Trendlines
Trendline strategies
Trendlines are used in technical analysis to define an uptrend or downtrend. Traditionally, uptrend lines are made by drawing a straight line through a series of ascending higher troughs (lows). A trend line could also be called a ‘trend support line’ because it shows the direction of a trend, and it acts as a support line, similar to that discussed in the introduction to support and resistance section.
In the case of downtrends, trendlines are formed by drawing a straight line through a series of descending lower highs. See figures 1.1 and 1.2 for examples of down and up trendlines. It is usual practice to join the highs or lows (wicks) of the candlesticks and not the closing prices.
Uptrend and downtrend examples
Figure 1.1 – A trendline (in a downtrend) set through the highs
Figure 1.2 – A trendline (in an uptrend) set through the lows
Common trendline and channel rules
The following rules are usually applied to trendlines and channels:
1. Declines in price that approach an uptrend line, or price rises that approach a downtrend line, are often good opportunities to initiate positions in the same direction as the trendline.
2. The penetration of an uptrend line, particularly on a closing basis, is a sell signal, and the penetration of a downtrend line is a buy signal. Normally, analysts apply a minimum percentage price move (1% breach on a stock for example) through the line or a minimum price move.
According to rule 1, as price approaches an uptrend line, the trendline (if it’s a valid one) tends to act as a support, so one would tend to buy as price approaches the line. Please note that it must not be breached. If a trendline is cut through, then we can say in effect that a support has been breached and we should act as we would if it were a normal support break.
Conversely, downtrend lines tend to act as resistances. One would usually sell as price approaches the line — again it must not be breached. In figure 1.3 you will notice our entry points would be chosen with this in mind, providing ‘cheaper’ buy-in levels in an uptrend, nearer the trendline, and in a downtrend, providing higher levels to sell into a downtrend.
Figure 1.3 - Setting orders using trendlines in a downtrend
The ‘sell’ points in figure 1.3 represent the ideal ‘sell’ orders which would tend to cluster near and underneath a downtrend line. The reason they have to be underneath and NOT above is that a downtrend line acts like a resistance line. Price action above the line would, by definition, be a ‘technical break’ over the line, which would mean a trader could expect a short term spike up and should be looking to exit short trades rather than enter them.
Figure 1.4 - Setting orders using a trendline in a downtrend, with a technical breakout
In figure 1.4 you can see an example of a downtrend and trendline for most of the chart, with the ideal selling points (shown to us by the trendline) throughout the course of the downtrend. Then, as all good trends do, the trend comes to an end with the break of the downtrend line and resultant short term spike up that follows.
Please note: your Tracker chart software allows you to draw your own trendlines. You can find this capability in the drawing tools section of the chart function.
A warning about trendlines and charts in general
Changes in trend speed may necessitate the redrawing of the lines. This is particularly important if they are breached temporarily, only to resume the trend, as this could make the lines themselves unreliable. While penetrations of trendlines often warn of a trend reversal, a breach usually also means you will need to redraw a trendline. See figure 1.5 below for a graphical representation of this. It is not enough to show a trendline that works — it is important that the trend method also works.
Figure 1.5 - Which trendline is the correct one?