How to Drawing a Trendline in Stock Market

TRENDLINES

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.

Figure 4.6a Example of an up trendline. The up trendline is drawn under the rising reaction lows. A tentative trendline is first drawn under two successively higher lows (points 1 and 3), but needs a third test to confirm the trendline (point 5).

Figure 4.6b A down trendline is drawn over the successively lower rally highs. The tentative down trendline needs two points (1 and 3) to be drawn and a third test (5) to confirm its validity.

Figure 4.6c Long term up trendline at work. The up trendline was drawn upward and to the right along the first two reaction lows (see arrows). The third low at the start of 1998 bounced right off the rising trendline, thereby keeping the uptrend intact.

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 trend­line 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 of a change in trend.

Figure 4.7a Once the up trendline has been established, subsequent dips near the line can be used as buying areas. Points 5 and 7 in this example could have been used for new or additional longs. The breaking of the trendline at point 9 called for liquidation of all longs by signaling a downside trend reversal.

Figure 4.7b Points 5 and 7 could have been used as selling areas. The breaking of the trendline at point 9 signaled an upside trend reversal.

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. (See Figure 4.8.)

Figure 4.8 The correct drawing of a trendline should include the entire day's trading range.

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?

Figure 4.9 Sometimes an intraday violation of a trendline will leave the chartist in doubt as to whether the original trendline is still valid or if a new line should be drawn. A compromise is to keep the original trendline, but draw a new dotted line until it can be better determined which is the truer line.

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 trend­lines, 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 1- 3% rule and the two day rule are also applied to the breaking of important support and resistance levels, not just to major trendlines. 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 chapters

Figure 4.10 Example of a raising support line becoming resistance. Usually a support line will function as a resistance barrier on subsequent rallies, after it has been broken on the downside.

Figure 4.10b Very often a down trendline will become a support line once it's been broken on the upside.

Figure 4.10c Trendlines also reverse roles. On this chart, the broken up trendline become a resistance barrier on the following rally attempt

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.

THE FAN PRINCIPLE

This brings us to another interesting use of the trendline—the fan principle. (See Figures 4.11a-c.) Sometimes after the violation of an up trendline, prices will decline a bit before rallying back to the bottom of the old up trendline (now a resistance line). In Figure 4.11a, notice how prices rallied to but failed to penetrate line 1.

Figure 4.11a Example of the fan principle. The breaking of the third trendline signals the reversal of a trend. Notice also that the broken trend­lines 1 and 2 often become resistance lines.

Figure 4.11bThe fan principle at a bottom. The breaking of the third trendline signals the upside trend reversal. The previously broken trendlines (1 and 2) often become support levels

Figure 4.11c Fan lines are drawn along successive peaks as shown in this chart. The breaking of the third fan line usually signals the start of the uptrend.