minor breach, especially if subsequent market action proves that the original line is still valid.
What Constitutes a Valid Breaking of a Trendline?
As a general rule, a close beyond the trendline is more significant than just an intraday penetration. To go a step further, sometimes even a closing penetration is not enough. Most technicians employ a variety of time and price filters in an attempt to isolate valid trendline penetrations and eliminate bad signals or "whipsaws." One example of a price filter is the 3% penetration criteria. This price filter is used mainly for the breaking of longer term trend-lines, but requires that the trendline be broken, on a closing basis, by at least 3%. (The 3% rule doesn't apply to some financial futures, such as the interest rate markets.)
If, for example, gold prices broke a major up trendline at $400, prices would have to close below that line by 3% of the price level where the line was broken (in this case, prices would have to close $12 below the trendline, or at $388). Obviously, a $12 penetration criteria would not be appropriate for shorter term trading. Perhaps a 1% criterion would serve better in such cases. The % rule represents just one type of price filter. Stock chartists, for example, might require a full point penetration and ignore fractional moves. There is tradeoff involved in the use of any type of filter. If the filter is too small, it won't be very useful in reducing the impact of whipsaws. If it's too big, then much of the initial move will be missed before a valid signal is given. Here again, the trader must determine what type of filter is best suited to the degree of trend being followed, always making allowances for the differences in the individuals markets.
An alternative to a price filter (requiring that a trendline be broken by some predetermined price increment or percentage amount) is a time filter. A common time filter is the two day rule. In other words, to have a valid breaking of a trendline, prices must close beyond the trendline for two successive days. To break
an up trendline, therefore, prices must close under the trendline two days in a row. A one day violation would not count. The 13% rule and the two day rule are also applied to the breaking of important support and resistance levels, not just to major trend-lines. Another filter would require a Friday close beyond a major breakout point to ensure a weekly signal.
How Trendlines Reverse Roles
It was mentioned earlier that support and resistance levels became the opposite once violated. The same principle holds true of trendlines. (See Figures 4.10a-c.) In other words, an up trendline (a support line) will usually become a resistance line once it's decisively broken. A down trendline (a resistance line) will often become a support line once it's decisively broken. This is why it's usually a good idea to project all trendlines as far out to the right on the chart as possible even after they've been broken. It's surprising how often old trendlines act as support and resistance lines again in the future, but in the opposite role.
Measuring Implications of Trendlines
Trendlines can be used to help determine price objectives. We'll have a lot more to say about price objectives in the next two chap‑ters on price patterns. In fact, some of the price objectives addressed that are derived from various price patterns are similar to the one we'll cover here with trendlines. Stated briefly, once a trendline is broken, prices will usually move a distance beyond the trendline equal to the vertical distance that prices achieved on the other side of the line, prior to the trend reversal.
In other words, if in the prior uptrend, prices moved $50 above the up trendline (measured vertically), then prices would be expected to drop that same $50 below the trendline after it's broken. In the next chapter, for example, we'll see that this measuring rule using the trendline is similar to that used for the well-known head and shoulders reversal pattern, where the distance from the "head" to the "neckline" is projected beyond that line once it's broken.
Drawing a Trendline
The correct drawing of trendlines is a lot like every other aspect of charting and some experimenting with different lines is usually necessary to find the correct one. Sometimes a trendline that looks correct may have to be redrawn. But there are some useful guidelines in the search for that correct line.
First of all, there must be evidence of a trend. This means that, for an up trendline to be drawn, there must be at least two reaction lows with the second low higher than the first. Of course, it always takes two points to draw any straight line. In Figure 4.6a, for example, only after prices have begun to move higher from point 3 is the chartist reasonably confident that a reaction low has been formed, and only then can a tentative up trendline be drawn under points 1 and 3.
Some chartists require that the peak at point 2 be penetrated to confirm the uptrend before drawing the trendline. Others only require a 50% retracement of wave 2-3, or that prices approach the top of wave 2. While the criteria may differ, the main point to remember is that the chartist wants to be reasonably sure that a reaction low has been formed before identifying a valid reaction low. Once two ascending lows have been identified, a straight line is drawn connecting the lows and projected up and to the right.
Tentative Versus the Valid Trendline
So far, all we have is a tentative trendline. In order to confirm the validity of a trendline, however, that line should be touched a third time with prices bouncing off of it. Therefore, in Figure 4.6a, the successful test of the up trendline at point 5 confirmed the validity of that line. Figure 4.6b shows a downtrend, but the rules are the same. The successful test of the trendline occurs at point 5. To summarize, two points are needed to draw the trendline, and a third point to make it a valid trendline.
How to Use the Trendline
Once the third point has been confirmed and the trend proceeds in its original direction, that trendline becomes very useful in a
variety of ways. One of the basic concepts of trend is that a trend in motion will tend to remain in motion. As a corollary to that, once a trend assumes a certain slope or rate of speed, as identified by the trendline, it will usually maintain the same slope. The trendline then helps not only to determine the extremities of the corrective phases, but maybe even more importantly, tells us when that trend is changing.
In an uptrend, for example, the inevitable corrective dip will often touch or come very close to the up trendline. Because the intent of the trader is to buy dips in an uptrend, that trend-line provides a support boundary under the market that can be used as a buying area. A down trendline can be used as a resistance area for selling purposes. (See Figures 4.7a and b.)As long as the trendline is not violated, it can be used to determine buying and selling areas. However, at point 9 in Figures 4.7a-b, the violation of the trendline signals a trend change, calling for liquidation of all positions in the direction of the previous trend. Very often, the breaking of the trendline is one of the best early warnings a change in trend How to Determine the Significance of a Trendline
Let's discuss some of the refinements of the trendline. First, what determines the significance of a trendline? The answer to that question is twofold—the longer it has been intact and the number of times it has been tested. A trendline that has been successfully tested eight times, for example, that has continually demonstrated its validity, is obviously a more significant trendline than one that has only been touched three times. Also, a trendline that has been in effect for nine months is of more importance than one that has been in effect for nine weeks or nine days. The more significant the trendline, the more confidence it inspires and the more important is its penetration.
Trendlines Should Include All Price Action
Trendlines on bar charts should be drawn over or under the entire day's price range. Some chartists prefer to draw the trendline by connecting only the closing prices, but that is not the more standard procedure. The closing price may very well be the most important price of the day, but it still represents only a small sample of that day's activity. The technique of including the day's price range takes into account all of the activity and is the more common usage. How to Handle Small Trendline Penetrations
Sometimes prices will violate a trendline on an intraday basis, but then close in the direction of the original trend, leaving the analyst in some doubt as to whether or not the trendline has actually been broken. (See Figure 4.9.) Figure 4.9 shows how such a situation might look. Prices did dip under the trendline during the day, but closed back above the up trendline. Should the trendline be redrawn?
Unfortunately, there's no hard and fast rule to follow in such a situation. Sometimes it is best to ignore the minor breach, especially if subsequent market action proves that the original line is still valid.
What Constitutes a Valid Breaking of a Trendline?
As a general rule, a close beyond the trendline is more significant than just an intraday penetration. To go a step further, sometimes even a closing penetration is not enough. Most technicians employ a variety of time and price filters in an attempt to isolate valid trendline penetrations and eliminate bad signals or "whipsaws." One example of a price filter is the 3% penetration criteria. This price filter is used mainly for the breaking of longer term trend-lines, but requires that the trendline be broken, on a closing basis, by at least 3%. (The 3% rule doesn't apply to some financial futures, such as the interest rate markets.)
If, for example, gold prices broke a major up trendline at $400, prices would have to close below that line by 3% of the price level where the line was broken (in this case, prices would have to close $12 below the trendline, or at $388). Obviously, a $12 penetration criteria would not be appropriate for shorter term trading. Perhaps a 1% criterion would serve better in such cases. The % rule represents just one type of price filter. Stock chartists, for example, might require a full point penetration and ignore fractional moves. There is tradeoff involved in the use of any type of filter. If the filter is too small, it won't be very useful in reducing the impact of whipsaws. If it's too big, then much of the initial move will be missed before a valid signal is given. Here again, the trader must determine what type of filter is best suited to the degree of trend being followed, always making allowances for the differences in the individuals markets.
An alternative to a price filter (requiring that a trendline be broken by some predetermined price increment or percentage amount) is a time filter. A common time filter is the two day rule. In other words, to have a valid breaking of a trendline, prices must close beyond the trendline for two successive days. To break
an up trendline, therefore, prices must close under the trendline two days in a row. A one day violation would not count. The 13% rule and the two day rule are also applied to the breaking of important support and resistance levels, not just to major trend-lines. Another filter would require a Friday close beyond a major breakout point to ensure a weekly signal.
How Trendlines Reverse Roles
It was mentioned earlier that support and resistance levels became the opposite once violated. The same principle holds true of trendlines. (See Figures 4.10a-c.) In other words, an up trendline (a support line) will usually become a resistance line once it's decisively broken. A down trendline (a resistance line) will often become a support line once it's decisively broken. This is why it's usually a good idea to project all trendlines as far out to the right on the chart as possible even after they've been broken. It's surprising how often old trendlines act as support and resistance lines again in the future, but in the opposite role.
Measuring Implications of Trendlines
Trendlines can be used to help determine price objectives. We'll have a lot more to say about price objectives in the next two chap‑ters on price patterns. In fact, some of the price objectives addressed that are derived from various price patterns are similar to the one we'll cover here with trendlines. Stated briefly, once a trendline is broken, prices will usually move a distance beyond the trendline equal to the vertical distance that prices achieved on the other side of the line, prior to the trend reversal.
In other words, if in the prior uptrend, prices moved $50 above the up trendline (measured vertically), then prices would be expected to drop that same $50 below the trendline after it's broken. In the next chapter, for example, we'll see that this measuring rule using the trendline is similar to that used for the well-known head and shoulders reversal pattern, where the distance from the "head" to the "neckline" is projected beyond that line once it's broken.
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