Types Of Trend Lines in Forex Trading

Trends and Trend lines

Types of Trends

Trends are used to determine the relative direction of prices in a market over different time periods. The ability to first determine a trend direction is the basis of technical trading. There are mainly three types of trends: Primary (long-term), intermediate (medium-term), and short-term.

Primary trend: Generally lasts between 9 months and 2 years. This is the major trend.

Intermediate trend: Within a primary trend, there will be counter-cyclical trends, and such price movements form the intermediate trend. It generally lasts from 6 weeks to as long as 9 months.

Short-term trend: Just like the intermediate trend interrupts the primary trend, the short-term trend interrupts the course of the intermediate trend. It generally lasts from 1 week to as long as a month. In Forex, short-term trends are a good way to trade because there are many explosive short-term price movements that can lead to significant profit opportunities.

Identify the primary trend, the intermediate trend, and the short-term trend, and then construct your trades in that direction, based on the time frame used in your trading approach.

A very important thing to keep in mind is this: “The trend is your friend until the end”. It pays not to go against the trend unless you have reversal signals based on technical or market sentiment.

Trend Directions

Uptrend - In an uptrend, the base currency appreciates in value. It is characterized by a series of higher highs and higher lows.

Downtrend - In a downtrend, the base currency depreciates in value. It is characterized by a series of lower highs and lower lows.

Sideways – The currency prices are moving within a narrow range, and are neither appreciating or depreciating in value.

What is a Trendline?

Trendlines are one of the most simple, yet effective tools of technical analysis. As a market moves in a series of waves, with periods of expansion and contraction, peaks (tops) and troughs (bottoms) will form, and along these points, trendlines are drawn. Trendlines can be horizontal in a trading range, or ascending in an uptrend, or descending in a downtrend. Trendlines act as support or resistance in themselves and act as a graphic way of representing the underlying trend.

How to Use Trendlines with Currencies?

In order to draw an up trendline, you draw a line connecting a series of bottoms. Your line need not necessarily connect all the bottoms of the uptrend, as long as it connects a minimum of two bottom points. This becomes your up trendline, with the trendline acting as support.

Figure 1 shows a daily chart of NZD/USD with an up trendline. The blue arrows indicate higher highs while the red arrows indicate higher lows, representative of an uptrend.

Figure 1

In order to draw a down trendline, you draw a line connecting a series of peaks, and again, your line may not necessarily touch all the tops of the downtrend, as long as it connects a minimum of two rally points. This forms your down trendline, with the trendline acting as resistance.

Figure 2 below shows a daily chart of NZD/USD with a down trendline. The red arrows indicate lower highs while the blue arrows indicate lower lows, representative of a downtrend.

Figure 2

From experience, I find it more useful to connect the highs or lows of candles, rather than to construct trendlines using closing prices.

Trendline Breaks

An up trendline represents points of support, whereas a down trendline represents points of resistance. Hence, when these lines are violated, there are two implications for the future course of prices. A trendline break could signal a reversal or continuation of trend. In the case of trend continuation, this break may indicate a temporary interruption in the prevailing trend or signal that the trend will continue, but at a slower pace.

How can you tell whether it is signaling reversal or consolidation? You can't really tell from trendline breaks alone, but if you can combine with other chart patterns like a head-and-shoulders pattern (which you will learn in another lesson), you will have a better chance of predicting the outcome.

Figure 3 below shows a weekly chart of NZD/USD. The up trendline is also the neckline of a head-and-shoulders pattern. While the H&S is in the process of completion, it gives you a clue about a possible trend reversal should this up trendline breaks. After an initial false break, the NZD/USD finally broke decisively below this trendline/neckline, and the trend reversed.

Figure 3

Usually, an initial trendline, especially if drawn on a long-term chart (e.g., daily chart), will give way to either a steeper or shallower second trendline over time, and the second trendline may then later give way to a third trendline.

Figure 4 below shows a daily chart of EUR/USD. A is the first down trendline, and when the price broke above trendline A, there was a period of consolidation, before the downtrend resumed at a slower pace, and that was when the second down trendline B was formed. When the price broke above trendline B, it again interrupted and slowed the downtrend, and gave rise to the third down trendline C. As you can observe, the trendlines subsequently became less and less steep. Eventually, the trend reversed when EUR/USD broke above trendline C.

Figure 4

Trendline Extensions

Once trendlines are violated, they tend to reverse their roles as support and resistance. An up-trendline, once violated, will become resistance, whereas a down-trendline will become support when broken. Hence, it is very useful to extend your up or down trendlines even after they have been violated because then you can see the new potential barrier more clearly in future price action.

If a trendline has been very strong support or resistance before the break, you can expect it to be a very strong resistance or support respectively after the break has taken place.

Refer to Figure 3 again. You can see that the extended up trendline later became a strong resistance for the currency pair.

Significance Of Trendlines in Forex Charts

You can evaluate the significance of trendlines using the following guidelines:

·       Time period spanning the trendline

As with all chart patterns, the amount of time taken to form the trendline is proportional to its significance. A trendline formed over several months or years will be more significant than one that is formed over several weeks or days. A violation of a trendline that has taken a long time to form will mark a significant juncture point. Remember that big trends result in big signals, and small trends result in small signals.

·       Number of times the trendline has been approached or touched

The more times a trendline is touched or approached, the more significant that line is. In the case of an up trendline, it acts as a dynamic support line, and so with each bounce,

·       Steepness of the trendline

The steeper a trendline, the more unsustainable it is, and hence the less significant it is. Violations of steep trendlines are often followed by consolidations rather than reversals.

Trend Channels

A trend channel consists of two trendlines, which can be drawn in parallel to each other. The higher line acts as the resistance line while the lower line acts as the support. A trend channel can be upward, downward, or sideways. In an up channel, buying bounces off the support line can be a good trading opportunity. In a down channel, selling bounces off the resistance line can be a good trading opportunity.

Figure 5 shows an up channel in a daily chart of EUR/USD. Note that the two trendlines are parallel to each other and are excellent places to short the resistance and to long the support.

Figure 5

Figure 6 below is an extension of Figure 5, showing the up channel extension even after EUR/USD had already broken out of the upper line. The dotted blue line is the extension of the upper line, and the red arrow indicates that the extended upper line again became a very strong resistance, even though the currency pair had broken above and back within the up channel. The blue arrow points to where the extended lower line again became very support.

Figure 6

For an up channel, when the price breaks above the upper resistance line, one of two things is likely to happen: either the uptrend accelerates or the move is temporary (exhaustion move). The same goes for a price break below the lower support line. The steeper the trend channel, the more likely an exhaustion move will occur.